Affordable Housing Institute : US

[Continued from Part 1 and Part 2.]

Unbeknownst to most home borrowers, our residential capital markets have been revolutionized by the takeover of the derivatives, byproducts of securitization.

 

Our derivatives are sneaking up on you

In general, this risk distillation should yield more efficient use of capital, and therefore lower spreads and lower cost to consumers. (Which means, as well, that it helps explain the ongoing real-dollar rise in home prices.) Back to the Economist:

 

So what are the dangers? The first is the most obvious and the least worrying. As with any new instrument, some investors may be exposed to risks they do not understand.

A fool and his money are soon parted.

 

And you think you’re rich?

Corollary: over time, those who retain money are not fools.

Somewhere, someone is going to re-enact the saga of Orange County in California, which lost a bundle speculating on interest-rate derivatives in 1994. That will be bad news for investors, but people lose money all the time, in everything from technology stocks to commodities. That is what happens in markets.

Financial evolution at work: dumber creatures die out. For them that’s tragic, but it’s a good thing for the species homo investus.

 

I’m smarter than these guys

Systemic risk is more of a worry. Dispersing risk ought to make the system more secure. When a bank fails because of loan defaults, depositors at other banks lose confidence; the result can be a contraction of credit in the economy. If loans are held by investors, such as hedge funds, in diversified pools, corporate defaults should have less of an effect. Each investor should lose only a fraction of its portfolio.

 

At the moment risk does indeed seem to be well diversified. Stephen Dulake, head of European credit strategy at JPMorgan, says he would be concerned about the derivatives market if risk positions were concentrated in a few hands, as they were in 2005 when the downgrading of the debt of Ford and General Motors caused a brief period of turmoil in the CDO market. Since then, the market has broadened and many more investors are involved.

Spread the wealth around = diversify and distribute the risk. The system gets safer — if people are minding the store:

 

Are you the manager here?

In addition, if risk is too diversified, who will monitor credit quality closely? This is the “toddler by the swimming pool” problem. If one parent is in charge, he will never take his eyes off the moppet. But if both parents and others are around, all may assume someone else is on guard. Everyone may be reading their newspapers when they hear the splash.

 

I’m safe as long as you’re watching me

The holders of the equity tranches should act as the concerned parent, because they will suffer first if defaults rise. However, it may be more difficult for them to do so if they are two or three removes away from the borrower in question.

 

Originators should always take first loss; they’re the ones who thought it up. Under securitization, they generally do.

So the system may seem to have become safer, but new dangers could be in the making.

Foolish virgins.

 

Perhaps credit derivatives will alter the behaviour of investors and companies, encouraging them to take more risk. That seems to have happened in the American subprime mortgage market –

 

I know not seems.

Seems? It happened.

– where underwriting standards fell sharply in recent years, leading to a rapid rise in delinquent loans.

In other words, if individuals feel safer they may act less responsibly. This is the “seatbelt problem”: motorists wearing belts may drive faster knowing they are less likely to go through the windscreen if they have an accident. The overall level of risk ends up the same.

 

Risk rising without the seat belt?

A second, and potentially just as serious, problem could be the effect of derivatives on the global supply of credit. David Roche, of Independent Strategy, argues that derivatives have created a form of liquidity outside the control of central bankers.

 

Roche is unhappy about uncontrollable liquidity

“It is pretty obvious that if one can buy a security that represents an asset for 3-5% of its value, an awful lot of liquidity has been freed up,” he says. “Derivatives have led to many more assets and liabilities being created. By reducing the cost of buying assets, you increase the demand.”

True enough, but central bankers lost control over the money supply when money became electronic. Private parties can always invent currency (in the form of financial products), and we want them to, because that means more velocity, and better risk distribution through the system.

The danger is things might go into reverse.

 

Prices backing up?

A rising cost of capital (perhaps from inflation worries) or a rise in risk aversion (due to a pick-up in defaults) might be the culprit. If liquidity falls throughout the system, derivatives will take the biggest hit. But the result, if derivatives have been pumping up the demand for assets, could be a sharp fall in asset prices.

That makes the naughty or nice question hard to answer.

As it is for alcohol; it can be sauternes or it can be rotgut.

 

You questioning my distillation?

So far, credit derivatives have shown their nice side. Their explosive growth has come against a background of generally benign economic conditions, with only modest recessions and low or falling interest rates. Indeed, derivatives have helped produce those benign conditions, by removing some of the financial constraints on growth.

 

But it is in the nature of capitalism to test new ideas to destruction and to use new instruments as the basis of speculative excess.

So it is with liquor. Some people handle it; some don’t.

 

I have a large tolerance for risk

Like risk, liquor appears intrinsic to the human condition. There’s a plausible theory that we owe our civilization to beer, because to cultivate the barley for fermentation meant settling down to an agrarian lifestyle, in a spontaneous community on the Nile’s banks.

 

Raise a frosty to civilization!

Just as a cool one at day’s end may just have been the stimulus that civilized man, so too maybe the management of risk is what lowers loan rates and increases homeownership.

In vino veritas might be translated, in the financial markets, in risko veritas.

 

Keep smiling

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