This article is a guest contribution by Richard Clarida, EVP, Global Strategic Advisor, PIMCO.
âThe âNew Normalâ...turns out to be a world where scenarios move from impossible to inevitable without even pausing at improbable. Flocks of black swans go winging by with a frequency that is dulling our sensitivity to just how extraordinary these financial times are. Call it crisis fatigue.â
â Mark Gilbert, Bloomberg, June 2010
July 2010 marks the third anniversary of the onset of the global financial crisis. No, Iâm not celebrating and I donât know anyone who is. But anniversaries â even those associated with disruptive events â serve the useful purpose of reminding us to ask ourselves what we know now, what we donât yet know and what we can never know about major historical events. This is especially important today because, like generals plotting military victories, policymakers and regulators â as well as the legislators drafting laws that will govern their actions â have every incentive to âfight the last warâ and fight it well. In fact â at least in the U.S. â the track record posted by policymakers in fighting the last war is impressive. But while some experts may be reassured that we have learned how to avoid another Lehman Brothersâstyle disaster, it should also give them pause to remember a few other moments:
- Twenty years ago we learned how to avoid another savings and loan crisis;
- A dozen years ago we learned how to avoid another Long-Term Capital Management; and
- Eight years ago we learned how to avoid another Enron. (So far, though I fear Enron accounting may be making a comeback in certain countries as they allow national champion banks increasing accounting forbearance in an effort to buy time as they repair tattered and mismarked balance sheets.)
I recall a conversation six or seven years ago with a very senior policymaker in which he said the number one problem facing the global financial system today is hedge funds, because unlike tightly regulated banks, hedge funds are unregulated. He invited me to react (I then advised a hedge fund), to which I replied, âA hedge fund is a compensation scheme, not an investment strategy. The prop desks at all the major banks you regulate have the same trades that hedge funds have. Does this make you more or less nervous?â
Financial history suggests ânever againâ eventually becomes âthis time itâs differentâ and, as Kenneth Rogoff and Carmen Reinhart remind us, throughout history âthis time itâs differentâ eventually sets the stage for the next financial crisis. This is especially true when, as emphasized by Hyman Minsky, the âthis time itâs differentâ wisdom supports and encourages greater and greater use of leverage.
In the case of the current crisis, the âthis time it was differentâ embodied the logic that securitization and the expertise of the ratings agencies in assessing default risk in tranches of structured products could, in theory, diversify and distribute credit risk among a large global pool of sophisticated investors and away from an excessive concentration on the balance sheets of the too-big-to-fail institutions that were issuing these securities. It was supposed to be the brave new world of âoriginate and distributeâ and for a while it was, until it wasnât. An explicit assumption deployed by the rating agencies and the investment banks to price these complex structures was that default probabilities â and, crucially, their correlations â were drawn (to paraphrase Donald Rumsfeld) from an âold normalâ distribution, in which realized cash flows from different tranches would cluster close to historic means. In reality, they didnât, and hundreds of billions of dollarsâ worth of AAA-rated CDO tranches were downgraded to junk. What should have been a Six Sigma event in an âold normalâ world became an everyday occurrence in a New Normal reality.
