Here are my two cents on concerns about possible systemic financial problems.
There were some very useful discussions yesterday on collateralized debt obligations, financial instruments in which an institution creates a new series of assets by repackaging the cash flows received from a given pool of underlying assets (some of which might themselves be CDOs). Felix Salmon tries to categorize calmly the various concerns in terms of possible defaults on underlying subprime mortgages, defaults on the part of the institution that issued the CDO, and mispricing that could result from “fire sales” of such assets. Felix acknowledges a potential cycling feedback between these three developments, and concludes:
So there is cause for concern, to be sure. But there isn’t cause for panic.
Saskia Scholtes and Gillian Tett, writing for the Financial Times, characterize the problem as an absence of independent arms-length valuation of the CDOs, so that holders do not recognize or warn their creditors of the magnitude of already-realized losses. Naked Capitalism sounds a related theme, emphasizing the lack of public documentation and transparency. Tanta suggests that references to the “illiquidity” of such assets are euphemizing the reality that their objective market value is far below the book valuation.
The benign view of CDOs is that they represent an important technological improvement that allows for better pooling of risk. I would characterize the main concerns as centering on whether in the process existing financial arrangements have accurately priced aggregate risk.
First let me clarify what I mean by aggregate risk. Some risks are inherently undiversifiable. One can understand that point most clearly with Robert Lucas’s elegant asset-pricing model. Suppose that the entire economy consisted of one big potato farm. All financial assets would then ultimately be nothing more than claims against future potato production, and there is no way they can credibly promise to deliver more potatoes than are actually available. If there is a bad harvest, people will be hungry, and no clever set of financial instruments can possibly insure you against that.
An example of the kind of aggregate risk I have in mind is thinking through what would be the consequences of, say, a 20% decline in average U.S. real estate prices, and what that might mean for default rates.
Let me next clarify what I mean by mispricing of this risk. I am not concerned about whether those who are bearing the aggregate risk (i.e., setting themselves up to be the guy who has the fewest potatoes when times are bad) earn a higher expected return to compensate them for the risk. Rather, my concern is whether they may have invested in assets with a negative expected return. For example, if you purchased an asset with an 85% chance of a 15% return (which you’ll earn as long as a recession does not occur), and a 15% chance of a -100% return (you’re wiped out if it does), then your expected return would be -2.25%.
The specific kind of example that comes to mind is New Century Financial Corporation, which was pushed into bankruptcy from a substantially more modest aggregate shock than the one I am concerned about here. The concern about mispricing is that if loans were extended that should not have been, the magnitude of both the real estate boom and its subsequent bust are amplified substantially relative to what they would have been with accurate pricing of aggregate risk.
But who would be so foolish to have invested hundreds of billions of dollars in extra risky assets with negative expected returns? The logical answer would appear to be– someone who did not understand that they were accepting this risk.
So here is the heart of the question that troubles me– who is the residual bearer of risk if there is a substantial decline in U.S. real-estate prices?
To the extent that the answer might be the taxpayers who are liable for government employee pension commitments (, ) or a perceived public fiscal commitment to the government sponsored enterprises, then I think a reasonable case can be made that the bearers of the risk were indeed insufficiently informed.
If there has been some mispricing of aggregate risk, then the magnitude of the economic consequences of the housing cycle are going to be greatly amplified. Indeed, the reason I have been developing increasing concern about this possibility is that it looks to me like we are already seeing evidence of just such effects. The ongoing woes of the housing market are clearly now reflecting something much more than a simple response to higher interest rates. But all this has happened without any significant undiversifiable shock, such as an actual recession or broad decline in real-estate values. What will happen when such a shock finally does arrive?
If any of our readers can see the answer to these questions more clearly than I can, I would welcome your insights and reassurance that all is well.