The heroes in Michael Lewis latest book The Big Short are different short sellers speculating against the lending excess in the US mortgage market in the run-up to its collapse.1 They undertake the fundamental analysis which so many financial institutions dispensed with and arrive independently at their dooms prediction.
A story of missing markets
What is eye-opening about their experience is how much these speculators were dependent on the very investment banks they speculated against. The investment banks set prices for illiquid credit default swaps more or less at will with large intermediation margins.
In one example Goldman Sachs is able to sell a mortgage credit insurance to a Californian fund at an annual premium of 2.5% and then pass on this very same risk to AIG for a mere 0.12%. Moreover, as increasing default rates in 2006 provide more and more signals about the dismal quality of many mortgage pools, short sellers find it impossible to obtain updated price quotes of their insurance (swap) contracts from the monopolistic investment banks.
The conclusion here and throughout the book is that "The world's single biggest capital market (for mortgage debt) wasn't a market; it was something else – but what?"
Indeed, transactions in the multi-trillion dollar market of mortgage securitisation generally occurred in what is called an OTC or "over the counter" market – a technical term for the opacity of inter-bank transactions. It is a far cry from the ideal market in which a large number of investors engages in a competitive price discovery process and expected trading profits become small – such as the global equity market.
Unlike equity risk, credit default risk – the second biggest macroeconomic risk of the US economy – was not traded in any centralised market at all. This meant that there was no real price discovery process in which the information and analysis of short sellers could have any price impact.
Consequences of the OTC structure
This lack of market development had important consequences. Speculators found it difficult to mark their positions to market. The illiquidity of their OTC swap contracts in turn implied that the amount of short selling capital was relatively limited. More short selling and a transparent centralised price discovery process could have accelerated the collapse of the "crazy subprime machine". Investors and market insiders alike would have been alerted by clear market signal if mortgage default swaps were competitively and transparently traded. Even captured rating agencies would have faced pressure to revise complacent ratings. For banks, the absence of an observable market price for credit default implied that much of the mortgage debt on bank balance sheets did not enter their internal risk models. As there was no price, there were no price fluctuations and hence no risk. The default risk could simply be ignored based on illusionary assumptions about low default correlations.
Investment banks had a vested interest in limiting market development. The very opacity of the OTC market was their source of large intermediation profits. The scale of these profits was clear proof for the absence of a functioning market. It is therefore not surprising that investment banks obstructed any move by regulators towards more centralised trading and clearing. But ironically, the bank's a narrow pursuit of self-interest here laid the seeds for their own self-destruction. Without functioning market prices for credit default risk they also were blind to the very same default risks on their own balance sheet until it was too late. Investment banks steamed on like the Titanic where the speed of advancement was not matched by any forward looking vision inherent in market prices.
After the sinking of the investment banking industry in 2008, we have to draw the lessons to make future banking disasters less likely.
A better market infrastructure with competitive derivative market and centralised clearing should be a top priority. Banks will again try to resist such market development. But their credibility seems compromised by the recent crisis and this should provide an opportunity for real market reform. Exchange trading should become the rule for most derivatives combined with suitable collateral standards as proposed at the G20 summit.
By contrast, market development is hardly served by new restrictions on market access like the outright banning of so-called naked swap contracts.2 The EU draft law on derivative markets promised by July 2010 will hopefully marks a leap into a more market-based and less bank-centric financial system. Thus one legacy of the subprime crisis could be a big boost to financial market development.
Competitive markets, risk management and governance
Just as radar has made iceberg collisions rare, more informative market prices on default risk can support better bank risk management and more effective bank governance.3 Shortcomings in both before the crisis are related to the opacity of the OTC structure. Market prices often alert even the outsider to an upcoming problem or risk before it is too late. The recent emergence of a centralised credit default market on sovereign bonds is a good example. Not even the most unsavy bank board member can ignore a market price which gives a default probability of 30% to Greek debt.
Unfortunately, no such observable price existed for US mortgage debt in 2005 or 2006. The most important market failure, therefore, was a missing market: a centralised market for mortgage default risk did not exist.
1 Lewis, Michael (2010), The Big Short : Inside the Doomsday Machine
2 Duffie, Darrel (2009), “How Should We Regulate Derivative Markets?”, PEW Financial Reform Project, Briefing Paper #5.
3 Hau, Harald and Marcel Thum (2009), “Subprime Crisis and Board (In)Competence: Private versus Public Banks in Germany’’, Economic Policy, Vol. 24(60), 701-752.
Lewis, Michael (2010), The Big Short : Inside the Doomsday Machine