This was entirely counter-intuitive. Explanations of why this had happened were confusing and focused on complicated cross-correlations between tranches. In essence it turned out that there had been a short squeeze in non-investment-grade tranches, driving their prices up, and a general selling of all more senior structured tranches, even the very best AAA ones.
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold. But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis.
So how did we get ourselves into a situation where we built up such large trading positions? There were a number of factors. As is often the case, it happened so gradually that it was barely perceptible.
Fighting the last war
The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed. Equities, government bonds and foreign exchange, and their derivatives, were well managed in the trading book and monitored on a daily basis.
The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk. The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.
The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted. We set portfolio limits on each rating category but otherwise left the trading desks to their own devices. We made two assumptions which would cost us dearly. First, we thought that all mark-to-market positions in the trading book would receive immediate attention when losses occurred, because their profits and losses were published daily. Second, we assumed that, if the market ran into difficulties, we could easily adjust and liquidate our positions, especially on securities rated AAA and AA. Our focus was always on the non-investment-grade part of the portfolio, especially the emerging-markets paper. The previous crises in Russia and Latin America had left a deeply ingrained fear of sudden liquidity shocks and widening credit spreads. Ironically, of course, in the credit crunch the emerging-market bonds have outperformed the Western credit assets.