Batten down the hatches

Date: Tuesday, May 26, 2009
Author: Claire Milhench, Reuters.com

 It’s fashionable now for leading economists and financial wizards to claim that they saw the credit crunch coming and the kind of dislocation it would create. But how many have predicted where the next implosion will occur?

Dr Andrew Lo, founder of hedge fund firm AlphaSimplex, and director of the MIT laboratory for financial engineering, has spent his career studying market behaviour, publishing papers examining why quant funds imploded in August 2007, and trying to reconcile behavioural economics with efficient market theory.

He sees the next big meltdown in commercial mortgages, but this time it’s pensions funds that will bear the brunt of the losses rather than banks. Lo points out that commercial mortgages have been packed and sold in the same way as residential mortgages - different levels of risk exposure sliced and diced and wrapped up together in one package with a triple A rating slapped on top.

But commercial mortgage backed securities (CMBS) are facing the same liquidity problems as RMBS following the sub-prime meltdown. When mortgages start to reset at higher rates this year the defaults will pile up and the losses will hit the end-investor - in this case, large pension funds in the US, Europe and Japan, says Lo.

“We are likely to see a number of pension funds having a hard time meeting their liabilities, and the government may have to step in and help out some of these insolvent funds,” he says.

Why pension funds rather than banks, which had the greatest exposure to RMBS?

Lo says that large pension funds expanded their programmes into riskier areas like CMBS to capture additional yield during the low volatility, low return years.

Lo is now trying to develop a way to measure systemic risk, so regulators have an early warning system when the global economy starts nudging critical levels. The idea is to measure the gearing in the economy and how this compares to the level of activity by looking at factors like the notional exposure in the credit markets, public debt as a ratio to GDP, inflation and money supply.

“My hope is that within the next couple of years we will have a way to measure systemic risk and we’ll be able to control it like we can with pollution,” he said. He suggests one way to do this would be to ”tax” investment banks when they start to put the financial system under too much strain, so their behaviour becomes counter-cyclical.