Letter From Europe
Sub-prime mortgage turmoil
Following the example of the European Central Bank (ECB), the Federal Reserve (Fed) has just approved a half-percentage point (from 6.25% to 5.75%) cut in its discount rate on loans to banks, with the objective of containing the damage done to the credit market by the turmoil in the US sub-prime mortgage market and to avoid a slowdown of the US economy. Stock markets in the United States and Europe reacted favourably to this move.
What the Fed is really trying to do is to halt the process of the modern equivalent of a run on the banks. Before financial engineering became too sophisticated, bank depositors used to react to financial panic with runs on banks. Unfortunately, such panic reactions often snowballed, causing perfectly healthy institutions to fail because of their inability to raise enough cash quickly. In order to avoid such a situation, the central banks across the world, including the Fed and the ECB, had already injected billions of dollars into the system. How did this liquidity crunch begin?
The entire financial system is based on people's trust and confidence. As long as people have confidence in the system, it functions smoothly. But if there is a crisis of confidence in any one of the sectors of the financial market, it has a tendency to spread like wildfire to other sectors as well. Under normal circumstances, one should be able to convert certain financial instruments into cash without any difficulty. But if people stop buying financial instruments like the collateralised debt obligations (CDO) with triple A ratings, inevitably there is a liquidity crisis.
As Professor Paul Krugman of the University of Princeton wrote recently: "when liquidity dries up, it can produce a chain reaction of defaults." Although many experts had hoped that the crisis would be limited to the CDOs market, it did not come as a big surprise when the turmoil of the sub-prime mortgage market started spreading to other parts of the securities market, like the short-term commercial papers.
Commercial papers are short-term promissory notes (IOUs), issued by corporations that promise to repay the loans within a few weeks or a few months. They are easily convertible and are supposed to finance day-to-day operations, not long-term investments like fixed assets. But now that the rating agencies have warned that some of these promissory notes could be downgraded because they are backed by residential mortgages, the liquidity crisis has intensified, hence the recent corrective measures taken by the central banks.
We do not know yet whether these measures would be enough to correct the situation, but questions are already being asked as to who bears the responsibility for this crisis.
Derivatives are financial instruments whose value is derived from the value of underlying stocks, bonds, currencies, commodities, and mortgages. The ever-innovative financiers are experts in this sort of financial engineering. "Mortgages were bundled with others and sold to investment banks, which in turn sliced and diced the claims to produce artificial assets that Moody's or Standard & Poor's were willing to classify as AAA." That means that, in theory, they were as safe as the US Treasury securities. Therefore, the rating agencies are primarily responsible for this debacle.
In fact, as far as the rating agencies are concerned, this is a clear case of conflict of interest. The rating agencies, which work as unofficial regulators, are supposed to be independent overseers. Yet, they collect a huge amount of fees from the issuers of these CDOs for rating them. It seems that the investment banks knew more about the growing risks of the sub-prime market. Several due-diligence firms like Clayton Holdings or Opus Capital Markets issued damaging due-diligence reports and submitted them to their clients, the investment banks. Summaries of these reports were given to the rating agencies by the investment banks, but not the full reports that might have helped the rating agencies to evaluate the securities better unless, of course, they (the rating agencies) preferred not to find out more about them. Therefore, the investment banks also share some of the responsibilities for this sub-prime mortgage meltdown. Whatever the case, this is a serious market failure. It is time for the Treasury Department, the Federal Reserve, and the Securities and Exchange Commission to sit together and come up with measures which would give greater transparency to financial transactions in the future.
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