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The Crash of 2007-08

What makes the ongoing crisis in world financial markets more complicated and more hazardous than the previous ones is the very thing that Alan Greenspan and others argued that made financial systems safer: the securitisation of credit.


The Crash of 2007-08

What makes the ongoing crisis in world financial markets more complicated and more hazardous than the previous ones is the very thing that Alan Greenspan and others argued that made financial systems safer: the securitisation of credit.


oncerted central bank intervention in August 2007, to inject liquidity into the global financial system, did not, in my view, mark the beginning of the end of financial market turmoil. It merely marked the end of the beginning. Liquidity injections will not deliver lengthy respite. Financial dislocation will not be limited to the US sub-prime mortgage market and closely surrounding markets. I believe that when it arrives, the next phase of market volatility will be more vicious than before, will be led by downgrading of credit ratings on a wide range of instruments and will be followed by a more general dislocation in the credit markets that will spill over to global equity markets.

Credit Markets and Ratings

It is sometimes necessary to remind those in countries where the “equity culture” is strong like the UK and India, that globally, credit markets are the big brother of equity markets. In the US and Europe, for instance, the capitalisation of private debt securities is a combined $ 28 trillion, compared with $ 23 trillion in equity markets.

Every financial crisis has similarities and differences with crises that have gone before. One of the major differences between this crisis and others more recently is that substantial parts of the credit markets are not routinely traded. Instead of mark-to-market, many credit funds mark-to-model or formula. Credit ratings from one of the big three credit rating agencies – Moody’s, Standard & Poor’s and Fitch – are often at the centre of these formulae. Incidentally, the role of credit rating agencies in the ensuing crisis will increasingly come under the microscope as investors start looking for a scapegoat. One of the similarities with this crisis and the dot com crisis that went before it could be the way rating agencies today, and investment banking analysts last time around, are fined and regulated.

Although rating downgrades will be a consequence of existing anxieties about credit quality, downgrades will have significant knock-on effects. Rating downgrades will convert risks into losses. Loss-making credit funds will suffer redemptions, forcing fund managers to dump the wellperforming parts of their portfolios along with the toxic parts. Loan covenants will require rated entities to inject liquidity on a downgrade. These factors could push the financial markets into a liquidity black hole [Persaud 2004]. And where central banks are pushed to ease liqui dity conditions more aggressively than their inflation objectives might suggest, currencies will weaken. The Japanese yen will rebound, especially versus the US dollar, UK sterling and the Indian rupee.

Those who are older than the tradingfloor average will have seen this before. The shortness of trading room memory is often a contributory factor to financial crisis. But what makes this crisis more complicated, and perhaps more hazardous than previous ones, is the very thing that Alan Greenspan and others argued that made financial systems safer: the securitisation of credit. Securitisation brings certain microeconomic benefits. But in these circumstances, it will make the down cycle more severe and will transmit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.


Central bankers and regulators in general

– those at a number of emerging markets have always been a little sceptical – used to argue that securitisation brings financial stability because risks that were previously concentrated on the balance sheets of a few banks are now thinly spread across many different investors. In my view, this falls into a familiar error committed by many regulators of concentrating too much on instruments and institutions in markets that are very fluid, and not enough on investor behaviour. Securitisation has in fact led to more concentrated behaviour. It raises, not lowers, systemic risk.

Before securitisation, whenever the credit cycle turned down, a bank’s loan officer could conclude, through his long relationship with the credit or a portfolio of credits, that the market was under-pricing the credit and could use the bank’s balance sheet to hold on to out-of-favour credits until the market stabilised. In essence there were two opinions about credit quality, one inside the bank based on substantial experience with the credit and in which the bank was well-incentivised to get right, and the other view was the external market’s view of the credit risk. There was also the presence of capital that allowed risks to be warehoused.

Banks have since earned fees for securi tising credits and selling them on to credit funds and pension funds. This has freed up bank capital and enabled them to originate more loans than their capital would have previously allowed and to earn more low-risk fee income. Now when the down cycle arrives and credit prices fall and daily risk management systems scream that risk should be sold, the fund manager with an only passing knowledge of the underlying credit and without much capital, has little option but to sell into a falling market, worsening the market environment. There is only one view of the credit risk.

