The start of the great unwinding

The start of the great unwinding

Published: January 25 2008 19:11 | Last updated: January 25 2008 19:11

This is hyperfinance. In the space of five frenetic days, stock markets have plunged and recovered; the US Federal Reserve has cut interest rates to 3.5 per cent; so-called “monoline” insurers, revealed as a small but vital valve in the financial machinery, have wobbled; and one Je'ro^me Kerviel has lost EUR5bn for a venerable French bank.

If the US suffers a recession in 2008 or 2009 it will not be due to an industrial decline or an oil price shock. It will be a recession that began in the financial system. The response of the general public is confusion, tinged with horror, at how intangible finance can impinge on their daily lives. Even some bankers and traders must be struck by the chaos their business can unleash, and feel awe at just how powerful they have become.

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope? On that diagnosis rests the future of our highly liberalised financial markets.

Analysis One would begin with the actions of the Federal Reserve in 2001-02. In the wake of the internet bubble the Fed, under then chairman Alan Greenspan, cut interest rates to 1 per cent in order to stave off the threat of deflation. One result, arguably, was to create a new asset price bubble in the housing market, fuelled by the sudden affordability of mortgage loans to subprime borrowers who previously could not afford them.

At the same time, to protect against a repetition of 1997’s Asian financial crisis, China and others pegged their currencies to the dollar at undervalued rates. The only way to keep their currencies down was to buy ever more US bonds. A supply of cheap credit met its demand.

The final part of this view would be a resulting explosion in the depth, liquidity and inventiveness of financial markets that went too far, too fast. The acronyms -- CDS, ABS, CDO -- swarmed faster than the markets’ institutional capacity to price and manage them. Even the losses at Socie'te' Ge'ne'rale can be explained in this way. Twenty years ago a whole floor of traders would struggle to lose EUR5bn even if they were trying. Today, thanks to the deep liquidity of futures markets and the anonymity of electronic trading, one man can do so in days.

Analysis One is benign for the financial markets: they are the acted upon, not the actors. Analysis Two would put markets’ own failings at the centre of current events.

The core of this second analysis is the vastly increased complexity of hyperfinance. Once upon a time, banks lent depositors’ money to their customers. Now, money market funds buy asset-backed securities from conduits filled by banks originating loans from brokers. The advantage of this system is that no one entity need be overexposed to any one borrower. The disadvantage is that the seller at each step has the ability and incentive to offload bad loans to the buyer.

Complexity also adds to the danger that any one part of the hyper-financial system can bring down the whole. Monoline insurers exemplify this kind of reef under the water. Their capitalisation is tiny -- a few tens of billion dollars in equity -- yet because they act as guarantors to hundreds of billion dollars in bonds, their failure would cause losses at almost every bank and insurance company in the world. Given the risks, and their small size, every effort should be made to co-ordinate a private rescue of these feckless but now vital institutions.

Another conflict of interest that has become pronounced is between banks’ shareholders and their employees. This is the more cynical interpretation of Socie'te' Ge'ne'rale. If employees make profits they are paid bonuses; if they make losses, they are sacked. Their incentive, from graduate trainee up to chief executive, is to take more risk and so increase the potential profits. All too often, shareholders are not only blind to this conflict, but connive in it. Fund managers measured on their profits demand an increase in short-term returns -- which are best achieved by taking on more risk.

If this second view is right then regulators have failed. They will have to change the rules to try to eliminate the conflicts that imperil the financial system. Before they do so, however, they need to consider exactly how far the woes of the markets are due to their own faults, and how far they are due to a stimulus administered from outside.

After the excesses of recent years, a great unwinding has begun. That is necessary and good. But if the ultimate result is markets that are even bigger and better, banks and their like need to do more to show they can be trusted, and that the public’s gain from hyperfinance is at least as great as their own.