Research

Accounting valuation and the credit crisis

Alistair Milne and Perry Mehrling, together with Laurence Kotlikoff of Boston University, propose using government credit insurance guarantees to combat the credit crisis. Their idea is to use these guarantees to put a floor under the prices of the better quality tranches of structured credit securities, hence restoring liquidity to credit markets and arresting the global credit contraction.

The origins of the crisis

The deluge of media commentary on the credit crisis has missed an important fact. Seemingly all-pervasive withdrawal of credit availability can be traced back to a single cause, the collapse of liquidity and the consequent dislocation of prices in the secondary market for the most senior structured credit securities.

The seeds of the current crisis were planted in the years 2002 to 2007 when commercial and investment banks worldwide built up large portfolios of what they thought were safe senior tranches of structured credit securities. Importantly, their holdings of these securities were largely financed with short term borrowing, using asset-backed commercial paper or 'sale and repurchase' repo agreements. This short term funding was the principal means of intermediation of the worldwide global savings surplus and thus the main source of finance for the long credit boom that has now come to an end.

The trick that released this vast new supply of credit was the repackaging of loans - mainly household mortgage loans but also other loans - as asset backed and structured securities. In this way heterogeneous and illiquid loans were transformed into homogeneous and liquid bonds that could always be sold, if need be, or so the banks believed. Banks thus persuaded themselves (and their regulators) that they had avoided the usual liquidity risk from borrowing short and lending long.

Given the assumed liquidity of the new structured credits, the decision to finance their holdings using short term money was driven simply by cost considerations. Short term funding was much cheaper than long term money. So banks aggressively pursued this new business opportunity, piling up more of these exposures year after year until the total amount of good quality senior long term structured loans financed by banks in the short term markets rose to around $3.5 trillion dollars worldwide.