Contrarians exist and many investors are likely to consider themselves so. But the average fund manager, with less access to information about the credit than the bank was, and not well incentivised to know about the credit because he is only planning to hold on to it for a short time, is not in a position to take an expensive and risky stand against the views of the agencies or the market. The practice of marking the price of the portfolio to market where a price exists, and enabling

Economic and Political Weekly August 25, 2007

investors to leave a fund, further reduces the ability of funds to hold on to credit risks that are being sold in a fire sale. Trading and risk management practices, many of which regulators promote as “best practice” mean that although risks are spread across a wide number of investors, investor behaviour is so common, that it is as if the risks were highly concentrated with one investor [Persaud 2000].

Securitisation may have increased the micro-efficiency of banking, but it has done so at the expense of worsening the macro-prudential position of markets. Credit risk has moved from the hands of those with a capacity to hold it and diversify it, to those with fast hands, whose principal risk management strategy is to sell it before others do. Whither the regulators in all this?

Policy Responses

One of the knee-jerk responses to crisis from those who generally do not believe in market systems is that we should cut interest rates immediately and we should tighten and broaden the scope of financial regulation. These responses are in my view part of the problem. In terms of financial regulation the problem is not that we do not have enough of it, but we have too much of the wrong kind. Over the past 20 years regulators built pervasive regulatory systems to avoid credit problems at one bank becoming systemic. These systems by and large succeeded; but only by shifting risks elsewhere [Nugee and Persaud 2006]. I do not claim that regulation is easy and it has probably been made harder still by financial innovation. But I do claim that despite the dead-weight loss of lots of regulations and regulators [Elliehausen 1998], regulation has in many cases, and most particularly in the G-7 countries, failed in its primary job of making the financial system safer.

Those who seek to defend the current approach to regulation cite the fact that fewer banks have gone bust. But this is a 1980s view of financial markets. Fewer banks have gone bust but does that matter if risks have moved elsewhere. What matters is systemic stability not banking stability. A measure of regulatory failure is that the instances of emergency rate cuts to save the financial and economic system from the spread of a financial crisis have not become less frequent. Remember the emergency interest rate cuts after the October 1987 crash, during the savings and loans disaster in the late 1980s or following the Tequilla Crisis in 1995, the LTCM debacle in October 1998 or the bursting of the dot com bubble in 2001-03?

The recent bias of savers in many countries to save through the housing market rather than financial markets or the large “pension deficits” that have arisen and make individuals feel financially insecure are also measures of the weakness of financial regulation. Part of the reason for this policy failure is institutional. Few regulators have the remit to worry about the efficient and stable placement of risk in the financial system as a whole. An insufficient distinction is made between those who have a built-in capacity to hold risks and those who are merely trying to trade risks. It is no one’s responsibility to ensure that the right risks are being held by those with the right capacity to hold those risks. This task often falls through the cracks between central banks who are focused on macroeconomic threats to financial stability and financial sector regulators who focus on how individual institutions manage their own risks.

Today, the principal avenues of systemic risk are via investment losses, not bank runs. The transmission mechanism from investment losses to economic losses is not straightforward. But the example from the UK and Sweden following the property market collapse in the mid-1980s, Japan in the late-1980s following the bursting of the stock market bubble and emerging Asia after the 1997 Asian financial crisis, is that large and widespread investment losses will lead to significant reductions in consumption and investment.

Can liquidity injections temper investor losses and halt systemic risk spreading? Was the US Federal Reserve right to cut the discount rate? Yes, if the problem is caused by a temporary lack of liquidity; no, if the problem is caused by a “derating” of asset quality – as is occurring today. Put another way, the problem today is not that investors are exhibiting a very strong liquidity preference where they would rather have cash than assets. Preference for liquidity can probably be altered by shifts in the price of money. Instead, investors are questioning the quality of the assets being presented to them and are finding it hard to value risky assets. Although they are related, we are seeing more a reappraisal of risks than liqui dity preference [Kumar and Persaud 2002]. Shifting the price of money at the margin will not alter the fact that people view the credit risk they own as being fundamentally more risky than they thought it was.

