Economist.comThe rating agencies failed us in the Enron scandal too, not to mention the last market crash. Maybe we need to oblige rating agencies to make financial bets aligned with their ratings -- so if they rate wrongly they go out of business. Oh, and the CEO's compensation should be aligned with those predictions as well.
... On December 18th the European Central Bank lent almost €350 billion ($500 billion) to tide banks over the new year. And yet most fear-meters, including, crucially, the price banks have to pay for funds (see chart), still register chronic anxiety...
... Subprime borrowers will probably default on $200 billion-300 billion of mortgages. That is a lot of money, to be sure, but hardly enough to imperil the world economy. For that, you need the baroque superstructure of mortgage-backed derivatives that enabled investors to bet on the housing market. From a mathematical viewpoint, the combined profits and losses on these derivatives will, by definition, cancel out, so they should not add anything to the total underlying loss. But that is only half the story. Individual investment vehicles may have sustained huge losses, especially if they borrowed heavily: it is the fear that your counterparty might be in that predicament that is gumming up the markets.
... banks now facing up to these contingent liabilities have not had to set aside capital in case of trouble—that gap in the regulations was precisely what made it so attractive to get their investments off the balance sheets in the first place...
... the money-market funds have gone on strike, cutting off the interbank markets' main source of cash ...
... Nobody yet knows whether the extreme borrowing in the credit boom was a sensible result of the powerful new machinery of debt, or the sort of excess still unwinding in Japan...
The markets will not recover until lenders believe the banks have credibly owned up to their losses...
... the frenzy of innovation around debt and securitisation got out of hand. Risk was supposed to be bought by those best able to afford it, but often ended up with those seduced by yields they did not understand. Mathematical brilliance was supposed to model risk with precision, but the models evaporated along with the liquidity that they had failed to quantify. Rating agencies were supposed to serve the market, but their first loyalty seems to have been to the issuers who were paying their fees...
Until that moment, the burden will fall on the central banks. They have tried to help by tinkering with the technical operations that supply liquidity (though they keep overnight interest rates on target by draining money elsewhere)...
The editorial claims that the primary fault with the financial instruments was a failure to model liquidity correctly. If so then increasing liquidity is a case of closing the proverbial gate after the horses have exited. I think DeLong and Krugman have been saying this, but I hadn't understood until now.
A significant part of the screw-up seems to have been that banks were allowed to hide very speculative bets from their balance sheets. Shades of the accounting scandals at Enron and others throughout the 90s! It would be interesting to know who put that loophole in, and how they got paid off for it. Now, to get the system going again, we need banks to reveal their liabilities -- to put this stuff back on the balance sheets.
It will be interesting to watch that fight.
Lastly, the reference to Japan is intended to scare. Japan's real estate bubble collapsed in the '80s -- more than 20 years ago. I don't think it will take 20 years for our real estate to recover, but there is a precedent.
As for recession, I guess we'll find out this year how big the pull is from India and China.
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