The Shadow Knows
The Shadow Financial Regulatory Committee, that is. They meet quarterly, under the auspices of the American Enterprise Institute, and their latest meeting took place while the real financial regulators were deciding to let Lehman walk the plank. Today, shortly after noon, the Shadow supported that decision.
The Q&A was lively. The best question got the best answer. Cato’s Bill Niskanen asked what was the difference between Bear Stearns, which got bailed, and Lehman, which didn’t? Peter Wallison said that markets actually have more confidence now, so they are better able to withstand a bankruptcy. The Bear implosion took everyone by surprise. But the Lehman situation took place in slow motion. Financial institutions have had time to adjust their exposures and raise capital. In March, no one knew who was in trouble and who was sound. Now, there is a consensus about who’s in trouble, and more trust in the folks who are not on everyone’s problem list. Nobody can be sure, but this view suggests that it is possible to put a firewall around Lehman, whereas that was not possible back in March with Bear.
Somebody asked about the credit rating agencies. The Shadow thinks that markets did not rely on them, although regulators did to some extent. Charles Calomiris pointed out that the Basel capital regulations favor almost any securitized debt over safer instruments. He said that years ago everyone knew that BBB structured debt defaulted at a much higher rate than BBB corporate bonds, but regulation does not recognize such differences.
Ed Kane said that the credit rating agencies do a fine job with ordinary bonds. The problem is that with structured debt their rules get manipulated. Structured debt is more volatile, but the rating agencies don’t report confidence intervals around their ratings.
The point is you should not try to fix the rating agencies. You should try to get regulators to use other measures of risk that are readily available in the market. Private investors can figure out when to use the ratings and when not to.
Calomiris says he does not think that the repo market in mortgage securities is coming back. I talked about the repo market in my previous post.