Taming Wild Markets (Part I)

At the center of the current collapse in financial markets is the failure of new products. Derivatives based on conventional products — especially U.S. home mortgages — have failed to perform as expected. Markets are operating outside historical experience. Contracts that were based on the record of the last 50 years are proving impossible to fulfill.

Some financial institutions do not have the capital to meet their commitments, but no one is sure which ones. Seasoned professionals are panicking — and all financial intermediaries are suspect.

Many commentators have pointed out that the current collapse has roots in bad regulation. That is a bit like saying that juvenile delinquency comes from poor child-rearing practices, but it does not help those who want to learn something about good parenting. A key lesson of the meltdown of 2008 is that financial innovation in itself carries the seeds of future crises.

In the future, regulators must ask a question that has been routinely neglected in recent years: How is financial innovation changing the way finance is conducted — and in particular, how are new contracts changing incentives that face buyers and sellers of securities?

Regulatory reform also must create the data that will allow future assessment of responsibility for bad underwriting.

When new securities appeared, consisting of bundles of mortgages from all parts of the United States, money managers were pleased with these new assets, which promised good returns and moderate risk.

But this perceived low risk was based on the history of housing prices and mortgage default rates from another era — that is, from the time when bankers and brokers were careful in underwriting mortgages for fear they would be stuck with subsequent defaults.

Securitization of various contracts — the practice of bundling a number of them together and selling shares in the package — has made it possible for some institutions to specialize in writing contracts (for example, issuing mortgages) while others specialized in carrying risk.

That sounds like a fine idea, but the banks and mutual funds that bought "collateralized debt obligations" were naïve in assuming the risks of default on the underlying assets. As is now evident, they had no real idea of these risks.

Securitization of mortgages broke the connection between the performance of the loan and the reward to the people who originated it. On the front line, rewards depended on signing up customers for mortgages.

What happened to the mortgage down the road was someone else's problem. Is it surprising that mortgages increasingly became “trash paper”? Everyone thought someone else was checking that the underlying mortgages were good loans.

In fact, in many instances, nobody was undertaking due diligence before making the loans.

We know that about $6.5 trillion in U.S. mortgages got packaged into securities and sold. Nobody knows what proportion of these loans was rushed through without scrutiny of the borrowers' creditworthiness. "Sub-prime" mortgages, including "ninja" mortgages (no income, no job, no assets), may well be only the tip of an iceberg.

Public policy, instead of leaning against the wind of over-lending, helped create that wind by applying pressure to increase homeownership.

Credit rating agencies, which are notorious for failing to anticipate spectacular financial market failures, missed again in this case. Financial operators, on their side, packaged the worst mortgages together with other mortgages, and eventually even packaged bundles of mortgages together with bundles of other assets in new securities that consisted of bundles of bundles of securities ("collateralized debt obligations," or CDOs).

In 2006 alone, the CDO market issued more than $600 billion of new securities, more than ten times the amount issued just a decade earlier.

This sausage made of fresh and rotten obligations would have been extremely difficult for anyone to rate for risk, but the rating agencies — who are paid by those who issue securities — continued to add flavor by giving these new debt instruments high ratings.

From Boston to Beijing, asset managers with no direct understanding of the U.S. mortgage market snapped up these new assets to include in the portfolios of banks, mutual funds, insurance companies, pension funds and foundations.

Market mechanisms were not sending up red flags, and government watchdogs were staffed with people hostile to government regulation. As a result, even basic data on new securities markets were often hard to come by, to say nothing of transparent and honest appraisals leading to new standards and their enforcement.

In this context, we should remember that bundling and securitization of home mortgages was only one part of a huge explosion of financial innovation. Financial derivatives have been created out of almost every traditional product of the banking industry.

It is possible to swap currencies, swap interest rates, break a loan into its interest and its principal portions and sell them separately, and generally to buy and sell pieces and bundles of products as mundane as car loans and student loans, and as far from the typical family's experience as international sovereign debt commitments.

Editor’s Note: Read Part II of this Globalist Paper — which explores how more-stringent regulations could prevent a future market meltdown — here.