Tuesday, February 13, 2007

Market collapse? Who ya gonna call?

A revealing synchronicity in today's Wall Street Journal and New York Times:

In a WSJ article on growing problems in the subprime lending industry, James R. Hagerty and Ruth Simon wonder whether the trouble will spread to the holders of "mortgage-backed securities" -- the disparate group of investors who have assumed the risk of potential mortgage defaults:

That could be a problem for regulators. In 1998, the Fed convened investment banks and worked out a rescue plan for hedge fund Long Term Capital Management LP, which was on the verge of collapse. But in today's splintered mortgage-securities market, the Fed wouldn't be able to "get the involved players into a room" to work out a plan to help a distressed institution sell off assets in an orderly manner, says Josh Rosner, managing director of Graham Fisher & Co., a New York investment research firm.

Over at the New York Times, in the middle of Jenny Anderson's laudatory profile of New York Fed president Timothy Geithner, who is struggling manfully to rein in the exploding world of credit derivatives, a remarkably similar paragraph occurs, as Anderson discusses Geithner's primary concern: credit derivatives are thought to be a way to spread risk as widely as possible, but this thesis has never really been tested in a true crisis situation.

Regulators struggle to imagine what the shock could be, but do know that the reaction will be far different from crises of the past. When Long-Term Capital Management tottered on the brink of collapse in 1998, the credit markets in the United States were controlled by such a small number of institutions that the New York Fed had to make calls to 14 Wall Street banks to try to resolve the crisis. Today, the number of institutions would be vastly higher.

One reaction to these parallel exercises in financial reporting is to realize that, dating back to the end of the Asian financial crisis of 1997, the last decade has been so calm (dot-com bust notwithstanding) on Wall Street that if you want to cite an example of something that could potentially have seriously disrupted the U.S. economy, your only option is to point to the Long Term Capital Management debacle.

Is this proof of what some economists call "The Great Moderation" -- a quarter-century or so in which the ups and downs of the business cycle have flattened out, inflation has been more or less under control, and overall growth far less volatile than in previous eras? (One caveat: for some reason, those who like to attribute the Great Moderation to the age of deregulation unleashed by Ronald Reagan and Maggie Thatcher rarely include rising income inequality in their list of benefits.)

Many economists attribute at least some of the credit for the relatively financial stability of modern times to the "financial innovations" that have spread risk out from traditional lenders, i.e. banks, to an ever more complex array of institutional investors, hedge funds, and other entities. Mortgage-backed securities and credit derivatives are two primary examples of these innovations.

The subtext of the Wall Street Journal article is that the housing bust is killing the subprime lending business. This is not all that surprising: if you choose to do business loaning money to people who are bad credit risks, then you asking to get burned. But will the pressure exerted by a reeling mortgage lending industry turn into the kind of shock to the system that sends serious ripples through the larger ecology of institutions who have been busy buying and selling off risk in an ever-growing frenzy? That is indeed the question, and to see both the Times and the Journal bring up exactly the same point -- if something goes wrong, it won't be easy to fix -- just reinforces how big the stakes are in determining the answer.

-- Andrew Leonard