It Takes A Citi

Washington-based policy tinkerers seem increasingly drawn to the idea that greater reliance on market information can forestall future problems – e.g., providing input into an early warning system that can be acted upon by a “macroprudential system regulator”. And while leading critics of the administration’s proposed approach to rating agencies make some good points, they also seem to think that the market tells us when big trouble is brewing.

The history of Citigroup’s credit default swap (CDS) spread is not so encouraging.

It’s true that in some instances during the past two years, CDS spreads have indicated pressure points, e.g., within types of lenders or across countries. And if you can tell me how Citi survives going forward with a CDS spread around 450 basis points, I would be grateful.

The people who price CDS obviously have every interest in assessing risk in a hard headed and accurate manner. But Greenspan’s Lament applies to CDS traders just as much as to incentives within mismanaged banks – where in the Citi CDS spread chart do you see the build up of risk through the end of 2006? If anything, the market for default probability was saying that Citi – and by implication the financial system with all its growing subprime vulnerabilities – was becoming less risky.

You can hope that, in the future, the market will not be so generally exuberant, but 400 years of modern financial history begs to differ.

The WSJ gets this right: regulatory capture is not only pervasive, it is by design. But what’s the implication?

All regulators must ultimately fail and, when that happens, markets may well also misprice risk. The question is: When this Twin Failure occurs next time, how much will be on the line?

You cannot design a financial system that is immune to crash – this would be like declaring earthquakes illegal. But in the aftermath of unexpectedly high damage from a serious earthquake, it makes sense to completely overhaul your building code and retrofit vulnerable buildings. In fact, if you largely ignored what the earthquake revealed in terms of structural weakness, wouldn’t that be negligence?

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