Everybody’s got it wrong this time – the markets as well as the policy makers...
The financial crisis that began late last summer in US, then took a brief vacation in September & October, is back with a vengeance. And market players seem truly horrified – because they’ve suddenly realised that they don’t understand the complex financial system they created. Before I get to that, however, let’s talk about what’s happening right now.
Credit is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole. But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets have risen even as interest rates on US government debt, which is still considered safe, have plunged.
The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction – and that will mean a recession, possibly a nasty one. Behind the disappearance of liquidity lies a collapse of trust: Market players don’t want to lend to each other because they’re not sure they will be repaid. In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble.
The run-up of home prices made even less sense than the dot-com bubble but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk. But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried.
How did things get so opaque? The answer is “financial innovation” – two words that should, from now on, strike fear into investors’ hearts. OK, to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.
But the innovations of recent years – the alphabet soup of CDOs and SIVs, RMBS and ABCP – were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead was to spread confusion, luring investors into taking on more risk than they realised.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: Policy makers, committed to the view that the market is always right, simply ignored the warning signs. And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted that financial innovation got ahead of regulation – but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary? Now, Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem. The bottom line is that policy makers left the financial industry free to innovate – and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
For Complete IIPM Article, Click on IIPM Article
Source : IIPM Editorial, 2008
The financial crisis that began late last summer in US, then took a brief vacation in September & October, is back with a vengeance. And market players seem truly horrified – because they’ve suddenly realised that they don’t understand the complex financial system they created. Before I get to that, however, let’s talk about what’s happening right now.
Credit is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole. But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets have risen even as interest rates on US government debt, which is still considered safe, have plunged.
The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction – and that will mean a recession, possibly a nasty one. Behind the disappearance of liquidity lies a collapse of trust: Market players don’t want to lend to each other because they’re not sure they will be repaid. In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble.
The run-up of home prices made even less sense than the dot-com bubble but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk. But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried.
How did things get so opaque? The answer is “financial innovation” – two words that should, from now on, strike fear into investors’ hearts. OK, to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.
But the innovations of recent years – the alphabet soup of CDOs and SIVs, RMBS and ABCP – were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead was to spread confusion, luring investors into taking on more risk than they realised.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: Policy makers, committed to the view that the market is always right, simply ignored the warning signs. And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted that financial innovation got ahead of regulation – but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary? Now, Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem. The bottom line is that policy makers left the financial industry free to innovate – and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
For Complete IIPM Article, Click on IIPM Article
Source : IIPM Editorial, 2008
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