A lot of people seem to believe that the current 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’ (CDO) 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 USA took out mortgages that had low interest rate lead-in periods and when the US housing market turned down earlier this year and even worse as the lead-in periods expired their mortgages lost value. Unfortunately no one knew where these bad mortgages had been buried in the securitised packages being held by banks and others. As in the card game of spades the question is who might hold the Queen of Spades and the object is to avoid having it offloaded onto you, 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. So did others with money to lend through the usual ‘wholesale markets’- ie direct lending by companies or wealthy individuals to banks or other companies. Hence the failure of Northern Rock which could not get money either from the wholesale market or from other banks through the ‘interbank’ market. Hence too the difficulties of any financial company that has lent long term but requires to borrow short term and therefore needs periodically to roll over its 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 privileged and the well-heeled is one of the great triumphs of modern competitive finance. By spreading the consequent risks around many well-capitalised holders they could be absorbed by the magic of ‘diversification’ which means of course that by holding a wide spread of assets whose risks are ‘not correlated’, the average risk is reduced. 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 take over large sleepy companies and finance the take-over by issuing debt that previously would not have been marketable. 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 this risk can be priced reasonably and will be taken up by the financial community when it is packaged with a variety of other assets.
Economists call this process 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. Thus a poor family will wish to borrow against their future income, however small it may be, in order to allow their consumption not be bounced around by temporary shocks to their income. In a complete financial system they can do so, high risk as they are; that risk will be absorbed by the markets much as a sub-prime mortgages were.
‘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 noone 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.
As for the current crisis it is well another banking crisis and 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, to ensure that no bank suffers a run on its deposits if it is sound. 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. Similarly with banking: we want banks to create an efficient financial environment in which risks can be insured as completely as possible, for the same reason. 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.
Who was to blame for Northern Rock?
The conventional wisdom is that the Northern Rock strategy was unjustifiably risky and that the FSA is at fault in not stopping it. However, all the Northern Rock assumed was that the wholesale and interbank markets for money would not be closed down. In other words it assumed that the Bank of England would maintain a stable banking system. This is a reasonable assumption to make.
That fact alone indicates that the true fault in this crisis lay with the Bank. It refused to take the equivalent actions to the Fed and the ECB. Indeed the governor publicly criticised these fellow-central banks for these actions, accusing them of fostering ‘moral hazard’. As noted above this accusation is not well taken; the general support of markets may indeed encourage financial firms to take risks on the assumption that there will be a stable market for funds but that is in he interests of the economy. In any case the Bank has now effectively retracted these criticisms and fallen into line.
The irony is that had it provided liquidity Northern Rock would not have needed a bail-out but instead would have simply lost profitability as it was forced to take lower margins. Thus it would have been punished by normal market forces, instead of being bailed out abnormally. This bail-out may have created some moral hazard among deposit-takers, especially now the guarantee limit is to be raised to £100,000. However, being bailed out by this government is a chancy business as the shareholders in Railtrack discovered. I doubt whether any bank will want to risk that road in future.
The Bank’s mistake should not now lead it to deflate the economy by refusing to cut interest rates, in a misplaced effort to regain face. Short-term rates in the markets have soared to around 6.2% because of the crisis and base rate needs to be cut to get them into a reasonable zone; either that or liquidity needs to be provided on terms that bring rates closer to base rate. Base rate will need cutting back on top of that.
The outlook post-crisis
In the US and euro-zone interest rates have returned to the vicinity of base rates. The Fed has also cut its base rate (Fed Funds target) by 0.5% to 4.75%. There is alarm at the spreading housing crisis. In the euro-zone the Spanish housing market is also in trouble; this is likely to put pressure on the ECB to cut rates. In both economies growth is slowing and the recent crisis has acted as a further brake. Lowering interest rates will not restore strong growth but it should prevent a recession. Since inflation is on or below target there is no reason for these central banks to avoid these supportive moves.
In the UK growth remains fairly solid as yet. However house price growth is slowing after another year of over 10% defying widespread predictions of collapse. The effects of the recent crisis will be taking their toll here too within a short space of time, unless the Bank takes avoiding action as above. If it does so and market interest rates move back down to below 5% over the next six months recession here also should be averted. With inflation again below target and forward inflation indicators weak, it has no reason not to follow the example in the US and euro-zone.