What is the origin of financial crises? A simple fact, a fact that may be summarised as follows: one tends to bet more freely with other people’s money than with one’s own.
The typical investment manager/financial innovator thinks: “If I win, my profit will be proportional to the gross sales I have initiated. If I lose, I will be dismissed, and perhaps I will lose my reputation in the process.” Thinking even further, the manager realises that the downside is limited to being fired, but the upside is limitless. This asymmetry between profits and losses encourages audacity. Once a certain risk threshold is breached, the investment manager who places bets with other people’s money ignores danger. From a social point of view, the problem stems from the divergence of incentives. Even though the intermediary knows that he may suffer a severe personal loss, it will never be proportional to the losses inflicted on investors.
This simple rule - that profits are for me (at least in part) while losses are for others – makes it possible to understand the enchanted world of finance. The investment manager lives in a world with “Panglossian” values, to borrow an expression used by the economist Paul Krugman. Just as Voltaire’s hero, this investor only sees the bright side of affairs. He ignores the risk – not by inadvertence, but by rationality.
In a recent CEPR Discussion Paper “Self fulfilling and self enforcing debt crises” (CEPR, Discussion Paper 6718), Sebastien Villemot and I show how this mechanism explains the sovereign debt crises of the last four decades. Let me show here how it helps understanding the subprime crisis of the last year. (Many Vox columnists have already written on the causes of the subprime crisis, Carmen Reinhart most recently in her 15 March 2008 column).
Panglossian principles first explain why finance requires regulation. Prudential rules set a minimum ratio of banks’ equity capital to the amount of their investments. The idea is to oblige them to hold at their disposal the liquidity necessary to pay, and therefore to anticipate, their potential losses. The subprime crisis illustrates a contrario how the applicable logic works when, by diverse artifices, the financial intermediaries were able to free themselves from regulatory constraints.
At the origin of the so-called subprime crisis, there is a brilliant innovation. To make real estate credit available more to investors at attractive rates, the engineers of Wall Street came up with the following idea. Slice up portfolios of pooled mortgage assets into several tranches. The highest quality tranches are paid first, the mezzanine tranches afterward, and the lowest (equity) tranches sustain the risk of eventual default. A palette of varied assets is constructed in this way, attracting vast classes of investors: pension funds for the senior tranches, and hedge funds for the risky assets. This invention, finalized in 1983 by a subsidiary of General Electric, was originally intended for ordinary borrowers. In spite of a first crisis in 1994, the technique took off in 2000, making it possible to broaden the range of households benefiting from mortgage loans. Thanks to the now famous subprimes, the most disadvantaged social classes were able at last to buy their housing on credit. Wall Street came to the aid of Harlem with “ninja” loans (No Income, No Job, no Assets).
Stage one: warped creditworthiness evaluation
The collapse of the subprime system unfolded in several stages, each of which revealed the Panglossian vision of financial intermediaries. Upstream from the crisis, one fact became apparent rapidly. The quality of mortgage extended had profoundly deteriorated, even making allowances for the new clientele for whom they were intended. The clients’ creditworthiness had been systematically overestimated by the intermediaries in charge of distributing the mortgages. The cause of this deterioration is evident. Beforehand, in the old school of bank lending, lenders originating a loan were the ones who collected it afterwards, so they had an incentive to evaluate creditworthiness correctly. With the advent of loan securitisation, the agent originating the credit sells it immediately in the financial markets. The incentives are totally changed. What counts is to increase the numbers, not to examine the quality of the client.
Step two: flippancy of the banks
However, this phenomenon is only the first level in the house of cards. The second story is the “flippancy” of the banks themselves. To profit to the maximum from the new opportunities in mortgage lending, the banks created new, off-balance-sheet structures – “Special Investment Vehicles” (the infamous SIVs). By placing their new activities in these ad hoc structures, the banks liberated themselves from prudential rules. They were able to exploit to the financial leverage to finance high yielding operations on credit, without having to make use of their equity capital. The machine for betting imprudently with other people’s money was then set in motion.
The crisis that began in the summer of 2007 revealed the magnitude of the phenomenon. Losses are between 422 billion dollars, according to the OECD, and 945 billion according to the IMF. Whatever the final figure turns out to be, depending on how the current crisis evolves, a “reverse leveraging effect” is at work, what is called “deleveraging” on Wall Street. The banks will indeed be forced to reduce the volume of their lending, (re-)proportioning it to their equity capital, at the very moment when this equity is amputated by losses. A contraction of credit is inevitable, and this usually leads to a recession.
Phase three: the real estate bubble
This leads to the third and last story in the house of cards: the real estate bubble. Easy money in the year 2000 nourished an explosion in asset prices, especially housing prices. This enabled American households to live on credit. A very lax system allowed them indeed to increase their debt progressively as the value of their real estate holdings rose. All goes well as long as prices rise. When price fall, the households whose mortgage debt exceeds the value of their house (negative equity) may want to or may be forced to default.
Phase four: the borrows become Panglossian
Panglossian reasoning applies again here, but this time on the part of borrowers. The most heavily indebted households have an incentive to bet on the continuation of the rise, ignoring the risk of market reversal. This is the where the greatest risk lies going forward. In the United States, the fall in real estate prices has now reached a 10% average annual rate. A vicious circle is in motion. The reduction in prices obliges households to declare bankruptcy, which leads the banks to put the unpaid houses up for sale, which brings down the prices still more. Many of the same households also borrowed to buy cars, run up credit card bills, etc, so ‘deleveraging’ by the little guys could spread the crises far beyond mortgage lending.
What easy money brought forth during the years 2000, tight credit will take away in the years to come. “Deleveraging” has begun on all levels: for the banks, for the financial institutions having used leveraging to the maximum, such as the hedge funds or the private equity firms, and for the households themselves. Is this the disenchantment of the financial world? No doubt - until the next round.
Cohen, Daniel and Sebastien Villemot (2008). “Self fulfilling and self enforcing debt crises” CEPR, Discussion Paper 6718.