Market failure and mark-to-market: anatomy of crisis
by George Hatjoullis
The concept of market failure has been a constant theme running throughout the blogs. The blog ‘Regulating financial markets and moral hazard: self-inflicted wounds’ illustrated the importance of the speculator in the functioning of markets and in particular the provision of liquidity. It illustrated how the authorities can distort speculative behaviour. Now for my most shocking declaration; speculators do not cause financial crisis. To grasp this one must re-read the previous blog and think again about the concept of liquidity. Ideally a market needs many buyers and sellers. No one agent can determine the market price. It evolves from a constant stream of activity. The buyers and sellers should be continuously well-informed about the product. There needs to be a continuous two-way flow of interest. Speculators are well-informed and typically two-way. It is the speculators that provide this liquidity.
Consider what happens when liquidity dries up. A seller with large holdings cannot sell the whole supply at the so-called market price. A small amount only may be bid at the so-called market price and any attempt to sell could drive the price much lower. This is precisely how a market failure appears (it works in reverse as well). The market becomes one-way. The market price ceases to be meaningful and becomes arbitrary. It is usually the last trade. However, the last trade may have been a long time ago and for a very small amount. Behind this lack of liquidity there may be large holdings which need to be bought and sold but in the absence of a market the transactions can only occur on a bilateral basis, if then. How does this situation arise? Fear and a lack of transparency.
It may be the counterparty rather than the product that initiates the failure. There may be concern that there is a counterparty that is about to fail e.g. Lehmans). No one knows which one it is so everyone holds back. It may be the product or class of products (e.g. eurozone sovereign bonds). The important point is everyone stops trading for a moment and the price is arbitrary and small trades generate dramatic price shifts (usually downwards). Note the speculators have not caused this. It is something else that has caused the counterparty and product fear. It is the absence of normal speculative activity that leads to the market failure. The problem is that market failure is infectious. It might be best to use models of epidemiology to study market failure.
Enter mark-to market. This expression refers to using market prices for asset valuation and risk management exercises. It is most common with assets that are normally traded in well-functioning markets. Needless to say even a brief period of non-functioning can have catastrophic results. One mechanism through which problems in one market can ‘infect’ other markets arises through mark-to-market. The market for product A fails. The price forces those that have exposure to this product to adjust. The adjustment however can create concern in other product areas or with other counterparts and lead to other market failures. The system can then quickly implode with perfectly healthy counterparts and products all sucked into the vortex. One important circuit breaker for financial markets is knowing when to switch off the mark-to-market mechanism. Unfortunately, regulators worldwide have proved not to be up to this task. It is lazy, box-ticking regulation.
One of the most problematic areas in which this general discussion has come to apply is the bank balance sheet and specifically bank loans. The practice of ‘securitising’ loans and selling them in various sliced and diced packages has created markets for loans. This has allowed concepts of mark-to-market to creep into risk monitoring and valuation. The most useful way of judging a loan is performance and not market value. Are the terms of the loan being met? Fine, but what if they are not? Provision against the loan (this should always be done right from the start). The problem for the regulator is how to assess whether provisions for a specific bank are adequate, in aggregate, and thus whether capital is adequate. You can see how sticking a market price on the loan book cuts out a lot of work. Unfortunately market price is useless precisely when you need it; in a crisis!
The example of bank loans may seem slightly unfair but it does illustrate the point. Let us look at it directly from the regulatory failure point of view; Cyprus banks. The PIMCO report on Cyprus banks (a link is available in an earlier blog) was somewhat poor in its quantitative assumptions but did lay bare the problem of Cyprus banking; stupid banking practices. The loans of Cyprus banks took little note of capacity to service the debt but rather focused on cross guarantees and collateral. Interest was often not paid (let alone the principal) and simply added to the loan. So long as the collateral value grew in line with interest no one worried. In fact interest added to the loan was, apparently, often booked as income. The regulator seemed unaware/unconcerned. A little mark-to-market might actually have woken up this system as any semi-intelligent buyer would have built a huge discount into the price of such loans. There was no mark-to-market and no oversight. The real problem was the lack of oversight. The regulations should be able to spot when someone is borrowing to pay interest. When the whole system is working this way you have a problem! Today Cyprus banks have been recapitalised using the funds of the hapless uninsured depositor but the loans are still there. If the bank forecloses it ends up with a lot of property and bankrupts a lot of relatives that cross guaranteed the loans. This just depresses the loan performance further. Cyprus banks will need more capital before the crisis ends.
From the earlier blog one can see that authorities can create market failure by distorting risk perceptions. They then allow the failure to spread through excessive reliance on market prices in the regulatory process. They then blame speculators who by virtue of some being successful are an easy target and are joined in this endeavour by the press and general population at large. The great puzzle is how the general population is still unaware. The Cyprus banking crisis perfectly illustrates that the great banker bailout was not a banker bailout. It was a bailout of uninsured depositors (and senior bondholders). If the UK government had not stepped in then everyone that had a bank deposit with funds in excess of the insured amount (£50k at the time) would have lost money. Indeed given it was a system wide problem even the insured amount was at risk. Bank shareholders lost money. Bank employees lost jobs and bonuses (though a few well publicised cases did not). Uninsured depositors lost nothing in the UK. Reality is clearly relative.