Moreover, while emergency interest rate cuts in response to risk aversion may not prove helpful in the short-run, it could cause long-run problems. Firstly, there is the issue of moral hazard. Supporting financial intermediaries during a financial crisis through lower interest rates, does not encourage them to be more circumspect in their origination of credit risk in the future. Secondly, it is hard to take back the extra liquidity when it is no longer deemed necessary. Each emergency rate cut referred to earlier has spawned a new asset bubble.

When central banks respond with emergency interest rates they are acting as lender-of-first-resort. Instead, they should return to Walter Bagehot’s original thesis of being the lender-of-last resort, by lending freely, but at a penalty rate [Bagehot 1873]. Bagehot’s proposal may be modernised by allowing the central bank to accept a wider range of securities as collateral, including those securities the market is finding it hard to price and trade (so they are lending more freely) but discount the value of the collateral by a large margin versus its pre-crisis valuation, like 30 per cent (the equivalent of lending at a penalty rate). A similar proposal has been made by Willem Buiter and Anne Sibert. They have referred to this as the central bank acting as marketmaker-of-last-resort.

From Credit to Equity

Today’s generalised risk aversion follows a long period of risk-loving behaviour. This was not just reflected in lax lending criteria for risky borrowers, like sub-prime mortgagees, but generally in an under-pricing of credit risks. During this risk-loving period of low credit costs, equity markets benefited from two “bids”. The first was the “bid” from private equity companies, using cheap debt financing, to buy-out the shareholders. In the US alone some $ 0.7 trillion or 5 per cent of stocks were purchased by private equity funds in 2006. Private equity funds have also been very active in many emerging markets like India.

The second bid was from companies buying back their own shares, essentially through an increase in cheap debt. In 2006, stock buy-backs in the US were worth

Economic and Political Weekly August 25, 2007 $0.6 trillion. Stock buy-backs were also a feature of many Asian markets. One of the striking things about the recent bull run in equity markets is that it has been associated, in the biggest markets at least, with a net reduction in the value of shares being issued. One might suppose that a bull run reflecting positive economic fundamentals and new investment opportunities would have led to a net issue of stock, not a net retirement of stock. The unwinding of these two bids will weigh on equity markets and will be the main transmission of credit market troubles to global equities. Indeed, higher credit costs will likely turn these “bids” for the equity market into “offers” as companies, public and private, are forced to respond to higher credit charges or credit downgrades by rebalancing their debt/equity ratios.

Learning from the Past

The crash of 2007-08 could have been avoided. It was the result of poor investment decisions supported by a mistaken mone tary and regulatory policy background. Investors will need to ensure that their fund managers are agile enough for fast markets. It is too late for policymakers to do much other than to protect the most vulnerable con sumers and ensure that misgivings over credit quality are not compounded by a genuine shortage of liquidity. Indeed, as policymakers respond to the current screams and anguish, they should be careful to ensure that they are not merely laying the foundations for the next crash.




Bagehot, W (1873): Lombard Street. Elliehausen, G (1998): ‘The Cost of Banking

Regulation: A Review of the Evidence’, Board

of Governors of the Federal Reserve System

Staff, p 171, April. Nugee, J and A Persaud (2006): ‘Redesigning

Regulation of Pensions and Other Financial

Products’, Oxford Review of Economic Policy,

Vol 22, No 1. Persaud, A (2000): ‘Sending the Herd of the Cliff

Edge: The Disturbing Interaction between

Herding and Market Sensitive Risk Man

agement Practices’, Winner of the Jacques

de Larosiere Award in Global Finance

from the Institute of International Finance,


– (ed) (2004): Liquidity Black Holes: Understanding, Measuring and Managing FinancialMarket Liquidity, Risk Books.

Kumar, M S and A Persaud (2002): ‘Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence’,International Finance, 5 (3), pp 401-36.

Economic and Political Weekly August 25, 2007

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