When the new age finance sausage-making machine was in full bore, it was virtually a truism that spreading risk around the globe to myriad institutions, markets, and nations was a good thing.
Not many regulators, politicians, bankers, managers, and investors thought about moral hazard and other dangers stemming from the increasingly widespread belief that risk had somehow been magically transformed into harmless vapor.
Few considered the analogy that one vehicle belching toxic fumes into the atmosphere was unlikely to cause much harm, but that the exhaust from millions of cars would eventually poison the air for everybody.
Only a relative handful explored the notion of how much harder it would be to contain the fallout in an increasingly complex, unevenly regulated, and opaquely interconnected world following sizable economic and financial shocks.
Now, though, I'm sure many of the so-called "smart money" types wish they had thought long and hard about these sorts of things before this past year unfolded.
In "Subprime Virus Infects One and All" Canada's National Post offers what some might characterize as a post-mortem on the perils of Pollyannaish pigheadedness.
A fishery co-operative in Japan, four municipalities in Norway, teachers in Florida, savers in England and financial wizards in Canada. All have been burned by the U.S. subprime wildfire that has swept around the world this year in financial markets that have become ever more globalized, synchronized and intertwined.
At Northern Rock bank in Newcastle, it sparked the first bank run in Britain since 1866. In Canada, US$35-billion of non-bank asset-backed commercial paper is only now starting to thaw; frozen solid since August. It is hoped the plan released a week ago will stop tainted subprime debt from dragging down a market leveraged to the tune of $300-billion.
Yet the very process that was designed to spread risk - packaging up mortgages and selling them off to investors around the world - has backfired spectacularly, creating a global freezing of liquidity that four months later has barely thawed.
"The mantra was that the debt was widely held, that the risk was spread across many participants, and that was always the Pollyanna view of the situation," said David Rosenberg, chief North American economist at Merrill Lynch. "But in reality, it makes the situation that more difficult to solve because of ... securitization and leverage."
Subprime mortgages started out as a useful way for those with blemished or sparse credit records to fund the purchase of a home (albeit at higher interest rates than those with stellar borrowing histories), but by the time the U.S. housing boom peaked at the end of 2005 they had become one of the most sought-after asset classes in a global investment community desperate for yield.
With inflation largely vanquished in the 1980s, inflation expectations and bond yields took another dive in the late 1990s as the emergence of such low-cost giants as China kept global wage pressures muted. As ageing Western labour markets began to wane, investment in technology and other capital also began to slow, adding further downward pressure to long-term interest rates.
Low bond yields were extremely supportive for growth and asset prices but challenging for investors looking for steady streams of juicy interest payments.
Through the early 2000s "the search for yield" became the clarion call for big investors, particularly pension funds, insurance companies and other institutional players that are mandated to fill a portion of their investments with bonds.
Enter the financial engineers. Investment bankers on Wall Street and Bay Street and in the City of London were only too happy to bring the borrowers and investors together.
They came up with ever-more complicated products designed to boost yield: collaterized debt obligations, synthetic collaterized debt obligations, asset-backed commercial paper, non-bank asset-backed commercial paper and credit default swaps to insure it all.
As the U.S. real-estate market began to boom, they found a new product to stuff into the packages of securities they sold - subprime mortgages.
Subprimes were mixed in with other higher-rated paper to lower the default risk and make them more attractive. Mixed in with other higher-rated bonds, the tranches of debt were still able to attract high credit ratings.
Investors from Tokyo to Toronto lapped the products up. At its peak in 2006, US$440-billion worth of subprime mortgages were securitized and sold; a full 80% of the subprime mortgages originated that year. Subprimes, meanwhile, made up 23% of the US$2.72-trillion in mortgage originations in 2006.
As they have done since the first trade was executed, investors found they could make more money on the products if they levered up, and historically low interest rates made the borrowing easy.
Hedge funds were set up to execute the deals. In an indication of how complex the securities became, one of Bear Stearns' funds was dubiously called the "High-Grade Structured Credit Strategies Enhanced Leverage Fund."
Others set up separate off-balance-sheet structured investment vehicles (SIVs) to sell short-term debt and use the proceeds to buy mortgage securities and finance company bonds with higher yields, profiting on the spread between the two.
"It's a bit cannibalistic," admitted Marc Chandler, chief currency strategist at Brown Brothers Harriman in New York.
The deals flew all through 2005 and 2006 as investors all over the world soaked up the subprime debt, either forgetting or wilfully ignoring a basic rule of debt investing: Yields go up when quality goes down.
But by late 2005, the series of interest-rate hikes the U.S. Federal Reserve put in motion in 2004 finally began to bite, and the housing market abruptly turned.
Amid huge overbuilding, demand dried up and prices began to fall. Meanwhile, as mortgage rates were set higher, foreclosure rates started to burgeon.
