The phrase “credit crisis” is unusably general.  The precise problem is that no one trusts their own estimates of default risk, so they’re afraid to lend.  It’s that simple.

Here are some key tools used to estimate default rate, and why they are no longer trusted.

1. Credit rating.  In 2007, it emerged that thousands of AAA ratings granted by the three rating agencies (Moody’s, Standard & Poor’s, and Fitch) were completely wrong.  
2. Extrapolation.  The economic environment has changed so abruptly, and so many unregulated financial instruments have been introduced in such a short time, that extrapolation of past default rates is increasingly recognized as a fallacy.  As an easy example, exotic mortgages mostly didn’t exist 10 years ago, so there is no historical basis to estimate default rates.
3. Financial statement transparency.  Previously, you could estimate the default risk of a company by looking at its books.  Today, increasing use of complex derivatives and off-balance-sheet liabilities make this more difficult.  For example, since many derivatives are illiquid, their market value cannot be estimated from current prices;  derivatives face their own counterparty risk (aka clearing risk) that is hard to estimate;  etc.  Worst, everyone knows the big financial institutions are holding out on us — whatever their books say, everyone knows they still have yet to write off all the junk.  As long as everyone believes that, they will be afraid to lend.

Note we have not mentioned monetary policy at all.  That’s because it doesn’t help.  As written here in January, short-term rates could go to zero, and lenders would still be afraid to lend, because they cannot estimate default risk from credit rating, nor balance sheets, nor extrapolation from the past.

The solution — the only solution — is to restore confidence through transparency.  At minimum, this would require:

• Major central banks to agree on disclosure standards, and force all banks to air the dirty laundry.  
• A very noisy, very public government oversight campaign to restore confidence in bond rating agencies.
• FASB standards to require public disclosure of the maximum exposure of a company’s derivative instruments, rather than just the market value of those instruments.

These and other steps would begin to restore a rational basis for estimating default risk, which in turn would permit rational pricing of bonds, which in turn would restore the bond market, which would cause bond yields to fall, which would restore the stock market.

The financial press and powers that be are weirdly silent on all these issues, exactly those required to mitigate the damage.  How strange that some civilian in southern California would even find it necessary to write a post like this one.

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