Arnold Kling

Turmoil in Financial Markets

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Back to School Edition... Cowen, Clark, and Malthus...

I offer my perspective.


What seems to have happened over the past year is that the hide-and-seek process in the financial intermediation process for mortgage loans to risky borrowers got out of hand. Some institutions wound up with more default exposure than they were expecting, based on the information that they could obtain from rating agencies or other parties. With some institutional investors burned in the sub-prime mortgage market, this has caused other institutions to question their own portfolios: which of our investments might have more potential to default than we have been allowing for? What if it turns out that bond ratings are less reliable than we thought?

The net result is that risk premiums, which had been trending down in recent years to historically low levels, have bounced back up in the past several weeks. This adversely affects companies, such as Countrwide Financial, that rely on their strong credit ratings to be able to finance their portfolios using low-cost debt. A small increase in the risk premium faced by Countrywide can cause an enormous drop in its profit margin.

...Changes in the risk-premium tend to cascade. When the risk premium falls, financial intermediaries look for more profit opportunities. Their lower cost of funds allows them to compete to lower the risk premium for other borrowers. That is how sub-prime mortgage lending was able to gather momentum from 2003 through 2006.

When the risk premium goes up, financial intermediaries that have been very profitable suddenly find themselves squeezed. As their viability suffers, investors become wary and the risk premium rises further.


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COMMENTS (2 to date)
shayne writes:

After reading your full article at TCS Daily, I would add the following: In addition to, and perhaps greater consequence than, the higher than expected default rate attributable to sub-primes, etc. one must add the artifact of reduced market value of all underlying collateral - even for performing loans. Your discussion of the lower grade loans, projected default rates, risk premiums and their impacts on interest rates is correct. And as you addressed, in most cases (as I understand this phenomena), such loans were bundled with a high percentage of low-risk types into marketable securities/bonds that were attractive to investors because they had relatively high yield, and were marketable/tradable in their own right due to underlying collateral asset values (home values) that were increasing at best and anticipated to remain stable at worst.

The current situation is one of a liquidity problem - the marketable/tradable nature of the collateralized debt obligations (CDO's) has changed (they are perceived to be more risky than originally thought) due to a market adjustment of the underlying collateral value of all loans.
Consider if the U.S. was still experiencing generally advancing home prices, rather than declining home prices. Even a higher than anticipated incidence of default would not result in loss of principal due to declining collateral value.

Mr. Econotarian writes:

To add to Shayne's comment, it is one thing to foreclose on a house that you can sell for more than the original loan amount (which had been the situation before). It is quite another to foreclose on a house that will sell for less than the loan amount (which is the current situation).

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