VoxEU Column Financial Markets

Subprime 'crisis': observations on the emerging debate

A basic principle of high uncertainty is to be careful. This principle also applies to analyses of the situation, even if decisiveness in the face of turmoil is at a premium. Better wait than make things worse. Here a few observations to sort through the emerging debate.

As financial anxiety keeps mounting worldwide, comments flourish and joyfully contradict each other. Central banks are bailing out dangerous gamblers, says one. They are skillfully preventing a 1929-style crash, says another one. Things are being gradually normalized, some assert. This is just the beginning of a vicious circle of unforeseen meltdown, just wait, warn others.

One thing all agree about is that uncertainty, which market participants with short memories – many of whom were teenagers or unborn the last big time around – thought was a thing of the past, has made a striking comeback. Uncertainty did not just hit markets all over the world, it is affecting our understanding as well, hence the wide disparity of opinions. A basic principle of high uncertainty is to be careful. This principle also applies to analyses of the situation, even if decisiveness in the face of turmoil is at a premium. Better wait than make things worse. Here are a few observations to sort through the emerging debate.

The origin of the problem is pretty well understood and adequately described in Stephen Cecchetti’s posting. As the US housing bubble is working its way out, mortgaged loans go sour. Since the institutions that granted these loans have promptly sold them on – this is the securitization process – to other institutions, which sold them on to others, and so on again and again, those who suffer losses are the ultimate holders. There are so many of them, all over the world, that no one knows where the losses are being borne. It could even be you, through your pension fund or some innocuous-looking investment.

The second observation that all agree about, is that the total size of the now-infamous subprime loans, even augmented by normal mortgages, does not add up to a huge amount. Normally, most financial institutions should be able to absorb them with much damage. Of course, a few may have bought too much of the stuff and they will go belly-up, but that is how things normally are. Most significant financial institutions should be able to absorb those particular losses.

In fact, no one can claim to be surprised by the mortgage crisis. For years now, the consensus view was that the US housing market was undergoing a bubble. The implication all along was that a correction would occur, with all the consequences. The correction has been underway for months, and in slow motion, which gave plenty of time for all to make adequate preparations. To be sure, some brave contrarians may have thought otherwise and bet accordingly. But it would be a momentous surprise if all respectable large financial institutions did not ready themselves. So far, so good. Why the interbank market crisis, then?

Here comes the securitization story, and it is not controversial either. The dilution of risk is a good thing, no doubt about it. But it is generally the case that any good thing has some drawback. In this case the drawback is that no one knows who holds how much of these bad loans. Where things got bad is that, the same as many other human beings, and maybe a little moreso, financiers are prone to mood swings. When all was going well, they trusted each other as if they had gone to the same schools, which in fact they did. When the situation soured, they went at light speed to the other corner and started to suspect that everyone else was more in trouble, especially those they knew best because they went to school together. So the interbank market froze.

This is where disagreements emerge. Did the central banks do the right thing? Some observers lament that they should act as lenders of last resort, which means intervening sparingly at punishing cost. The problem with that view is that central banks did not intervene as lenders of last resort. All central banks have the responsibility of assuring the orderly functioning of the financial markets. The interbank market is the mother of all financial markets, and it was drying up. So the central banks had no choice but to restart them. In addition, modern central banks operate by announcing an interest rate, the interbank rate. If they don’t enforce that rate, they destroy their own chosen strategy, which has served them well so far. This strategy allows them to change the interbank rate any time they wish. But until they do so, they have no choice but to make that rate stick. As for punishment, who were they supposed to punish? Not a particular bank, this time. The market, then? Collective punishment is generally a bad idea. In this case, it would be a terrible idea. If central banks punish the interbank market, they punish all financial markets, and therefore they punish all those who depend on these markets, which means almost all of humanity. Even Castro and Kim Jong Il.

The next big disagreement is whether things will become worse. It is easy to build scenarios that lead to disaster. Many excellent stories circulate and, like any good horror stories, they ring true. They usually describe hedge funds with serious exposure to subprime loans as quickly trying to restore solvency by selling their best assets, pushing their value down. Even hedge funds that are not exposed to bad loans may be fighting for their lives if their clients withdraw funds, either because they are worried or because they must, given their own regulations or rules. Rating agencies are then forced to downgrade loads of assets and funds whose fundamentals are perfectly safe, simply because they are being downloaded on the market. At that stage, 1929 starts looking heavenly in comparison with what happens next. Well, that could be what is in store. But note that it does not have to be so.

Remember first that, on its own, the mortgage crisis is small beer. Recall next that most serious financial institutions must have made adequate provisions to face this long-expected crisis, some call it normalization. Note that the large central banks have shown that they have learnt the lesson from past crisis and quickly moved to provide the interbank markets with the required liquidity. The situation is basically sound. But financial markets are always subject to self-fulfilling prophecies: if they believe that things will go wrong, things go wrong. That’s where we stand now.

Isn’t it very frustrating to find ourselves, once again, on the verge of disaster and realize that our well-being depends on the whims of a few financiers not particularly known for being sedate? Why can’t we prevent this once and for all? The sad thing is that armies of regulators and supervisors have being doing just that for years and years. Remember Basel II, meant to be even better than Basel I? Nowadays banks are so tightly regulated that it is almost not fun anymore to be a banker. Well, almost. Banking is about lending, and lending is risky. In addition, as we all know, high risk means high (expected) return. Naturally, bankers have responded to regulation by carrying on with lending, risky and not risky, but they have been subcontracting the risk that they are not supposed to hold. The great securitization wave is partly a consequence of the great regulation operation.

The deeper moral is simple. Financial markets exist to do risky things. The more risk they take, the higher the (expected) returns. You can use regulation to squeeze risk out of a segment of the market, say banks, but you don’t eliminate the risk, you just move it elsewhere. New segments, say hedge funds, emerge to take over the risk and the high (expected) returns that go with it. The problem is that little is known of the new segment and its players, so the armies of regulators and supervisors that protect us look in the wrong direction because they don’t know where to look. There has been much talk about regulating the hedge funds; it might happen, so the game will move elsewhere. The only way to eliminate financial crises is to fully eliminate risk. Kim Jung Il knows how; eliminate financial institutions. But that means no (expected) returns.