Zip back to the middle of 2006. Credit spreads were tightening, equity markets were buoyant and there was ample liquidity sloshing around. House prices were continuing their meteoric rise, encouraging banks to increase loan-to-value ratios and, in some cases, loosen lending criteria.
Even then, there were plenty of warnings from regulators that this couldn't continue. In its biannual Financial Stability Report, for instance, the Bank of England drew attention on several occasions to the risks posed by a blow-out in credit spreads, a sudden drying up of liquidity and possible ripple effects across the economy. In particular, it pointed to the risks posed by complex, difficult-to-value instruments such as CDOs.
The central bank noted many senior bankers shared their concerns. And here's the thing: everyone knew that much of what has occurred over the past eight months - widening spreads, a decline in the value of CDO investments, and even the collapse of some hedge funds - would happen eventually. The trick was guessing when. Any bank chief executive that insisted on pulling out of the credit market in 2005, for instance, would have lost the bank billions in missed revenue - and likely with it, their job.
(That's not to say banks were justified in loosening underwriting standards in an environment that, in hindsight, looked unsustainable, or that banks should not review their risk management controls - only that competitive pressures made it difficult for firms to step back.)
What nobody had considered, however, was that the rise in subprime mortgage delinquencies would trigger a catastrophic domino effect - in particular, the rapid de-leveraging of balance sheets and, crucially, the complete collapse of confidence among banks and investors. While Bear Stearns had racked up nasty mark-to-market losses on its mortgage portfolio, it probably would have survived the crisis had it not been for the pulling of liquidity lines by anxious investors.
Interbank rates have once again soared, reflecting reluctance by banks to lend money - that's despite six rate cuts by the US Federal Reserve and various initiatives to pump liquidity into the money markets.
All in all, things are looking hairy. Rising oil and food prices threaten to push up inflation, while at the same time the US economy appears to be heading for recession. What's more, the actions of central banks appear to be ineffective, default rates look set to rise further - and not just in the subprime sector - and the dollar is tumbling.
There are lots of moving parts to this crisis, but until confidence returns to the banking sector, it's difficult to see what will kick-start a recovery. One thing's for sure - a recovery will come eventually. Just as with the start of the crisis, however, it is a question of investors getting their timing right.
Nick Sawyer, Editor.
More on Credit Derivatives
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UBS in Australia sold off CDS portfolio in fixed income scale-back
Fears relationship between credit indexes and constituents becoming more tenuous
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