When a financial crisis erupts, there is usually an urge to identify perpetrators and see them suffer. Letting the speculators go bust seems fair as well as satisfying. Markets giveth and markets taketh away. But the credit crisis that has enveloped financial markets this summer is a lesson in the complexities of market management: if you do not intervene, you risk damaging the market as a whole and harming the innocent as well as the guilty; if you bail the speculators out, you risk encouraging even more reckless behaviour the next time—what is known in the trade as "moral hazard."
To be sure, capitalism's latest drama has villains aplenty. The plot ran something like this. Between 2001 and 2006, the US experienced a housing boom fuelled by low interest rates. The myth of ever-rising prices tempted speculators and people with dubious credit histories to pile into the market. Mortgage brokers and banks were happy to oblige. Six months ago, at the market's high point, the value of high-risk mortgages in the US was $1,300bn, or 13 per cent of all mortgages.
The lenders sold the mortgages to investment banks, where mathematical modellers took them apart and reassembled them as new, "structured" investments with attractive returns and—allegedly—low risk. Rating agencies gave these investments optimistic credit ratings. The investment banks then sold them to clients such as hedge funds, which funded their operations by raising money (often from the same investment banks) through issuing short-term securities supported by their holdings of the re-engineered mortgage-backed assets.
Everybody was merrily keeping Veuve Clicquot and Versace in business until US interest rates went up and house prices stopped rising. Mortgage payments faltered. Because they were the income stream that ultimately supported the instruments, which by now had changed hands many times, the value of the instruments became questionable. Valuations had always depended on complex and opaque mathematical models, but now the assumptions underlying the models no longer held.
As the value of the hedge funds' holdings disappeared into a statistical black hole, the banks that had lent them money demanded more security for their loans. There was no market for the new-fangled instruments, because the computer models couldn't price them in circumstances that had not been anticipated. So the funds tried to raise cash by liquidating other holdings such as equities, precipitating a stock market collapse, which undermined their creditworthiness further.
By this stage, the market was awash with rumours of bankruptcy. Not knowing who was good for credit, banks stopped lending to each other and the markets seized up. Central banks, the US Federal Reserve and the European Central Bank among them, had to inject hundreds of billions of dollars into the market to prevent paralysis. Some big names suffered casualties. Bear Stearns, one of New York's top investment banks, was forced to close two of its funds; BNP Paribas, one of France's biggest banks, incurred big losses; and even Goldman Sachs, the world's most powerful investment bank, had to inject $2bn into a fund that had plunged 30 per cent in a week.
As the drama unfolded, a bemused public became familiar with a string of euphemisms: high-risk mortgages were "sub-prime"; impenetrable investments were "collateralised debt obligations."
But the jargon couldn't conceal some awkward facts. A significant percentage of the mortgage borrowing was fraudulent: borrowers overstated their income and assets, or even lied about whether they had jobs. Mortgage brokers turned a blind eye and collected their commissions from the lenders. The lenders swelled their balance sheets with the dubious loans, and then swiftly transferred the risk to the investment banks.
Not to be outdone, the investment banks created instruments that were impossible to value properly. Undeterred, the credit agencies blessed the structured investments in return for higher than usual fees. The investment banks pocketed the substantial difference between the price of the mortgages bought from the lenders and the price at which they could unload structured investments on the hedge funds. Hedge funds borrowed up to nine times their capital to "gear up" their investment models. Pension funds and insurance companies invested in hedge funds to try to compensate for their own poor investment performance and raise returns for their policy-holders—which makes ordinary citizens the ultimate losers from this story. The US Federal Reserve estimates that investors will have lost between $50bn and $100bn by the time the dust settles—and that excludes the mandatory lawsuits. There are definitely victims.
But are there criminals? Legions of regulators and countless pages of rules could not prevent the crisis from unfolding. Punishing the perpetrators will be hard. Some heads have rolled, including that of Warren Spector, co-president of Bear Stearns, and more funds will probably close. But all the talk of the world economy being fundamentally sound and risk being widely dispersed leaves the uncomfortable feeling that financial markets cannot wait for the fun to start again.
