Diagnosis of economic crisis requires years of research, says Professor Bengt Holmström
|
|
|
By Petri Sajari
A year ago a bomb, which was never supposed to go off exploded on financial markets. One of the world’s most esteemed investment banks, Lehman Brothers, went bankrupt.
The bankruptcy was followed by the most hysterical panic on financial markets in decades. The entire financial system was about to collapse. If it had collapsed, the world economy would have been in dire straits.
Economists are still not sure exactly how it all happened.
Also still wondering is Bengt Holmström, Professor of Economics at the Massachusetts Institute of Technology. He predicts that it will take years before the real reasons for the economic crisis will come out.
Holmström feels that looking for people to blame will not help in clearing up the real reasons for the crisis.
“It is very dangerous to focus exclusively on incentives for bank directors in analysing the crisis. The result would be that we would not find the real causes of the crisis in the system, which in turn leads to the wrong kinds of remedies, and to new crises.”
What is known quite well is how the world came to the brink of the crisis.
During the extended rise in the world economy, money flowed from around the world to the United States. The country’s financial markets were seen to be especially safe.
New parking spaces had to be found in the United States for these enormous flows of money, because the old ones filled up. There was an oversupply of cheap money in the form of low-interest loans.
The investment banks figured out that money could be parked in the homes of people with low incomes.
“Support came from the government, which hoped that those with little money could own their own home. That is, after all, an admirable goal”, Holmström says.
The government supported home loans for those with low incomes through lenders Fannie Mae and Freddie Mac. With their help, default risk was shifted onto the government. Loans were granted to people who had no start-up capital, and who did not necessarily have much income.
There was one key problem with the system: people with low incomes cannot afford the price of a house.
Home loans were bundled together, and the bundles were turned into derivatives. The aim of the move was to spread the risks out, and to sell the papers to various owners depending on how much risk they were willing to take.
Different investment products were sliced form the bundles, the best of which were given the highest credit rating of AAA. Investment banks held on to the most high-risk slices of the packaged products as a way of strengthening their customers’ trust in the content of the entire package.
“Debt is a much lower-risk target of investment than a share of stock. That is why demand for debt as a safe parking place for money grew considerably. In the United States, interest rates went down as money flowed into the country. There was a need to develop new parking facilities fast.”
Traditional banks can lend only as much money as their liquidity rules allow. The dizzying growth of the housing loan market required financial institutions who were not bound by the same rules.
A shadow bank system emerged alongside the traditional banks, and turned into major brokers of home loans. They include investment banks, hedge funds, brokers, and finance companies.
The shadow bank system created loan financing with significantly less capital than traditional banks did - that is, with a much greater debt lever.
Holmström feels that the shadow bank system was a response to global demand for risk-free investments. He felt that it was the only way to expand the banking system quickly.
The channel of finance for the investment banks was the repo market. Repo is used as an abbreviation for “repurchase agreement”. It refers to an agreement to buy back the debt on a specific day for a specific price.
As collateral, the borrower sells derivatives, which can be home loans converted into derivatives. If the borrower is unable to buy the derivatives back, they become the property of the lender.
The shortest repo agreements are for one day.
“It was, in fact, a deposit market. As the loans were for a very short period of time, they involved very little risk. There was a liquid market in mortgage derivatives, which guaranteed the value of the deposits even if the borrower was not able to repay the loan.”
Alarm bells started going off on Wall Street when housing prices continued to fall in the summer of 2008. Investment banks started to question each others’ ability to deal with their debt, as the value of the houses that were used as collateral for the loans deteriorated.
As confidence between the banks collapsed, they stopped lending each other money. People started withdrawing money from the shadow banking system, and the whole house of cards collapsed.
Holmström sees it as a flight of capital from the repo market.
A flight of deposits is poison for any bank. If a large proportion of depositors start emptying their accounts in a short time, the bank is very quickly on the verge of bankruptcy.
The 30 per cent fall in housing prices was something that nobody could have anticipated. The value of collateral collapsed, which further accelerated the collapse of the financial market.
“There was no empirical data with which the risk could have been anticipated. It is about the same as if we had tried, on the basis of an explosion in one nuclear power plant, to create a statistical model to figure out when the next one will explode.”
Holmström says that the average nominal prices of homes increased in the United States constantly for 70 years since the Great Depression of the 1930s.
“Banks had built buffers, which may have been able to withstand a dip of 5-10 per cent in the average price of homes, but not a dip of 30 per cent.”
Holmström emphasises that banking is based almost 100 per cent on confidence, and certainly not on the amount of information, or the transparency of that information.
Nobody knew the true value of millions of mortgages that had been turned into derivatives. Holmström says that finding that out would have required extensive resources, and there was no time to dig up the information.
“That is why we needed to use investment products on this market, whose value is not dependent on how much information we have on the content of the product. An opaque debt product that is classified as trustworthy is ideal for this purpose. The problem was that trade that is based on trust does not create information on the overall risks of the system.”
The big question for the future in Holmström’s mind is how to get more information on the overall risks of the shadow bank system.
He notes that on the stock market, information on risks comes daily, through trading. Risk in the system is, therefore, one of the key factors that establish prices on the stock market.
“This is not the case in the debt market. For that reason, credit classification is needed. Their rough estimates are good enough for individual investors, but they are not sufficient for thoroughly revealing the causes of the present crisis.
The ongoing crisis is like a disease in which the propagation method is known, but for which no cure has been found.
Helsingin Sanomat / First published in print 13.9.2009
PETRI SAJARI / Helsingin Sanomat
petri.sajari@hs.fi
|
| 15.9.2009 - THIS WEEK |
 Diagnosis of economic crisis requires years of research, says Professor Bengt Holmström |
|
