Creditflux Newsletter

It is a cliché that regulators respond to the crisis that has just happened rather than the one that is likely to happen next. But this isn’t quite true. If you look at the rules that are being put in place around the world right now, it is clear that regulators and politicians are responding to the crises they spent most of the past decade worrying about, not the very different crisis that actually turned up in 2007 and 2008.

This may not be immediately obvious because it is so hard to think back to before subprime prices started to collapse. It doesn’t help that so many pundits claim they spent the early years of this decade warning of the collapse to come. In reality they did not. Regulators, politicians and newspaper columnists did indeed make dire warnings about the future. But most of their warnings were misplaced.

Let’s look at the fears they expressed and what actually happened.

The fear: Hedge funds that trade huge notionals of liquid derivatives will explode dragging down the investment banks (as LTCM nearly did).

What actually happened: The most illiquid, bespoke and theoretically safe credit derivatives became worthless. High volume derivative markets remained liquid.

The response: 1. Increase regulation of hedge funds. 2. Force the most liquid credit derivatives to use clearing houses, but exclude bespoke trades.

The fear: Bank prop trading books will blow up.

What actually happened: Bank investment books blew up.

The response: Stop banks prop trading.

The fear: The credit derivatives market will collapse under the weight of huge notional volumes.

What actually happened: Banks collapsed.

The response: 1. Force the credit derivative market to improve transparency and efficiency. 2. Bail out the banks.

The fear: Unrated (especially European) corporate bonds will be worthless.

What actually happened: Highly rated asset-backed securities became worthless.

The response: Force the market to increase its use of ratings by embedding them into new rules and give rating agencies a regulatory seal of approval.

The fear: Covenant-lite and second lien loans will result in lower recoveries.

What actually happened: Weaker documentation loans to big companies did indeed recover lower than traditional first lien loans to the same borrowers. But across the loan market, borrower industry and size was at least as important in determining loan losses as documentation. Losses have generally been higher on loans to small companies.

The response: Force banks to increase lending to small companies.

It is remarkable how closely today’s regulatory measures correspond to pre-crisis perceptions of risk, especially concerning derivatives.

Regulators are still a long way from learning the true lessons of the crisis. The first is that overreliance on ratings encourages credit bubbles. The second is that any kind of liquidity can vanish instantly. The third lesson – and we believe the most important – is that prescriptive risk rules (such as the Basel capital regime) do not work. They discourage those who follow them from exercising judgment about risk.

Basel I, II and III, Insolvency II, Ucits III and all the rest are merely recipes for a future disaster.