A problem, but still not a catastrophe

By William Rees-Mogg (THE TIMES, 13/08/07):

Many people are worried by last week’s big stock market falls; they want to know what will happen next. They want to know what it’s all about. It does not seem likely that the “sub-prime” crisis will turn into one of the big disasters of financial history. Even the sub-prime mortgages themselves would not have zero value; paper losses may total $200 billion (£100 billion) or so, but that is not in itself enough to turn the modern world upside down. World financial markets have survived much greater shocks.

Nevertheless, there is some probability that there will be further unpleasant aftershocks. So far the ripple effect has been greater than most people expected, and that may continue. More worrying are the weaknesses that have been shown up in the banking system, despite the apparent degree of overregulation of world banking.

The regulation of banks is governed by two principles, both of which have been set aside in the system of “collateralised debt obligations” (CDOs). The first principle is transparency and the second is that assets should be valued on a realistic basis, being “marked to market”.

At every stage, it has been difficult or impossible to find a realistic valuation for sub-prime mortgage CDOs. It may be possible to value a particular tranche of mortgages but it has not been possible to find valid valuations for groups of very different mortgages, ranging from prime down to sub-prime. Sub-prime mortgages themselves depend for their value both on changes in interest rates and on the movement of house prices. Houses, after all, provide the basic underlying security, and sub-prime mortgages are particularly liable to default. When it came to the crisis point, these mortgages could not be marked to market; there was no market.

There has been far too little transparency. Nobody knows who holds what CDOs or what liabilities they might have. When one says no one knows, that has been true of insiders as well as outsiders. Bank and hedge fund managers have publicly stated that they have only negligible exposure, and that has turned out to be mistaken.

Last week normal lending in the interbank market was almost frozen because the various banks had no idea who might hold what, or what the value of the holdings might be. Nor did anyone know what the undisclosed losses might be. Without full transparency and the realistic valuation of assets, the interbank market cannot form prudent judgments. This has obviously also applied to loans for hedge funds, some of which were large holders of CDOs.

Until recently most people outside the debt market did not know that CDOs based on sub-prime mortgages existed. Most of those who did had little knowledge of their role and the high-yielding investment for some hedge funds. It would have been possible to match the high yields on these low-grade mortgages to low-cost borrowing, perhaps in yen. So long as the yen did not appreciate and the mortgage borrowers did not default, there would have been a temptingly easy income to be made. If the yen rose or defaults occurred, the hedge fund might be in considerable difficulty.

There are thousands of varieties of derivatives that might provide similar opportunities for hedge funds. It happened to be the sub-prime mortgages in which this particular gamble came unstuck, but many of these obscure derivatives might have the same characteristics. They would offer easy money so long as the underlying risk remained favourable but they could lead to substantial loss if the risk moved against the hedge fund.

There had already been a debate on the issue of transparency, particularly for hedge funds and private equity. The defenders of commercial secrecy have argued that limited disclosure helps those funds to operate efficiently and protects them from unfair commercial competition. There is something in this, though central banks will argue for more transparency to reduce the risk of the recurrence of these troubles.

This crisis has arisen as a reaction to a more serious disorder of the world’s financial system. In many areas there are disturbing signs of inflation, in energy prices, in the prices of other raw materials, in food prices, in property values, even in the art market. There has also been a very large increase in global liquidity. At the time when the sub-prime crisis first became apparent, the central banks were not worrying about deflation, but about the threat of inflation. Provided it could be kept under control, the sub-prime disturbance of the debt markets will have a mild disinflationary effect, which goes with the grain of the central banks’ strategy. After last week lending is more reluctant and borrowing more difficult. That is no bad thing.

Most of the world’s central bankers are willing to act, if necessary, to maintain orderly conditions in their own markets. This week we shall see how successful they have been.

Yet the real anxiety is likely to remain what it was a week ago; the fear of global inflation. That could arise from the excessive liquidity that already exists and the alarming excess of debt. In Britain, private debt has risen to £1.3 trillion, a scary figure by any standards. Historically, the economic cycle has repeatedly gone through a sequence of debt and inflation, followed by a crash and deflation.

That occurred in its most dramatic form in the Wall Street boom of the late 1920s, followed by the financial crash of late 1929 and the industrial slump of the 1930s. If the central bankers do not allow inflation to take off, a recession does not have to follow. The sub-prime crisis is not likely to provide the climax of the present boom; inflation will still be the problem that worries the world.