LA MEDIDA DEL DOMINIO AFECTIVO MATEMÁTICO

As I see it, there is no excuse for the way in which certain banks used conduits and structured- investment vehicles in order to avoid capital requirements for holding asset-backed securities and to avail themselves of extra returns from maturity transformation. Hardly a risk in banking is as well known as the risk that is taken if one tries to earn money by using relatively cheap short- term funds to finance a longer commitment. Recent decades have provided many examples. The bankers involved must have known that a conduit with hardly any equity capital that issued commercial paper to finance the holding of long-term asset-backed securities was basically a time bomb waiting to explode. The question is why they engaged in this operation anyway. One answer to this question is provided by Table 2 above: From 2002 to 2004, yield curves were very steep. Money market rates – and commercial paper rates! – were significantly below two percent, ten-year treasury rates between four and five percent, ordinary mortgage rates around six percent. The margin between the interest rates on ordinary mortgages and the interest rates on short-term securities was on the order of four to five percentage points. Such a margin provided an enormous temptation to “play the yield curve”, i.e. to borrow short in order to lend long. For many institutions, this temptation was too much to resist. Yield mania and yield panic blinded them to associated risks in their refinancing choices as well as in their investments in asset- backed securities.

In this context, the monetary policy of the United States must take some of the blame. The low money market rates in 2002 – 2004 were largely the result of the Federal Reserve Bank’s trying to counteract the macroeconomic effects of the stock market downturn that had begun in March 2000 and accelerated after September 11, 2001. Given the downturn that was occurring, the Fed- eral Reserve Bank’s activism may have been understandable, especially in view of the fact that 2004 was going to be an election year. Already twice before under the Chairmanship of Alan Greenspan, the Federal Reserve Bank had engaged in such activism, first, by flooding the mar- kets with liquidity after the 1987 crash, and, second, by lowering money market rates in 1990 when US commercial banks appeared to be on the threshold of a major crisis;102 from 1990 to 1994, monetary policy enabled the commercial banks to rebuild their equity, earning record prof- its one quarter after the other by playing the yield curve.

A closer look at both these episodes would have shown that such activism was not without risks: There are good reasons to believe that the quandary of US commercial banks in 1990 had been caused by a combination of excessive lending in 1988, when monetary policy was extremely easy, and the interest rate increase in 1989, when recognition of the inflation that had been fu- elled in 1988 induced the central bank to step on the brakes. There are also good reasons to be- lieve that the financial turbulence that followed the relatively small interest hike in 1994 was largely due to the interest rate vulnerability of institutions that had been playing the yield curve. Thus, in both episodes, a phase of monetary ease seems to have induced behaviour that made

financial institutions vulnerable to the effects of monetary tightening. However, this lesson from these earlier episodes seems to have been overlooked.103

To some extent, the willingness of banking institutions to engage in maturity transformation through conduits and SIVs may also have been due to their underestimating their own commit- ments in these ventures. After all, they were separate legal entities, with assets and liabilities that were kept separate from the sponsoring institutions’ balance sheets. Commitments to provide liquidity in case of need were not put into balance sheets either; presumably, such commitments did not have to be put into the accounts if the sponsoring bank’s management considered it more likely than not that the commitment would not be called upon. In the crisis, of course, the com- mitments were called upon, and some banks found that, for the sake of their reputations, it was necessary to accept liabilities of their conduits and SIVs even beyond their own legal obligations. As a naïve academic, I have been wondering why commitments to provide liquidity in case of need would not have fallen under the prohibition of excessively large loans to single clients, at least for those institutions where such prohibitions are an integral part of prudential regulation. In Germany, for instance, the law stipulates that loans to a single client must not exceed 25 % of equity capital. A loan of more than four times the equity capital is not compatible with this regu- lation, yet, this is what Industriekreditbank and Sächsische Landesbank promised to provide to their conduits in case of needs. A lawyer might argue that a promise to provide such a loan is not the same as the loan itself, that the promise has been a conditional one, that it has been split into multiple smaller promises, and that all these considerations make a difference in law. In sub- stance, these considerations do not make a difference, and, to me, these banks’ promises of li- quidity assistance to their conduits smack of illegality.

In the end, of course, conduits and SIVs turned out not to be so independent after all, but had to be taken onto the sponsoring banks’ balance sheets. This outcome suggests that it would have been better to treat them as integrated subsidiaries from the very beginning, i.e., to enter their assets and liabilities into the sponsoring banks’ balance sheets. At the very least, this would have improved transparency about their doings. It would also have forced the sponsoring banks to put equity capital behind these institutions’ holdings of asset-backed securities. This might have slowed their growth and diminished the danger they posed for the system.

103 If the turnaround in US residential real-estate markets is seen as being induced by the tightening of monetary policy in 2005 and 2006 (see Table 2), then at least the onset of the current crisis can be said to have fol- lowed the same pattern as the earlier crises. However, it seems hardly appropriate to blame the crisis on tight monetary policy in 2005 and 2006; the development that I have described above seems like a bubble that was bound to burst sometime. As for Japan in 1991, the tightening of monetary policy merely provided the pin- prick.

4.9 Excessive Confidence in Quantitative Models as a Basis for Risk