VoxEU Column Financial Markets

Subprime "crisis": Who pays and what needs fixing

The market participants who profited from creating the faltering debt instruments are not the ones who will pay most of the cost of the crisis; the losses will fall on the shoulders of final investors. Three things need fixing: credit ratings, evaluations of asset marketability, and transparency in the retail market for financial assets.

The roller-coaster swings of the financial markets that are sending shivers down the investors’ spines since February are much more than the unavoidable correction after a 5-year bull period.

The Economist wrote that this is a good time for a credit squeeze and praised the benefits of tighter conditions, following the conventional wisdom that downfalls are helpful because they lead to a more correct pricing of goods and financial assets. There is however a peculiar feature of the last crises (and particularly of this one) that makes this position less acceptable, at least from the point of view of who bears the losses and who pocketed the gains during the boom.

There are four characteristics of the present financial system that are worth remembering.

  •  The dramatic rise of financial assets and derivatives all over the world. At the end of 2005 (IMF, Global Financial Stability Report, April 2007), total financial assets stood at an astonishing level of 3.7 times the world gdp. The notional amount of total derivatives was double than the volume of total financial assets, which means 11 times global gdp. Remember that financial derivatives did not exist only thirty years ago.
  • The historical low level of interest rates over the last years, since the mid-90s (as an effect of the Greenspan monetary policy and his attempt to feed the growth of the stock market). As a consequence of favourable monetary conditions, the price for risk required by the market also stood at very low levels. The two following graphs give clear evidence of the abnormal situation prevailing in the last years.

  • The growing weight of stocks and bonds as a percentage of total financial assets (therefore the decrease of loans by banks and other financial intermediaries). At the world level (and in the European Union), bank loans account for 50% of total financial assets, but in the US and Japan the ratio is much lower. In the US, only 1 dollar out of five is borrowed from a bank.
  • The decrease of government bonds (i.e. risk-free assets) on total debt securities. While the average ratio at the world level is 50%, in Europe is 35% and in North America 26%, with a downward trend. The last two points mean that households' portfolios are more and more made of securities bearing both market and credit risk.

These are the ingredients of the magic of financial innovation of the last decades: in a nutshell, banks created an astonishing volume of debt, packaged it into various kinds of securities, with different degrees of guarantees. These securities have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. According to an important school of thought, this “arm-length” financing is the most efficient to allocate resources. Others can recall Dickens who many years ago defined credit as a system “whereby a person who cannot pay gets another person who cannot pay to guarantee that he can pay”.

As a matter of fact, the global financial systems proved to be very resilient to real and financial shocks in the last two decades, but what mostly worries central banks is that – unlike the old bank-based times - they simply do not know where the risk is. Witness this statement in the June 2007 Report of the Bank for International Settlements (p. 145): “Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know”. Honest, but frightening.

The only thing we know is that the losses will fall on the shoulders of final investors, and will not be shared with banks as it happened in more intermediated forms of finance. The point is that banks’ profits in the last 20 years stood at historical high levels. Returns on equity have been normally at two-digit levels (the first being preferably two) and probably will only be dented by the forthcoming market correction. In other words, the credit madness is over, a diet was overdue, but those that will have to follow a rigid diet are not those who put on weight in the past years. The allocative efficiency of the arm-length financing deserves at least a second judgement.

The policy implications of what is under our eyes are at least threefold.

First, once again, a rating problem has emerged. Credit risk assessments have been made on too optimistic assumptions, using data not always statistically significant and systematically ignoring tail events. When banks do not take risks on their books, but only sell them, the fragmentation of responsibilities leads to what The Economist has defined as “too much money [being] lent too cheaply and too easily to too many people”. Banks should not skip risks so easily: a portion of the risk (for instance using capital requirements) should remain on banks’ balance sheets.

Second, the securities issued were much less marketable than banks pretended. Most sophisticated bonds were infrequently traded; some were tailored by investment banks for specific clients and were never traded. Mark-to-market was therefore only a subjective valuation involving complex computer models and assumptions. Both directly made by the investment bank itself. The price discovery by the market, the very heart of a securitised world was simply an illusion. Final investors are barely protected when their securities are traded in such over-the-counter (unregulated) thin markets.

Third, there is a problem of transparency in the retail market for financial assets. As financial products are becoming more and more sophisticated, a great majority of investors are not aware of the risks that they are actually taking. There are two hypocritical reactions that are emerging: to ask for more disclosure and/or for more financial literacy. The first one should lead only to an increase of sophisticated prospectuses, which can be read only by those holding a PhD in finance (possibly of a very recent vintage). The second one is even more absurd (not surprisingly was immediately backed by President Bush) as it is simply impossible to fill the gap between the current level of financial education and the current level of rocket-science finance involved in current financial products. The only solution is to use regulation (and particularly the conduct of business rules) to make more convenient for retailers to sell simple financial products. A wide body of research (particularly in the United Kingdom, sponsored by the Treasury and the FSA, the financial supervisor) proves that the present regulatory philosophy creates a strong bias towards sophistication and opacity. Time has come to change course and to create incentives for financial intermediaries to sell easier products to the final investors. Only at that point will a higher level of financial education be effective. Time has also come for finance economists to look more closely and in a more Dickensian way at what happens at the last step of the magic of credit creation.


This article comes from our Consortium partner www.LaVoce.info. You can find an Italian-language version there.