Until about a year ago, it was widely believed that financial shocks occur only in emerging markets. Advanced countries with ‘mature’ financial systems had discovered the secret of markets that never crash. This so-called wisdom has now been turned on its head. The United States has sneezed, and it remains as true today as it has in the past, that when the USA sneezes, the rest of the world catches a cold.
A year ago, few had heard of sub-prime mortgages and collateralized debt obligations. Today no one who has invested money in these securities can talk about anything else. The collapse of the market in securitized debt is a perfect example of how a financial storm can suddenly blow up out of nowhere, destroying all those sophisticated, pseudo-scientific schemes for ‘managing risk’ by which rational people try to convince themselves that the world is more predictable than it can ever be.
In one way, the United States is experiencing the bursting of a classic housing bubble. A housing boom driven by low –initially negative –real interest rates, rising house prices and over-optimism has collapsed as interest rates rose, house prices fell, and over-optimism gave way to over-pessimism. This is a familiar enough pattern.
The new factor has been the huge expansion in the market for securitized debt. This enabled banks to transfer the risk of lending money to those with a poor credit rating to those willing to buy this debt from them. As a result the volume of ‘sub-prime’ mortgages shot up. By 2006 they totalled $600bn. or one fifth of the US home loan market. Most of these loans were not held by the originator. They were pooled into ‘tranches’ of bonds of varying risk, which were sold to investors round the world, often several times over. The scale and complexity of these transactions obscured the fact that an ever larger inverted pyramid of debt rested on the foundation of shaky collateral.
But then the whole engine went into reverse. In 2004, house prices started to turn down, and interest rates go up. Another ingenious financial innovation compounded the misery. Most sub-prime lending was on the basis of ‘2-28’ – a low initial interest that stays fixed for two years, after which the loan re-sets to a higher adjustable rate –typically 5% above LIBOR – for the remaining 28 years. With sub-prime borrowers unable to repay the re-set rates, delinquencies and foreclosures shot up. Securities hitherto rated triple AAA by the bond-rating agencies were suddenly down-graded. The down-grades caused investors to flee from such investments into cash. The ‘credit crunch’ started to spill over into the real economy. Housing starts, a good predictor of recession, are down by 46 per cent. Rising oil and commodity prices add a further deflationary twist.
The system now in free fall was a monument of financial ingenuity erected to serve the most basic human emotion –greed. It will probably be rescued by the world’s central banks and governments lowering interest rates, re-financing the banking system, and cutting taxes.
But two issues remain for the future. No financial system which has to be periodically rescued by central banks and governments (ultimately by taxpayers) can be said to efficient. It clearly needs to be better regulated. A deeper problem for our consumption-crazed societies is the breakdown of all moral restraints on spending. What people want they must have now. Once people saved today in order to buy tomorrow. Now they borrow. Borrowing abolishes tomorrow. And it is the inventiveness of the financial system which has made this possible. Such societies must either rediscover the virtues of restraint or they will go the way of all the civilizations which mortgaged their futures so recklessly.
Robert Skidelsky 