Bad feelings become self fulfilling

Having trouble understanding what is going on in the financial markets? Cannot understand why all the financial markets and most of the world’s major banks are suddenly on the verge of meltdown - all because of troubles in a comparatively obscure part of the American mortgage market?

You are not alone. The professionals also have no real idea why this crisis has blown up so suddenly, why it is so severe, or when it might go away. Nor was any of this foreseen. There were plenty of people who warned that the bubble in the American housing market would burst - it was a classic bubble market where prices had long outstripped reality - and there were others who warned all along that no good would come of the sub-prime market. There was something odd about lending to people who, by definition, would have trouble making repayments. But no one thought that the bust would have such severe consequences, more than a year after it occurred.

After all the high-tech boom of the 1990s, which was much noisier than the sub-prime boom in its time, imploded messily in 2001 only to be swept up and forgotten, without the British having to make massive investments in their banks or the German or Australian authorities hurriedly guaranteeing bank deposits. The American savings and loan crisis of the 1980s and 1990s - also caused by imprudent real estate lending - affected a major part of the US financial system, but again without causing such problems.

One point we can make is that this crisis underlines a fundamental aspect of market behaviour that does not appear in textbooks. Ninety-nine per cent of the time markets do pretty much what they are supposed to, and the people involved in them behave more or less rationally. The remaining 1 per cent of the time, however, suddenly everyone starts doing the same thing at the same time, either all trying to buy at once, or all sell at once. In other words everyone gets excessively enthusiastic or gets into a blind panic. The panic phase usually marks the end of a bubble such as the American housing market or the dot.com boom.

The problem with the current melt down is that markets everywhere have gone into panic, irrespective of their place in the market cycle - boom, bust or somewhere in-between - or the state of the underlying economy. Nothing like this has occurred before.

One factor which may differentiate this crisis from all the others, and I mention it as a possibility, is that sub-prime collapse created a crisis of confidence at the top end of the US finance system. For when the American housing market went bust in late 2006 early 2007 the crisis affected a part of the securities market. The sub prime mortgages had been cut up into bonds and on-sold, and those bonds issues were hedged and forward sold and so on, with all that clever financial engineering being undone when the underlying securities abruptly lost value. Again, that should not have been a major problem, but trouble in one part of the debt market made traders and institutions in other parts cautious.

A paper presented to a Reserve Bank of Australia conference in July by two executives from the Bank for International Settlements, Ben Cohen and Eli Remolona, notes that liquidity suddenly disappeared even from the government securities market and major debt markets - markets that had not experienced any defaults, or even credit downgrading, and were not connected to the housing market at all.

“Market participants say they just had ‘a bad feeling about things’”, the paper says. “Unfortunately we don’t have a good theory about how such bad feelings are generated.”

These “bad feelings” seem to have spread through the markets and into the main banking system, which is connected with the real estate market. With everyone having “bad feelings” the “bad feelings” quickly became self-fulfilling. Matters were not helped by the US Congress initially knocking back a US$700 billion liquidity package, and by a failure in the Icelandic banking system, although neither event in itself should have mattered. Iceland is hardly a lynchpin of the world economy, and the package was quickly revamped and passed, although it remains open to question whether the package would make any real difference.

The problem is that by their nature banks dislike risk, any sort of risk. An old joke is that banks will not lend you any money until you have shown that you don’t need the loan. Reserve banks everywhere also do not like banks who take risks. With every major investment bank on Wall Street suddenly in trouble of one sort of another, banks everywhere developed a bad feeling about the banking system itself.

A bank failure of any kind, even one in Iceland, does not help to improve the mood.

So banks started to hoard capital in the event of an emergency. That hoarding is unlikely to be reversed by US-style liquidity packages, at least not in the short term, and is bad news for business lending.