Global stock markets hit the skids the week of August 13. By mid-week, all three major U.S. indices had fallen 10 percent from July highs, with European and Asian markets also facing substantial losses. The global dips came with investors increasingly spooked over the prospect of a credit crunch spawned from troubles in the U.S. subprime loan markets. CFR’s Sebastian Mallaby says rating agencies, which facilitated the sale of bad loans by giving them good ratings, “ought to be discredited by this.” Still, Mallaby guesses “the pessimistic story is going to be overwhelmed by the optimistic one”—that even stiff losses won’t erode substantial economic gains made in recent years.
Stock markets worldwide have taken a hit over the last week or so due to concerns that the global credit markets might be feeling a pinch. This situation arose in large part from concerns over the U.S. subprime debt markets. It was already clear, a few months ago, that there were some serious problems with the subprime market. So why is this happening now?
It’s a very good question. It’s true that back in February and March there were quite credible estimates about the losses that were likely to result from subprime defaults, which you could project given the fact that property prices had fallen and the incentive for somebody who bought a house with a 100 percent mortgage is simply to default the moment the value of the house goes down because they have no skin in the game. So people made those predictions and there were credible estimates about the amount of losses out there. But no one knew where the losses were, so after a brief scare, people forgot about it and focused on the good economic news, focused on the fact that we’re still in a period of amazing economic growth. They just looked past the subprime to better economic news elsewhere.
You’ve written about how the debt from subprime loans got passed through the financial system, from the original lenders, to investment banks, and then on to the hedge funds or other investors who are now feeling the pain as the debt implodes. If these loans were so risky, why were firms so willing to buy it up at each step along the way? And why were the investment banks so confident they could resell it in the first place?
Well, this debt was being packaged and sold off as securities before the scare began in the spring of this year. The reason why the investment banks could do it is that they brought the rating agencies into the conversation when they were figuring out what types of debt to buy, to put into a pool, which then could be sliced up and sold as different securities. They would ask the rating agencies, “Okay, to get such and such a rating, what’s the mix of debt that we need to put into the pool?” And the rating agencies essentially underestimated the correlation between the different types of debt that the investment bankers were putting in, and said that they were willing to give a high rating where they shouldn’t have done it. I think the investment banks knew the rating agencies were making a mistake because their own analysts understood the product they were creating. But they knew they could sell it if the rating agencies gave them a good rating, so they just went with it.
Does this undermine the authority of rating agencies going forward?
Yes. But the difficulty is, what do you do if you can’t trust the rating agencies? If you are a purchaser of this kind of debt, let’s say a European bank—two of which have reported difficulties as a result of buying subprime debt—are you going to go to the mortgage originator in Texas and start poring over their books? No, not likely. So I think the answer is the rating agencies ought to be discredited by this. There is a problem in that you have a near duopoly in Moody’s and Standard & Poor’s. Fitch’s is there, but is substantially smaller than the other two. And so you’ve got two companies doing this. And they’re being paid by the bond issuers, so they have an incentive to look on the bright side in terms of the quality of rating they give. And if investors don’t have an alternative, even if they know that they ought not look at the rating agency’s call and trust in it completely, they may fall back on that if there isn’t an alternative.
The FT reported that the European Commission is looking to investigate ratings agencies. They allege that the agencies were slow to react to subprime problems they knew about. Do you see anything coming from these investigations?
The peculiar incentive faced by rating agencies—that they are paid by the issuer of the bond but ostensibly are trying to serve the purchaser of the bond—has been remarked upon before by regulators both in Europe and in the United States. People get indignant, but then they fall back on not really knowing what to do about it. You would have thought that the market would correct this problem because investors would insist on taking advice from financial experts who they pay. But time and again, in the financial system, you have the opposite effect. I mean, that’s true of the fact that investors are not paying big company auditors. The company pays for the auditing, and therefore may get a soft break in terms of the quality of the audit. That was the case with Enron and a number of other scandals. The investment community was taking advice from stock analysts, during the tech bubble, who were actually being paid by the equity-issuing dot-com.
So repeatedly, what the market ought to correct in the financial business, it doesn’t seem to. And the regulators are stumped because they look at this and say, “Well, should we intervene? Should the government take over the business of rating all this debt?” No, obviously that’s too much; that would be huge overreach. So, what do you do? Do you use your bully pulpit to warn market participants to be more careful? You could try to foster more competition in the rating business, and that often comes up in these debates. But there’s a brand advantage. You want to have what looks like the most high-quality rating, and Standard & Poor’s and Moody’s are considered to be it.
We’ve seen a few firms—Bear Stearns, Goldman Sachs, and a few others—announcing that some of their funds have been hit very hard by all this. How likely do you think it is that there are other firms with skeletons in their closet, at this point, that have yet to reveal it to the markets?
Well, I think it’s virtually certain. We know there is a large chunk of defaulted subprime debt, or likely-to-default subprime debt out there. We just don’t know where all of it is. As the tide goes up the beach, the bodies start to be visible. That’s what’s happening. So it’s a sure thing that others are going to announce losses. We just don’t know who yet.
How international of a problem is it? Are there lots of international banks that are invested in U.S. mortgage-backed securities?
I don’t know. Clearly the European banks were major participants. You’ve seen that not only with BNP Paribas, but also with IKB, the German bank that had to be bailed out by the German government. And I’m sure there’s going to be more of that. Whether Asian banks are purchasers of this stuff, I actually don’t know, and that will be an interesting thing to see. But Asian markets could be affected—and in fact have been affected, if you look at the equity markets—because in a general credit crunch and a general flight from liquidity, you’ve got a problem where hedge funds are unwinding positions, and those positions could be global. So you’ve got a knock-on effect for markets all around the world.
Do you think the current slump is simply a reflection of the credit markets? Or are there really deeper weaknesses in the underlying economy that are going to come out of this?
Well, the pessimistic story is that the U.S. consumer is over-stretched and has been living off debt for the past five years. That cycle of high consumption based on debt was fueled by a strong real estate market, which first made people feel rich because their house just got more valuable, and then second, allowed them to actually extract spending money by taking out an equity loan against the security of their house. Now that you have property prices falling in many markets in the U.S., that wealth-effect goes into reverse and households start to realize that they have to rebuild their balance sheets.
Now, the correction in the housing market is a small fraction of what the run-up in house prices was before. So, my own guess is that the pessimistic story is going to be overwhelmed by the optimistic one. In an environment where global growth is extraordinarily strong—we’re in a run of three years or so which has been the most remarkable period of global growth since the Second World War, or at least one of them. So even if the U.S. consumer is not going to fuel the global economy, as perhaps it has done at certain points in the last few years, there are plenty of other sources of demand that can take its place. If you can have a bit more growth in Europe, continued extremely fast growth in China and other developing Asian countries, that kind of thing can make up for American consumption being flat.