More Risky Business

Earthquakes have taught vulnerable countries to impose stricter architectural standards so that buildings don't fall down at the first tremor. Something like that will have to follow the shock to our new financial architecture, now experiencing its first major crisis. The danger is that the credit crunch, moving with unnerving speed, may hit Main Street, and not just Main Street in America but in many of the world's major financial centers.

Before the 1930s, the greatest threat to financial stability came from bank runs. The Federal Deposit Insurance Act was passed to protect deposits and calm the panic that caused people to rush to take their money out. There is no such protection in the new financial architecture, built on securities rather than bank loans. We're now in a world where loans are packaged, sold, and resold to a chain of investors around the globe. With everyone having sold risk to everyone else, no one is sure where the losses are or how much the value of these securities has fallen. In this new financial realm, there is no equivalent of deposit insurance to maintain confidence, much less the price of the underlying assets.

Mortgage lenders, money market mutual funds, hedge funds, and investment banks risk losing the source of their funds, such as short-term IOUs, by which they had financed these securities. What we have is the 21st-century version of a bank run.

Iffy IOUs. These short-term IOUs, known as asset-backed commercial paper, represent about $1 trillion and were bought because they were rated AAA. They seemed to have the backup of solid collateral, but now no one knows for sure whether the assets backing the paper are worth what the issuers say, given that a proportion of these assets are those iffy subprime mortgages, which have contaminated the whole category.

The valuation of these assets was determined by sophisticated mathematical models rather than by the market, since they were rarely traded. But the models were based on simulations of the past—a past that did not capture the lax credit standards of subprime loans (for homes bought on speculation with virtually no equity)—nor did they assess the prospects of a sharp decline in the price of real estate. Adding to the uncertainty is the knowledge that hedge funds had every incentive to over-value their assets, since they receive a fee of 2 percent of the asset value of holdings plus a 20 percent participation in the appreciation.

Now, nobody knows who has lost or how much. How to distinguish solvent from shaky borrowers? The new financial architecture dispersed risk—which was passed from buyer to buyer—but it also dispersed trust. Even the banks no longer trust other banks enough to lend them money, except on onerous terms. Hence we face a credit crunch and a liquidity crisis that may yet cause runs on otherwise solvent financial institutions.

Lenders facing uncertainty have pushed up rates on all debt other than U.S. treasuries. Risk is back big time as the spread between junk bond rates and treasuries has more than doubled after a sharp fall from 2001. Then, the spread between the average junk bond and the 10-year treasury bond was more than 9 points; earlier this year, it hit a low of about 2.6 percentage points before heading up.

Can the central banks come to the rescue? There are limits. Cheaper money from the Fed will not necessarily restore the value of this paper. If these assets have been de-rated or down-rated by the credit rating agencies, changes in interest rates won't reverse most of the loss of wealth.

For the moment, the Fed and the European Central Bank have been injecting liquidity into bank reserves. But the banks, meanwhile, have been cutting back on their lending, making it more difficult for the Fed to transmit liquidity to the rest of the financial system through them: Most of the doubtful paper is held by hedge funds, investment banks, and similar institutions.

Indeed, the Fed can do little to control the behavior of these bodies that have to decide whether to hold on or conduct fire sales. This is a new world of finance. Lowering the discount rates of loans to banks will not suffice. The best that the Fed can do is cut the federal funds rate so as to lower the cost and increase the availability of funds. That would give lenders the time to sort out their mistakes.