The very process of securitization, however, meant the subprime taint would be spread far and wide.
By the third quarter of 2007 subprime mortgages made up 43% of all the foreclosures started and banks began to report huge losses.
Bear Stearns had to bail out its hedge fund, the U.K. Treasury and the Bank of England had to bail out Northern Rock PLC, Citigroup Inc. aid its subprime losses would likely reach US$8-billion to US$10-billion, although they are now thought to be even higher, and in early December UBS announced it would take a US$10-billion writedown on top of a US$3.7-billion loss announced in October.
Stock markets have quaked under the news but what has been more damaging to investor confidence - and perhaps, ultimately, global economic growth - has been the uncertainty over how deep the subprime rot goes.
It may not be nearly as bad as investors fear, but banks have been hoarding cash to offset possible losses and have been reluctant to lend even among themselves. This has led to a spike in borrowing rates in a key conduit of international financing - the interbank lending market.
"[Subprime] has been packaged and repacked so many times it makes it very difficult to deal with," said Martin Barnes, managing editor of Bank Credit Analyst in Montreal. "It has spread the risk but you didn't spread the risk as much as you think because the banks ended up keeping it. "
The banks may have sold off the mortgage but they ended up buying it back in SIVs.
"The banks are still up to their eyeballs in it as it is in the case in all financial shocks," Mr. Barnes said.
Stephen Poloz, chief economist at Export Development Canada, added the degree of diversification in the bundles of debt that were sold may have been overestimated.
"They can be highly correlated when there's these big bunches of people that come up for renewal at the same time and their rates get reset and you get a large run on defaults," he said.
Comparing the current mortgage crisis to the U.S. savings & loan crisis in the 1990s, which was also set off by a real-estate bust, is inadequate, Mr. Rosenberg said.
The U.S. Federal Reserve ultimately bought up all the damaged loans and eventually sold them off again.
"During the S&L crisis in the 1990s it was regional; these were federally insured institutions," he said. "As painful as it was, dealing with the S&L crisis was a walk in the park next to dealing with securitized products that have gone global."
For his part, Mr. Chandler at BBH said financial-market globalization is nothing new.
"When the 1987 crash happened you had a similar type of contagion," he said. "The emerging-market crisis of the 19th century was U.S. states and railroads defaulting, and that also caused strains in Britain."
The problem with the subprime market is not that it has spread around the world but that it is simply immature, he said.
"It reminds me of a time earlier in my career - junk bonds," he said. "When they were run out of one man's drawers [Michael Milken's], it wasn't a market. It wasn't very transparent. Now high-yield bonds or junk bonds are a genuine asset class and more transparent. So I suspect the solution to this lack of transparency ... is going to be more market, not less. How can you call these things a market when they can't trade, and there's no price-discovery process?"
Just like in the junk-bond market, he contends subprime securities will become more standardized and more-credible indexes will be developed for them to be measured against.
Although lower inflation and interest rates have allowed economies to become less volatile and the business cycle to be smoother and longer, easier money has meant asset and credit markets have become more volatile and prone to excess.
"We thought the way to smooth out the credit cycle was disintermediation - break the banks' monopoly on the distribution of capital. What this crisis points to is that process has not gone nearly as far as it should," Mr. Chandler said.
Before the market has a chance to evolve, however, it has to get out of its current mess.
The U.S. Federal Reserve, under chairman Ben Bernanke, has chopped its key interest rate 100 basis points to try to protect the U.S. economy from the credit crunch, and both the Bank of Canada and the Bank of England have trimmed rates.
But the central banks are also taking a novel approach. Instead of cutting rates further in economies sporting inflation pressures and that have so far showed little strain from the subprime fiasco, they have opted to try to unjam the borrowing freeze by making it easier for financial institutions to borrow directly from them.
But many analysts said they will ultimately have to slash rates too.
"There's nothing that a big dose of easy money at the end of the day can't put right," Mr. Barnes said. "The banks themselves have to be a bit more proactive about cleaning up their balance sheets, give a bit more transparency about where the [subprime] paper is."
Mr. Poloz said the subprime experience has demonstrated just how deep economic globalization has reached.
"I'd say that's is one of globalization's aspects, to allow the ultimate in the diversification of risk," he said. "Diversification of risk means everyone has a piece of it. That's just the way it goes."
In the end, investors have to take the bad with the good.
"If we can increase transparency and so on, then we will learn something from this experience," he said.
The sub prime mortgage market was based on an inherent contradiction: low interest rates for borrowers (so they can afford the loans), but high returns for investors. How can risk spreading cure this basic contradiction? Such a market cannot come to equilibrium. You don’t need a lot of transparency and analysis to see that that can’t make a perpetual motion machine.
Posted by: A. Zarkov | December 29, 2007 at 04:24 PM