Sunday, 28 September 2008

Market Fallacy #1: the blame lies with the regulators

This is the one that really irritates me. Over the years, many in the financial services community have lobbied against government-sponsored regulation of the markets. Their reasoning is that the markets are perfectly capable of regulating themselves. This of course is a fallacy of the highest order and a most perverse lie.

After years of successfully lobbing for de-regulation of the capital markets, spreading the message that governments should let business get on with it and stop interfering, now investment bankers are going cap in hand to our governments in the US and UK asking to be rescued. It is a sickening joke.

It is unlikely you will read this anywhere, but let me share a secret with you: the UK regulator, the Financial Services Authority (FSA) did warn the industry in January 2007 that we were likely to experience a repricing of credit risk, a reappraisal of credit risk premia, and the consequent effect of more restrictive liquidity conditions.

Every January, the FSA publishes a wonderful document called Financial Risk Outlook. It is a risk assessment of the next 12-18 months. It is a very valuable document –if you read it. Sadly, the patronising, arrogant, over-paid tossers that rule many financial services companies in the UK do not accept that the regulator may come up with anything worth reading. These business leaders think that the FSA is staffed by a bunch of inexperienced civil servants that cannot get a job in the industry proper. Recent events have shown that the FSA may have very good people in its ranks. Like the people that produce these annual reports.

But read on and draw your own conclusions. These are extracts of the Financial Risk Outlook 2006, 2007 and 2008.

FSA FRO 2006: (pdf)

Given the current environment of high liquidity levels, it is important that market participants consider how they would operate in an environment where liquidity is restricted.
In addition, some societies have started originating ‘sub-prime’ loans. There is a risk here that the risk/reward equation for these loans is not being assessed correctly by firms which have little previous experience of operating in these markets.

FSA FRO 2007: (pdf)

The combination of low volatility, high correlation and a historically low level of risk premia brings with it an inherently high likelihood of a major shock, especially if an event were to occur that triggered a significant deterioration in market sentiment.
In addition, global imbalances have continued to widen while investors’ willingness to take risks has increased. This means that even a modest deterioration in the economic environment could lead to an increase in risk premia, and have disproportionate effects on financial markets.

And there was a whole section dedicated to the repricing of risk scenario (p33):

Risks for firms and markets
• If economic conditions were to deteriorate, risk aversion among investors could increase and they could seek to liquidate positions in higher-risk asset classes (as was seen in May/June 2006 when investors sought to exit emerging markets and commodities). This could lead to crowded exits, draining liquidity from the market and causing erratic price swings in commodities, emerging-market equities and debt, and high yield debt.

• Volatility across the markets could increase for a prolonged period of time, resulting in a lasting aversion to higher-risk assets and more complex strategies and products. Volatility could quickly spread to other markets and to assets with lower risk premia.

• The fact that many asset classes and investment strategies that have traditionally tended to be weakly correlated are now more strongly correlated with each other could exacerbate the impact of this scenario on investors, as most of their portfolio will be re-priced in the same direction. Firms could see their balance sheets deteriorate quickly as the values of their portfolios fall.

Later on in the document:

Market liquidity remains abundant (irrespective of how it is measured), but it
is still important for market participants to consider how they would operate in
an environment where liquidity is restricted.

FSA FRO 2008: (after the start of the credit crunch and the nationalisation Northern Rock, pdf)

There is a risk that credit conditions could tighten further over the next 18 months, further exacerbating the already stretched financial market conditions. Financial market volatility is likely to remain high as the financial markets return to a new equilibrium.
It is likely that liquidity conditions will remain tighter and that financial markets will not return to the conditions market participants have got used to in recent years.
Liquidity conditions in money markets deteriorated in August 2007 as banks began to store liquidity and became increasingly reluctant to lend to each other in light of
concern over the extent of subprime exposures. Accordingly, term LIBORs rose quickly in both the dollar and the sterling markets to reflect tightening conditions.
As credit conditions tighten, the lending industry could become more concentrated. In particular, those who rely on wholesale funding could find it difficult to satisfy demand for loans given funding and pricing pressures.

So there you have it. The regulator asked firms to ensure their stress-testing models included a reappraisal for credit risk premia and a change in liquidity conditions. Many firms ignored the FSA’s warnings and now are being nationalised or bought over by competitors, reducing consumer choice. First, Northern Rock, then HBOS was rescued by LloydsTSB, then this weekend Bradford & Bingley is also going to be rescued by the government (ie: taxpayer).
Who will be next? Who knows. Alliance & Leicester has already been bought by probably Britannia (a "safe" building society!) could be next.....

But what we know for sure is that we were all warned about it, and most market participants did nothing at all to prepare their firms, or their mutual funds, for the scenarios highlighted by the FSA in 2007 and 2008.

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