This summers market turmoil was foreseeable. You just had to know where to see the signs.
Orin Kramer knew where to look. In a prescient speech he delivered April 23, Mr. Kramer general partner of Boston Provident LP and chairman of the New Jersey State Investment Council, which oversees the $80 billion New Jersey Division of Investment raised the prospects of a liquidity crunch. His full comments are available at www.pionline.com/kramer.
He said lax underwriting standards for home loans, particularly from the subprime area, could call the quality of credit ratings in general into question. If so, the ripple effects across other levered portfolios could exceed the imagination of some market participants, he said.
In his speech, Mr. Kramer asked whether the explosion of derivative products such as collateralized debt obligations the new financial architecture, he calls it had lulled investors into a false sense of security.
For one thing, there is a paucity of empirical data on how structured credit products and credit derivatives could behave in different environments, he noted. Has the availability of credit derivatives letting structured product originators offload their risk changed underwriting incentives in a way that makes credit performance data less relevant?
Will correlations between different credit markets once thought unrelated show greater linkage in an economic downturn now that multiple structured and derivative products tie diverse credit sectors together in new complex and non-transparent ways precisely because they were historically unconnected? he asked.
Whats more, creators of some credit derivative products have a moral hazard. They collect a premium for writing such insurance, but those bets can backfire during volatile market conditions. Worse, some managers may believe that they are actually creating value while really just selling underpriced insurance, he added. Meanwhile, rating agencies generate fees by collaborating with the makers of these products, he said.
Risk models, Mr. Kramer added, afford little protection because they typically predict the future distribution of returns based on past outcomes. But managers have had to jack up leverage as opportunities decreased. Managers not adopting recently successful strategies such as shorting volatility and owning credit exposure underperform their benchmarks and appear paranoid, he said.
History suggests that in the not-distant future, the paranoid, if they still have assets under management, will become fashionable, Mr. Kramer explained. The reversal will involve a steep rise in risk perceptions, declining prices and higher volatility as players reduce their exposure to losses. The ensuing margin calls and contracting risk appetites will create contagion effects, deepening the spiral. Shades of August.
Investors presume that moving credit risk outside the banking system is a good thing, stabilizing market conditions. But the flip side, Mr. Kramer said, is that traditional lenders now pay less attention to credit risk, new debtholders lack credit expertise, risk exposures are unregulated and unknown, and the amount of leverage used by holders of credit is unknown.
Meanwhile, structured product originators, aided by the rating agencies, continued to crank out new products. When the chickens came home to roost, a lot of that product was repriced by the market.
In sum, Mr. Kramer asked whether the new financial architecture provides as strong a foundation for markets as what existed in the past. Its a question worth asking.