Efficient markets require a clear link between the primary risk and subsequent layers of borrowing and lending.
The market for credit is not like the market for potatoes. When I buy potatoes, I choose a vendor, select the spuds, pay the cash and that is the end of it. I do not need to know much about the vendor; nor does he need to know much about me. Once I have paid for and collected the potatoes, the relationship between us is at an end.
Financial markets are substantially different. In essence the giving and taking of credit is a futures transaction. The borrower gets current purchasing power in return for a promise to repay with future purchasing power. Apart from the link between current prices and expectations of future prices, which can happen in commodity markets also, credit markets show two crucial differences. First the trade takes place with provisions to guard against default which link the buyer and seller over time. Second, as a consequence, the buyer and seller cannot remain anonymous since trust and confidence, which lie at the heart of this transaction, require a direct and continuing relationship.
An absolutely direct bilateral relationship between every saver and every investor is not possible in any complex economy and that is why financial intermediation develops. Most loan transactions originate in banks and other financial intermediaries who take on the responsibility of due diligence. There are also many institutional measures which can be undertaken to reduce the costs of default risk, e.g. the pledging of collateral, laws relating to debt recovery and credit ratings. But this does not dilute the fact that the relationship between the lender and borrower stretches months and years into the future and that a specific judgment of default risk has to be made for each individual borrower.
The sub-prime crisis arose because this relationship between lender and borrower was breached as the mortgage originators packaged loans with diverse risks and off-loaded them to others. In earlier days, when this was not easy, the mortgage lender had to make judgments about the borrower’s capacity over the period of the loan. But once this off-loading was facilitated by securitization (the packaging of individual loan transactions into a tradable financial instrument), they could decide simply on the basis of the immediate profit that they made on the transaction and leave someone else to worry about future repayment capacity.
Securitization was facilitated by rating agencies that started rating intermediary financial assets. When a rating agency rates default risk for a corporation, it takes into account the real risks of business conditions changing or managerial weaknesses. But when it rates intermediary instruments, where the primary risk is hidden behind layers of borrowing and lending, it has little to go by other than the “reputation” of the issuer. Rating agencies clearly did not get it right as the bloodbath amongst the CDO holders suggests.
The dilution of prudential standards at the primary level was further facilitated by the securitization of risk in the form of derivatives. Foreign exchange and interest swaps were originally designed to provide hedging options for the bearers of primary risk. But these, and newer instruments like credit default swaps became a stand alone market in risk with outstanding amounts becoming multiples of the volume of the underlying transaction. They became a tool for betting rather than hedging of real trade or investment transactions.
A market for risk does not reduce risk — it may even increase it by relaxing due diligence at the primary lending point. But the bigger threat is over-exposure further down the line. When the intermediary instruments being traded are several steps removed from the source of primary risk, changes in this risk, say mortgage default because of falling house prices, may not be reflected in the derivative instruments accurately or expeditiously. Hence when the change in the primary risk is recognised, many investors may be grossly over-exposed. Lehman Brothers came to grief because they kept holding the not so good parts of mortgage-linked CDOs and AIG had to be rescued from its liabilities for the potential credit defaults by Lehman that it had insured.
Financial engineering was made possible by the flow of liquidity brought about by the huge US budget deficit, the high levels of leveraging that this facilitated and the technological advances in financial trading systems that allowed high-speed, high-adrenalin all-day trading motivated by managerial bonuses based on short-term returns regardless of any increase in portfolio risk.
For all of these reasons, the market for credit cannot be understood with simple-minded micro-economics. Yet policy makers act as if they are confronted by stable well-behaved demand and supply curves showing quantities as a function of the interest rate. In the market for credit these two curves jump back and forth on the basis of expectations about the future, liquidity constraints, irrational exuberance and despair and so on. To believe, that in the present febrile atmosphere, fiddling around with interest rates or liquidity is going to do the trick is futile. The only thing that can work is a change in perceptions about the primary risks which lie behind the turmoil.
In the longer term, the time has come to ask some difficult questions about financial industry liberalisation. We have seen clear evidence of moral hazard, of firms growing to a point where they are too large to fail and whose managers therefore take unreasonable risks, particularly if their bonuses depend on it. Capital adequacy and other supervisory arrangements have failed to prevent an elaborate tower of debt, built on shaky foundations that came crashing down when the first high flyer crashed into it.
The principal goal of regulatory reform must be to prevent dissociation between the primary risk in the real economy and subsequent layers of borrowing and lending. This will require a closer look at matters like capital adequacy at different levels, transparency in off-balance sheet operations, tying managerial remuneration to both returns and portfolio risk profiles, ensuring responsible diligence in rating agencies and holding them responsible for egregious errors.
The G-20 proposals for reform cover all of these areas and will require major changes in the US financial industry in particular. But will the free-wheeling capitalists of Wall Street accept these constraints or will this agenda for stability, like the one that was announced with such conviction after the 1997-98 crisis, also be forgotten once normalcy returns?