Financial markets are generally good at responding to events, but lousy at reckoning with an uncertainty. The collapse of the US sub-prime mortgage market sent ripples into credit markets all over the world, because so many financial institutions had traded in these home loans, and other loans, without being overly concerned about the creditworthiness of the core borrower. The potential number of Americans who may default on their mortgages is at least known, and the potential cost to mortgage lenders, more than $100 billion, is significant. The continuing nervousness in the markets chiefly reflects uncertainty over who was left holding what in the elaborate games of pass-the-parcel-adding-wrapping-each-time that financiers have played avidly for years. We cannot really know how much to worry, until more institutions ’fess up to what is on their books.
The firms that have so far admitted to problems have done so only under duress. The suggestion that Barclays might be liable to pick up some of the tab has been made since one of its clients, a German bank called Sachsen LB, had to be bailed out after suffering heavy losses linked to the US sub-prime market. Barclays is denying that it has significant liabilities. But its involvement in setting up a special investment vehicle for Sachsen only three months before its collapse will concern people who expect such risky manoeuvres from hedge funds, but not from a high street institution. Like many banks, Barclays has something of a split personality: it is part buccaneering dealmaker and part retail bank serving the public. The onus is on it, along with other banks, to explain clearly what has been going on.
Banks have become increasingly sophisticated at parcelling up mortgages and other kinds of debt, and selling them on to a wide range of buyers as collaterised debt obligations (CDOs) and loan obligations (CLOs). By spreading the risk between pension funds, hedge funds, banks and insurers, this process has probably lessened the dangers to the financial system and to the “real” economy. But because this process is utterly opaque, it is impossible to gauge how weakened some companies are. The lack of transparency is not helped by so few people really understanding the complex financial instruments that have been involved: a CDO may sound confusing enough, but try getting your head around a CDO “squared”: the CDO of CDOs. The picture is complicated even further because so many banks have been playing similar games to the hedge funds and private equity houses they have been content to see reviled. Banks’ proprietary trading desks have made bets on the market and their corporate finance departments have made huge fees out of raising extraordinary amounts of debt for private equity deals.
The impact on economic growth remains unclear, but we are all reaping material benefits from the industrial revolutions in India and China. US mortgage approvals are down but not vanished. The US and UK stock markets have bounced back from their mid-August low, but there will surely be shocks to come. Those who will suffer most will probably be the poorest Americans, who will find it harder to get credit.
There is no reason for investors to panic. Markets will remain volatile, and investors will stay twitchy, as long as there is uncertainty about the depth of indebtedness. It would be better to get the bad news over with. That means institutions being much more forthcoming about their activities than they have been so far.
