Questions and answers on the debt crisis
By Martin Wolf /The Financial Times/
Published: September 4 2007 19:06 | Last updated: September 4 2007 19:06
We are living through the first crisis of our brave new world of securitised financial markets. It is too early to tell how economically important this upheaval will prove. But nobody can doubt its significance for the financial system. Its origins lie with credit expansion and financial innovation in the US itself. It cannot be blamed on “crony capitalism” in peripheral economies, but rather on irresponsibility in the core of the world economy.
What has happened raises important questions. Here are seven.
First, why did this crisis start in the US? The answer is: “The borrowing, stupid”. Default on debt – actual and feared – always drives big financial crises because creditors think that they ought to be repaid. US households were the world economy’s most important net borrowers in the mid-2000s, replacing the emerging markets of the 1990s.
Second, what created the conditions for the crisis? It took foolish borrowers, foolish investors and clever intermediaries, who persuaded the former to borrow what they could not afford and the latter to invest in what they did not understand. In fact, even the borrowers might not have been foolish: if one owns nothing, it may be quite sensible to speculate on ever-rising house prices in the knowledge that personal bankruptcy is always a way out.
Third, why did this crisis escalate? “Contagion” is, as always, the answer. Ben Bernanke, chairman of the Federal Reserve, described the process in his speech at the Jackson Hole conference last weekend.
“Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in US housing will restrain overall economic growth. But other factors are also at work.
“Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex pay-offs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities.”*
Fourth, how bad might the impact become? Since Americans borrow in their own currency, the US authorities can, it seems, loosen monetary and fiscal policy at will. Nevertheless, a significant global slowdown is not impossible. One reason is that even the US cannot risk losing the confidence of its creditors. Another is that risk premiums are likely to rise across the board, with adverse consequences for economic activity in many countries. Yet another is that banks may lack the capital to replace a temporary shrinkage in non-bank credit. It is not obvious, in addition, who would act as the world’s “borrower of last resort”, should US households retrench. Finally, big losses may yet emerge elsewhere, not least in other countries’ overvalued housing markets.
Fifth, how should central banks respond? They have two classic functions: to ensure stability in the economy, by avoiding both inflation and deflation; and to provide liquidity to an illiquid financial system.
The challenge on the first mandate is not to overreact in anticipation of what may be only a modest blip to the economy. The federal funds rate will almost certainly be cut this month. It is not obvious that it should be slashed, however. Inflation remains a risk, after all.
The challenge on the second mandate is to define what keeping the financial system “liquid” means. The classic definition is to provide money – the ultimate store of value and means of payment – to sound banks threatened by a run. A possible definition in securitised markets, however, is to act as buyer of last resort, thereby guaranteeing liquidity in markets at all times. For the reasons I explored <http://www.ft.com/cms/s/0/d3db8c86-5564-11dc-b971-0000779fd2ac.html> last week (this page, August 28 2007), the latter would be a dangerous departure.
Sixth, what is the future of securitised lending? Good reasons can still be advanced for shifting exposure from the balance sheets of thinly capitalised banks to those of better capitalised outside investors. The theory was that risk would thus be shifted on to those best able to bear it. The practice seems to have been that it was shifted on to those least able to understand it.
The supply of such fools has, if only temporarily, dried up. In the short run, securitised debt is likely to contract, as existing debt is paid down or written off. In the longer term, intermediaries will have to find a way to make their products more transparent to the buyers. Unfortunately, the ratings agencies, which once served this purpose, have lost their credibility.
Seventh, what does this event imply for the future of regulation? It is important to distinguish two objectives. One is to protect innocents. The investors who bought the products do not fall in this category. They were, if not fools, willing speculators. It is not at all obvious why the state should try to protect such institutions from their own folly. Those who borrowed the money to buy houses may, however, be deemed innocents. Whether this applies to people who exaggerated their earnings in applying for loans is an open question. But paternalists may require minimum down payments or the abolition of “teaser” interest rates and other devices that encouraged ordinary people to borrow more than they could afford.
The second objective of regulation is to insulate financial markets against the sort of panic seen in recent weeks. The only way to do that may be to re-regulate them comprehensively. Restrictions would have to be imposed on products sold or on the ability of guaranteed financial institutions to engage in off-balance-sheet transactions. I cannot see how either would now be made to work. Regulation of the detail of the financial system may fall somewhere between hard and impossible. It is why financial institutions must never be too big to fail.
Financial crises are always different in detail and the same in their essence. This one is no exception. It showed the normal pattern of rising prices of assets, expanding credit, speculation, excess, then falling prices, default and finally panic. The new securitised financial markets are meeting a test. We will soon know how far they manage to pass it.