Friday, April 11, 2008

Predicting the credit crisis

(FT Alphaville) This is a must-read paper from John Taylor of Stanford University and John Williams of the San Francisco Fed. The gist of it, is that the US Federal Reserve’s Term Auction Facility (TAF) - the market saving plan announced in December - didn’t work.

…we put forth the hypothesis, based on a simple financial market model, that the Term Auction Facility would not reduce the spreads between Libor and the federal funds rate when correcting for term expectations, contrary to the purpose of the facility.

We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads.

Such conclusions, of course, go some way against the grain of received wisdom at the Fed.

But perhaps the most interesting thing is a corollary of the research, rather incidental to its main findings about the TAF.

The graph below is an attempt at isolating the “expectation risk” of interest rates from lending and so capturing “pure risk” in interbank lending. It measures the Fed’s favoured metric for interbank lending risk - the OIS to Libor spread:

OIS Libor spread

Looking at spreads going back to December 2001 illustrates just how unusual this episode has been… the spread on August 9 was 25 basis points above the pre-August 9, 2007 average. That is 7 times the standard deviation before August 9-more than a 6-sigma event. The mean through March 20 was 16 standard deviations above the old mean, which under normality would have been an extraordinarily improbable event.

Statistically speaking, a six-sigma event should occur every 2,500,000 days - or once every 6849 years. Notwithstanding the fact that markets have experienced six six-sigma events in the past 20 years (what’s the probability of that?) they note that the OIS-Libor spread puts the current financial crisis as a sixteen sigma event.

Such perhaps, is the folly of stochastics. Even so, it’s the accepted line: statistically the credit crisis was shocking, sudden, and unexpected. Viz. there was a massive jump in market risk in August 2007.

Which is why taking a longer view is so arresting. Taylor and Williams also provide a graph going back to 1991 of 3 month Libor (unsecured) against 3 month treasury-backed interbank repos (secured). Although it’s more “fuzzy”, the authors do say it’s probably an even better measure of “pure risk” than the OIS-Libor proxy.

3 month Libor less 3 month Repos

Over the full sixteen year period, there are several spikes corresponding to past financial blips, of which the current is far and away the largest. What’s clear though, is that by any standard-deviation or measure of volatility over the longer period, the current crisis is nowhere near a six-sigma event.

So - extrapolating in lay terms here - while the current crisis was unlikely, it was historically predictable.

Unless of course, you succumbed to the seductive logic of the boom: just like the first, post 2000 OIS-Libor graph, the repo-Libor graph looks very different if you take it from the beginning of the current cycle:

Libor repo spread
We’re back again in the realm of six-sigmas.

Which, to some extent, seems to validate the oldest risk rule of them all: it wasn’t different this time.

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