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Markets can't work when lenders don't know what collateral is worth
The hardest thing to come by in the current financial crisis isn't money—it's reliable information. The lack of information—specifically, hard information about what assets are really worth—explains why prices in some markets are gyrating so wildly, and why trading in other markets has virtually ground to a halt.
The Federal Reserve is doing its best to restore confidence—most notably by cutting the discount rate by half a percent to 5.75% on Aug. 17 (see BusinessWeek.com, 8/17/07, "Fed Move Lifts Stocks").
But the Fed is running up against a big obstacle: If you don't trust the value of an asset, you won't be willing to buy it no matter how cheap your borrowing costs are. In an Aug. 17 commentary, Merrill Lynch (MER) economist David Rosenberg wrote: "Financial institutions, in general, are paralyzed by the lack of information [about asset values].… What brings this to an end, ultimately, is better information and transparency."
Making an Example of Mortgage Loans
This turn of events is more than a little surprising. Right up to the last few weeks, it seemed that financial information was better than ever.
The most obvious case is the mortgage lending market. In years past, lenders insisted on a 20% down payment because they didn't know whether borrowers would be able to repay. They figured the 20% would give them an ample cushion in case they needed to repossess the house and auction it off. But in the boom of the 2000s, lenders and buyers of loans in the secondary market concluded that they could tell whether borrowers would be able to repay by looking at their credit scores. Suddenly, even people with mediocre credit scores were able to buy houses with little or no money down. Investors who wanted to cash in on the housing boom practically demanded that lenders originate more loans, so lenders dipped deeper and deeper toward the bottom of the credit-score pond. The assumption was that information was growing better and better, so it was possible to measure the risk of default with unprecedented accuracy. This is how complex securities such as collateralized debt obligations were valued.
It's clear now that many of those hastily made mortgage loans are worth less than 100¢ on the dollar, but the still unanswered question is: How much less? Are they worth 90¢, 50¢, 10¢? Until people figure that out, they can't tell how much mortgage-backed securities are worth—whether to lend money to banks and hedge funds that have invested heavily in those securities—and so on. Even big, profitable, and well-funded companies like Countrywide Financial (CFC), the nation's largest mortgage lender, have been waylaid by the credit crunch. Countrywide drew down $11.5 billion in emergency funding from a consortium of banks Aug. 16 to make sure it would have enough cash to tide itself over during the current crisis of confidence.
A Chill in the Air
Economists understand this phenomenon. Three American economists won a Nobel Prize in 2001 for their analysis of how markets break down when information is "asymmetric," such as when the buyer knows more about what's for sale than the seller. George Akerlof, Michael Spence, and Joseph Stiglitz said that when buyers realize they're in the dark about the quality of what they're buying, they will insist on paying less—so much less that it won't be worthwhile for the seller to sell. Hence, no deal. Market freeze.
It sure is cold out there now. Chilliest of all are the markets where information is the skimpiest, such as mortgage-backed securities and commercial paper. Analysts simply can't accurately value the collateral backing those securities. In contrast, the junk bond market is reasonably healthy. Why? Because junk bonds are issued by companies that issue quarterly financial statements and have real, going businesses that generate cash. You can estimate to a reasonable degree their ability to keep making payments on their debt.
In the 1920s, an economist named Frank Knight made the crucial distinction between risk, which markets know how to deal with, and uncertainty, which they don't. Risk is what you face when you have a basic understanding of how things work but there's a degree of randomness or luck involved. Knightian uncertainty is when you're really just stumbling around in the dark. And right now, there's an awful lot of stumbling around in the financial markets, with little idea of what comes next.