Trump
01-26-2008, 10:16 PM
By Patrick Minford,
A lot of people seem to believe that the Northern Rock crisis means the death of credit as we have known it in recent years.
They have looked on in bewilderment as huge companies like Boots have been bought by wealthy individuals and turned into 'private equity', all financed by massive debts.
They have worried as mortgages have been made available for 'buy-to-let' and second mortgages on terms that appear excessively flexible to borrowers with perhaps questionable ability to repay.
Then, of course, the 'securitisation' of these mortgages into packages with long and incomprehensible names such as 'collateralised debt obligation' has seemed yet another bridge too far.
Now everyone knows that it is these CDOs on the balance sheets of banks and of their offshoots (thus off their balance sheets) that triggered the crisis when mortgages sliced up in them went sour.
'Sub-prime' borrowers in the US took out loans that had low interest rate lead-in periods, and when the US housing market turned down earlier this year their mortgages lost value.
Unfortunately noone knew where these bad mortgages had been buried in the securitised packages being held by banks and others.
As in the card game where the question is who holds the Queen of Spades, so here the banks were anxious not to be caught making loans to a bank that had a large dollop of these bad mortgages buried on their balance sheet.
They stopped lending to each other; and no-one else, of course, would lend to them either through the 'wholesale markets'. Hence Northern Rock, and soon perhaps some others who lent long term and need to roll over their short term debts.
It seems a short step from this description to condemnation of a 'culture of credit'. Surely those involved in this game were playing with fire and should be stopped from doing it in future, if indeed they are not stopped by the very crisis itself and its effects on confidence in such manoeuvres?
The answer is No. In fact the spread of credit outwards from the well-heeled is one of the great triumphs of modern competitive finance.
By spreading the consequent risks around many well-capitalised holders they can be absorbed by the magic of 'diversification': by holding a wide spread of assets whose risks are 'not correlated', the average risk is reduced as in 'swings and roundabouts'.
It was this principle at work three decades ago that transformed company finance and governance through making possible the 'junk bond'; business has never looked back as entrepreneurs could use 'junk' debt to take over large sleepy companies.
So with the extension of credit to people; of course it is well-known that there will be default at a higher rate on this debt. But by opening up a market in it and spreading it around this risk can be priced reasonably.
This process is known as the 'completing' of financial markets. In 'complete' financial markets all risks that are not in principle uninsurable can actually be insured either directly or indirectly through the financial system.
'Well', you may say reluctantly, 'I take your point in theory. But surely in practice events have shown it was too risky; there should be limits placed by regulation on this sort of thing?' It is obvious something went wrong. But it is important to identify what it was and to ask whether it can be remedied without interference that would destroy the efficiency of credit markets.
In fact what seems to have gone wrong is a failure of information in a rapidly developing financial environment.
It seems not to have occurred to anyone that there would be a need to know exactly what was in each securitised package - after all, the whole idea was to spread risk around so that it became relatively innocuous.
So when the worries about sub-prime mortgages surfaced no-one did know; and then of course there was general panic.
However the scale of any possible losses on sub-prime mortgages, even at its very worst, is not very large on the scale of the total balance sheets of the world's banks.
Therefore had all parties known what percentage they actually had on each particular balance sheet this could easily have been priced; the bank's share prices would have been adjusted for the prospective loss of profits and normal banking business would have gone on being done.
So the remedy for the systemic problem seems rather simple and will undoubtedly be adopted in future anyway: any CDO must have its contents on the jar, so to speak.
The current crisis it is just another banking crisis.
Bagehot's principle of the 'lender of last resort' a century and half ago seems as valid as ever: the central bank should lend liberally against sound collateral at a modest penalty rate. The modest penalty is there to ensure that banks generally take good care of their reputations. The liberal provision is to reassure the general public that their deposits are safe.
Some people argue this will only worsen 'the next crisis'. This is like saying that allowing business to go bankrupt will only encourage 'the next generation of bankruptcies'.
In one sense it is true; when the state guarantees that certain behaviour cannot lead to extreme ruin, there will indeed be more such behaviour.
But of course states choose to provide such guarantees because they want businesses to take risks in the interests of future growth and progress. Banking of course is just the same. There are in fact plenty of penalties for failure in the capitalist system without adding the possibility of total banking collapse to them.
Looking to the future, we should see the system return fairly soon to normality if central banks behave in Bagehot's manner.
At some point the dirty linen on bank balance sheets will all be hung out to dry and priced into their shares; at that point the crisis will be over and the evolution of modern credit can resume.
http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2007/09/18/do1802.xml
A lot of people seem to believe that the Northern Rock crisis means the death of credit as we have known it in recent years.
