Boom to bust: are we there yet?

Post-mortems by their nature are sombre affairs.

But it would perhaps be comforting to investors if a formal post-mortem into the great credit crunch of 2007-08 was underway because that would at least signal the worst was behind us and we could begin to learn from past mistakes in order to (hopefully) not repeat them again.

But while there is no shortage of academic and regulatory analysis into the credit crunch it seems far too premature given recent market gyrations to consign this particular financial crisis to the history books.

More than 11 months into the credit and liquidity crunch sparked by the sub-prime mortgage mess in the US it is however illuminating to understand how some of the world's central bankers and regulators are seeing events unfold.

The Australian Reserve Bank this month hosted a conference on Lessons from the Financial Turmoil of 2007 and 2008 and papers from that conference are available on the Reserve Banks website and while they are hardly a ripping bedside read they are rich in insight into the issues the central banking brains trust has been grappling with.
Now financial crises tend to share common elements - such as rising levels of debt - yet exhibit distinctive and often innovative ways of delivering us to a position of high risk with the inevitable correction following some time after.

One interesting paper at the Reserve Bank conference was delivered by Ben Cohen and Eli Remolona from the Bank of International Settlements. The paper, their personal opinion rather than representing the bank's position, makes some telling observations.

It confirms the origins of the crisis as the development of debt instruments like the collateralisd debt obligations (CDOs) which were widely used in packaging the debt associated with US sub-prime mortgages. Cohen and Remolena make the point that in the 1990s the development of these types of instruments helped distribute risk but that in recent years the scale and variety of the instruments meant that even the most sophisticated dealers and investors could not manage or even understand the risks underlying them.

Add that to an environment when large institutions and banks had an increasingly voracious appetite and tolerance for risk and investors also slackening their demand for disclosure proved a debt-fuelled, high risk financial cocktail. Yet not all banks fell into the trap suggesting that the huge losses were far from inevitable if proper risk controls had been in place.

Why is this financial crisis proving so stubborn to put behind us? One explanation offered is that while it began as a credit crisis it quickly became a liquidity crisis and that possibly explains the depth and duration of the event. The fact that risk - even for professional bankers - is so difficult to price because of the opaque nature of these instruments continues to compound the problem.

It still seems ironical that instruments meant to spread risk actually had the opposite effect of concentrating it with catastrophic consequences for some organisations.
The bankers also touch on two other key issues - what they describe as "perverse incentives" that contributed to the crisis and also the role of credit rating agencies.
Clearly credit rating agencies failed to properly identify the risks and the Financial Stability Forum - an arm of the Bank of International Settlements - has recommended that they improve both information quality and also disclosure of conflicts of interests so investors are better informed. Credit ratings were an important catalyst because without a high rating these opaque instruments would have been almost impossible to sell.

Ratings aside investors are also reminded the need to take responsibility for their own due diligence and independent decisions.

There is no doubt the credit crunch has some way to run yet but the unwritten message out of the Reserve Bank conference is that regulators are getting a better understanding of what caused the issue and bankers, financial institutions and credit agencies should all be expecting a new regulatory world order in the future to guard against a re-run of the sub-prime contagion.