John Lipsky, the IMF's David Lereah

♠ Posted by Emmanuel in , at 9/30/2007 12:08:00 AM
Recently resigned National Association of Realtors Chief Economist David Lereah is (was?) infamous for his ever-optimistic take on the state of the US housing market. His belief is best summarized by his book's title, "Why the Real Estate Boom Will Not Bust - And How You Can Profit from It: How to Build Wealth in Today's Expanding Real Estate Market." So infamous is Lereah that there's even a website critiquing his merry pronouncements of everlasting housing mirth. Unfortunately for the rest of us, while Lereah is gone, we still have to listen to another Lereah-esque character. Worse yet, he's at the IMF, the supposed guardian of the international financial system. Who will guard the guardians when the guardians are Wall St. cheerleaders?

Michael Panzer, Mr. Financial Armageddon
himself, beat me to the punch in characterizing John Lipsky--First Deputy Managing Director of the IMF and former Vice Chairman of JPMorgan Chase Investment Bank--as a competitor to Lereah in the "don't worry, be happy" sweepstakes. While Lipsky also sounded a sanguine note on US real estate by noting in January that "a more stable US housing market [has] diminished risks in the global economy," he is more famous for his easygoing prognostications on financial derivatives. You know the Wall St. line as it is identical to Lipsky's: Financial derivatives are innovations which quantify risks precisely and enable market participants to diversify risks to those who can bear them. As recent events have demonstrated, Lipsky was wrong on all three counts. First, mark-to-model and rating agency shenanigans laid waste to realistic pricing of these instruments. Second, most hedge funds have shown how un-diverse their strategies were as most got hit at the same time. Third, all sorts of financial institutions have gone belly up.

Ah, but don't sweat it, Lipsky reminds the world at the IMF's Globalization & Risk Conference. Here is the non-apology for his previous statements:
A few months ago, I would have said that one of most striking features of financial globalization has been the broadening reach of financial institutions and markets, creating an ability to disperse risk much more widely than previously. The process of globalized risk transfer is being facilitated by securitization and by the use of complex derivative transactions. As is well understood, the key benefit of modern risk transfer instruments is that they allow investors to bear only the financial risks they wish to.

While I still believe this to be one of the most relevant facets of financial globalization, the events of the past few months have demonstrated that the process of risk dispersion contains some inherent potential [not realized?] problems. In particular, the complex composition of some derivative instruments-and the lack of transparency regarding some holders' balance sheets-make it hard to assess the risk exposure of individual entities, including some regulated institutions. For example, over the last couple of years, U.S. sub-prime and other mortgage-backed assets have been a key ingredient of structured credit products that have been sold to a broad set of investors, many outside the United States. In fact, this aspect of financial globalization has worked well up to now-abstracting from the issue of whether investors became excessively exuberant. [Worked ripping off the ROW?]

Problems arose when it became apparent that the underlying assets were not performing very well-that is, when U.S. house prices began to weaken and mortgage delinquencies rose quickly. At that point, the lack of transparency regarding both instruments and investors created a sudden loss of confidence in the predictability of the mapping of changes in the underlying housing market, to the prices of the relevant derivative securities. Liquidity disruptions emerged quickly-both in terms of the market liquidity of the instruments themselves and the funding liquidity of some of the institutions that purchased them.
Got that? It was a liquidity problem at work. There was nothing much wrong with the instruments themselves. So what are we to do? This is the most head-scratching part. What Lipsky basically says is that "innovation" should not be stifled. Moreover, trying to regulate "innovation" to improve transparency is futile since we may end up watching out for yesterday's problems in an ever-changing world. Nevermind that it seems innovation is causing a lot of these emerging problems but...

Here, I would like to sound a note of caution: We must be careful not to focus excessively on new regulations intended to fight the last battle when the next one could be different. We already have made a lot of progress in recognizing that supervision should be "risk-based" and that regulation should be "incentive compatible." These principles should be kept in mind when we look ahead. The key will be to adapt these concepts to the problems of today with careful thought given to what we expect to happen tomorrow.

For this reason, I find some of the latest criticism of Basel II [banking regulations] to be just a bit too facile. It has been claimed that conduits and SIVs were conceived as a means to avoid Basel II capital charges by placing assets off bank's balance sheets. In a Basel II world, however, it would be less costly to put the assets held by conduits and SIVs on the balance sheet than in the current Basel I world, since their risk-sensitive ratings likely would have required less capital charges than in Basel I. The current debate about ratings agency regulation is another area where we must tread carefully in order not to stifle innovation...

Clearly, investors share the blame for recent market difficulties. They should not take a credit rating letter grade on complex securities as the principal element of their due diligence process. Nonetheless, rating agencies will continue to play an important role in providing third party opinions about credit risks, especially in areas where credit risks are difficult to assess.

Huh? We should do the rating agencies' jobs so we aren't hoodwinked by them, yet they will still have an "important role...where credit risks are difficult to assess"? Don't you feel safer now that the IMF is staffed by the likes of John Lipsky? I'll second Felix Salmon's thoughts on Lipsky: "I, for one, can't ever remember a public official being so Panglossian – certainly not an unelected one." (Someone, please set up a "John Lipsky Watch" before it's too late.)