Theory building in real time

The global turmoil of 2007-08 has been a crisis in slow motion that has allowed an astonishing amount of theory building and conceptualization to happen in real time even as the crisis is evolving. I think that the theorization is much greater both quantitatively and qualitiatively than what I saw during the Asian (and LTCM) crisis of 1997-98 which was also a crisis in slow motion. I have spend the last several days reading and digesting a part of the huge literature that has emerged. That explains why there have been no posts on my blog for a long time now. The sense that I get is that, at a deeper theoretical level, what has happened is not quite so puzzling though financial market participants find the crisis inexplicable.

I will not attempt to summarize all the excellent work that I have been reading – they all deserve to be read in full. I shall just provide the links:

• Leveraged Losses: Lessons from the Mortgage Market Meltdown by David Greenlaw, Jan Hatzius, Anil K Kashyap and Hyun Song Shin provides several alternative estimates of the aggregate losses from the mortgage market and reconciles the huge differences between what the ABX market is telling us and what vintage-by-vintage analysis suggests.
• The BIS Quarterly Review, March 2008 has several special articles related to the current turmoil. In particular, I would point to Credit fundamentals, ratings and value-at-risk: CDOs versus corporate exposures by Ingo Fender, Nikola Tarashev and Haibin Zhu
• The Banque de France has an entire Special issue on Liquidity in its Financial Stability Review of February 2008. My mind goes back to 1999 when the BIS Committee on Global Financial Stability produced a collection Market Liquidity: Research Findings and Selected Policy Implications in response to the LTCM crisis. It is indeed heartening to find that our theoretical understanding of liquidity is far superior to what it was then.
• The Senior Supervisors Group consisting of banking regulators from France, Germany, Switzerland, UK and US presented a report titled Observations on Risk Management Practices during the Recent Market Turbulence on March 6, 2008 to the Financial Stability Forum. This provides an insightful comparison of risk management practices in firms that were badly affected by the crisis and those that avoided severe problems. Since it is based on an indepth study of eleven of the largest banks and securities firms in the world and not any silly check-box ticking survey, the report is extremely valuable.
• Is the 2007 U.S. Sub-Prime Financial Crisis so Different? An International Historical Comparison" by Reinhart and Rogoff provides a much needed historical perspective on what is going on.
• I would also like to mention a paper that is a little older but highly relevant to what is going on today: Market Liquidity and Funding Liquidity by Markus K. Brunnermeier and Lasse Heje Pedersen.

Posted at 3:43 pm IST on Tue, 11 Mar 2008         permanent link

Categories: crisis

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