Analogies and the current crisis

The current crisis is like:

• LTCM and the Asian crisis in 1998;
• the S&L crisis;the Scandinavian crisis of the early 1990’s;
• the 1907 credit crunch;
• the Latin American crisis;
• none of the above.
  

This credit crunch is like all of these crises and it is also like none of them. Nevertheless, we like to extrapolate from the past and form analogies to past events especially if we had some experience with them. It is part of our human nature to think through analogies. While there are similarities with all of these crises, our power of explanation is tied to our ability to find both commonality and uniqueness in these cases. This represents our creativity. The wrong analogy could be more costly than no analogy because we may extrapolate the wrong answer. The correct analogy will allow us to capitalize on the opportunities that will present themselves.

One of the key issues is determining the type of problem that exists. Here are some generalizations concerning credit crunch / liquidity crises which seem to be apparent from all analogies to the past. However, explaining the past is a lot different from forecasting the future and this is where poor analogies often breakdown.

Discovery consists of seeing what everybody has seen and thinking what nobody has thought.
– Albert Szent-Gyorgi

First, the commonality:

• Decline in asset prices from a change in economic conditions. In this case a slowdown in the housing market and rising interest rates.
  
• Credit crisis are usually preceded by rising interest rates, a slowdown in credit expansion. Tighter liquidity leads to tighter credit conditions.
  
• Herding behavior by one or more groups is present. Everyone is hit by greed through buying securities that are believed to be cheap on a relative basis or gaining access to credit which would not be given during other times. deviations from fair value are rationalized away as the old paradigm.
  
• One-sided markets exist when prices decline. Change in expectations or risk create a lack of buyers in the market. The herd changes direction and prices have to fall to induce new buyers.
  
• Significant decline in price from fair value. These deviations are deep and may last for a long time. There is a risk premium for providing liquidity.
  
• Change in lending practices either through the market or through regulatory process. The structure of lending changes. The old ways of lending are gone.
  
• Significant increase in defaults often in places not usually expected. The defaults move beyond the problems of the initial declining asst class. Contagion will occur.
  
• Leverage increases the size of the problem through increasing the sensitivity to price changes. Leverage is affected by the cost of borrowing.
• The extent of the problem is associated with the behavior of central banks. Continued tight credit leads to a more severe problem. The Great Depression was more severe because of a lack of liquidity and tight central bank policies.
  
• The work-out period could be years.
  

There are also unique risks which we have not seen in other crisis which have to be addressed.

• Securitization of risk. Risk is dispersed across a wider group of investors. This increases the surprise factor in the market.
  
• Risks held in securities thought to be liquid. Sub=rime loans were usually considered a special area of bank lending and not something that could be structured in liquid instruments. The pricing of securities is very different in a securitization versus a bank which may hold loans at book value.
  
• Greater decoupling between lender and borrower. Less regional risk, but risk can appear around the world from a local problem. The lender does not know the borrower and is less likely to be able to conduct a work-out. There is less incentives for a work-out given the disperse nature of the security holders. Who will run the process of a work-out?
  
• Greater reliance on rating agencies. Due diligence was given to the rating agency and not the buyer.
  
• This crisis is not yet associated with a business downturn. This crisis has not be preceded by strong business decline. A recession could be the ultimate stress test.
  

What is the right analogy? While every crisis has been unique, securitization makes this time different from other crises. Extrapolating into the future, not just reporting about the past, is perilous.