They have looked on in bewilderment as huge companies like Boots have been bought by wealthy individuals and turned into 'private equity', all financed by massive debts.
They have worried as mortgages have been made available for 'buy-to-let' and second mortgages on terms that appear excessively flexible to borrowers with perhaps questionable ability to repay.
Then, of course, the 'securitisation' of these mortgages into packages with long and incomprehensible names such as 'collateralised debt obligation' has seemed yet another bridge too far.
Now everyone knows that it is these CDOs on the balance sheets of banks and of their offshoots (thus off their balance sheets) that triggered the crisis when mortgages sliced up in them went sour.
'Sub-prime' borrowers in the US took out loans that had low interest rate lead-in periods, and when the US housing market turned down earlier this year their mortgages lost value.
Unfortunately noone knew where these bad mortgages had been buried in the securitised packages being held by banks and others.
As in the card game where the question is who holds the Queen of Spades, so here the banks were anxious not to be caught making loans to a bank that had a large dollop of these bad mortgages buried on their balance sheet.
They stopped lending to each other; and no-one else, of course, would lend to them either through the 'wholesale markets'. Hence Northern Rock, and soon perhaps some others who lent long term and need to roll over their short term debts.
It seems a short step from this description to condemnation of a 'culture of credit'. Surely those involved in this game were playing with fire and should be stopped from doing it in future, if indeed they are not stopped by the very crisis itself and its effects on confidence in such manoeuvres?
The answer is No. In fact the spread of credit outwards from the well-heeled is one of the great triumphs of modern competitive finance.
By spreading the consequent risks around many well-capitalised holders they can be absorbed by the magic of 'diversification': by holding a wide spread of assets whose risks are 'not correlated', the average risk is reduced as in 'swings and roundabouts'.
It was this principle at work three decades ago that transformed company finance and governance through making possible the 'junk bond'; business has never looked back as entrepreneurs could use 'junk' debt to take over large sleepy companies.
So with the extension of credit to people; of course it is well-known that there will be default at a higher rate on this debt. But by opening up a market in it and spreading it around this risk can be priced reasonably.
This process is known as the 'completing' of financial markets. In 'complete' financial markets all risks that are not in principle uninsurable can actually be insured either directly or indirectly through the financial system.
'Well', you may say reluctantly, 'I take your point in theory. But surely in practice events have shown it was too risky; there should be limits placed by regulation on this sort of thing?' It is obvious something went wrong. But it is important to identify what it was and to ask whether it can be remedied without interference that would destroy the efficiency of credit markets.
In fact what seems to have gone wrong is a failure of information in a rapidly developing financial environment.
It seems not to have occurred to anyone that there would be a need to know exactly what was in each securitised package - after all, the whole idea was to spread risk around so that it became relatively innocuous.
So when the worries about sub-prime mortgages surfaced no-one did know; and then of course there was general panic.
However the scale of any possible losses on sub-prime mortgages, even at its very worst, is not very large on the scale of the total balance sheets of the world's banks.
Therefore had all parties known what percentage they actually had on each particular balance sheet this could easily have been priced; the bank's share prices would have been adjusted for the prospective loss of profits and normal banking business would have gone on being done.
So the remedy for the systemic problem seems rather simple and will undoubtedly be adopted in future anyway: any CDO must have its contents on the jar, so to speak.
The current crisis it is just another banking crisis.
Bagehot's principle of the 'lender of last resort' a century and half ago seems as valid as ever: the central bank should lend liberally against sound collateral at a modest penalty rate. The modest penalty is there to ensure that banks generally take good care of their reputations. The liberal provision is to reassure the general public that their deposits are safe.
Some people argue this will only worsen 'the next crisis'. This is like saying that allowing business to go bankrupt will only encourage 'the next generation of bankruptcies'.
In one sense it is true; when the state guarantees that certain behaviour cannot lead to extreme ruin, there will indeed be more such behaviour.
But of course states choose to provide such guarantees because they want businesses to take risks in the interests of future growth and progress. Banking of course is just the same. There are in fact plenty of penalties for failure in the capitalist system without adding the possibility of total banking collapse to them.
Looking to the future, we should see the system return fairly soon to normality if central banks behave in Bagehot's manner.
At some point the dirty linen on bank balance sheets will all be hung out to dry and priced into their shares; at that point the crisis will be over and the evolution of modern credit can resume.
http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2007/09/18/do1802.xml