Sub prime woes ...
At the heart of the turmoil in financial markets, central bankers believe, is an information problem that has magnified the consequences of what appears to be a credit problem in securities backed by US subprime mortgages.
Underlying credit quality remains good in most of the US economy – including the prime mortgage market. Policymakers believe that this should limit the extent of any pull-back from lending.
They believe that markets are paralysed by lack of information as to the ultimate size and distribution of losses – which has contributed to a sudden drying up of liquidity in the three-month interbank and commercial paper markets.
The information problem has two components. First, investors do not know where the losses from subprime – which Ben Bernanke, the US Federal Reserve chairman, suggested last month could be up to $100bn – lie.
Second, they have lost confidence in their ability to value complex structured credit products that include some exposure to subprime bundled up with exposure to other underlying assets.
“Investors are facing enormous uncertainty on the likely size and distribution of financial losses, on the credit quality of their assets, and on counterparty risk,” said Marco Annunziata, chief economist of Unicredit, the banking group.
In principle at least, investors can overcome the problem of not knowing where subprime losses lie by investing in a diversified pool of credits. A few of these investments may turn sour, but the portfolio as a whole should not.
However, the uncertainty over where losses lie may be compounded by what economists call information asymmetries and adverse selection. Banks or other entities sitting on large losses may seek funding even at unattractive rates in current market conditions. Those in better shape may hold back, hoping for better times.
If this is the case, it would be unwise to lend to even a broad range of institutions now coming to market.
This information problem should abate over time, as banks, hedge funds and other institutions mark their investments to market and are forced to reveal the size of their losses.
However, Peter Hooper, chief economist at Deutsche Bank Securities, said “it is going to take a good while for this uncertainty to work its way through the system”.
The loss of confidence in valuation may take longer to fix. If investors do not know how to value a security, the classic “price discovery” process by which sellers and buyers settle on a new equilibrium price may not function. Markets – for instance for complex structured derivatives and some asset-backed securities – could remain closed for some time.
Ultimately the complexity problem too is solvable.
The financial institutions that created these products in the first place will break up the products into separate income streams investors can understand and can price: subprime, non-subprime mortgages, auto loans, and credit card receipts.
The dilemma for central banks is, if an information problem really is at the core of the turmoil, there is not much they can do to address it directly.
Jean-Claude Trichet, president of the European Central Bank, and Axel Weber, president of the Bundesbank, tried to give reassurance about the exposure of the European banking system, but to little effect.
Central banks on both sides of the Atlantic are likely to try to hold to the position that they should simply keep overnight liquidity flowing.
There is a danger rate cuts could aggravate the information problem, by suggesting that central banks have more negative information than the markets possess. But if markets remain dysfunctional for a long period the case for rate cuts will mount, because they would help offset its consequences for the real economy.
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