Blame should go to the phenomenon of ‘securitisation.’ In the past, banks kept their loans and mortgages on their books, retaining the credit risk. For example, during the housing bust in the United States in the late 1980’s, many banks that were mortgage lenders went belly up, leading to a banking crisis, a credit crunch, and a recession in 1990-91.
This systemic risk – a financial shock leading to severe economic contagion – was supposed to be reduced by securitisation. Financial globalisation meant that banks no longer held assets like mortgages on their books, but packaged them in asset-backed securities that were sold to investors in capital markets worldwide, thereby distributing risk more widely.
So what went wrong?
The problem was not just sub-prime mortgages. The same reckless lending practices – no down-payments, no verification of borrowers’ incomes and assets, interest-rate-only mortgages, negative amortisation, teaser rates – occurred in more than 50 percent of all US mortgages in 2005-2007. Because securitisation meant that banks were not carrying the risk and earned fees for transactions, they no longer cared about the quality of their lending.
Indeed, there is now a chain of financial intermediaries – mortgage brokers, the banks that package these loans into mortgage-backed securities (MBS’s), and investment banks that re-package MBS’s in tranches of collateralised debt obligations, or CDO’s (and sometimes into CDO’s of CDO’s) – earning fees without bearing the credit risk.
Moreover, credit rating agencies had serious conflicts of interest, because they received fees from these instruments’ managers, while regulators sat on their hands, as the US regulatory philosophy was free-market fundamentalism. Finally, the investors who bought MBS’s and CDO’s could not do otherwise than to believe misleading ratings, given the near impossibility of pricing these complex, exotic, and illiquid instruments.
Reckless lending also prevailed in the leveraged buyout market, the leveraged loan market, and the asset-backed commercial paper market. Small wonder, then, that when the sub-prime market blew up, these markets also froze. Because the size of the losses was unknown – sub-prime losses alone are estimated at between $50bn and $200bn, depending on the magnitude of the fall in home prices – and no one knew who was holding what, no one trusted counterparties, leading to a severe liquidity crunch.
Bankruptcy
But illiquidity was not the only problem; there was also a solvency problem. Indeed, in the US today, hundreds of thousands – possibly two million – households are bankrupt and thus will default on their mortgages. Around 60 sub-prime lenders have already gone bankrupt.
Many homebuilders are near bankrupt, as are some hedge funds and other highly leveraged institutions. Even in the US corporate sector, defaults will rise, owing to sharply higher corporate bond spreads. Easier monetary policy may boost liquidity, but it will not resolve the solvency crisis. So it is now clear that reforms are needed to address the negative side effects of financial liberalisation, including greater systemic risk.
First, more information about complex assets and who is holding them is needed. Second, complex instruments should be traded on exchanges rather than on over-the-counter markets, and they should be standardised so that liquid secondary markets for them can arise.
Third, we need better financial supervision and regulation, including of opaque or highly leveraged hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies needs to be rethought, with more regulation and competition introduced. Finally, liquidity risk should be properly assessed in risk management models, and both banks and other financial institutions should better price and manage such risk.
These crucial issues should be put on the agenda of the G7 finance ministers to prevent a serious backlash against financial globalisation and reduce the risk that financial turmoil will lead to severe economic damage.
© Project Syndicate, 2007
