The markets are in turmoil - £75 billion was wiped off London stocks last week, with the financial institutions taking the brunt of this; liquidity in credit markets is drying up to the extent that central banks had to inject $120 million last week with the promise of more to come; banks are refusing to lend to other banks for fear of being caught with the parcel when the music stops. Why?
It is impossible to look at any financial news today item without being dragged back to the impact that securitisation of sub-prime credit is having on the market. The principle is easy – take a bundle of retail mortgages, a low risk business according to Basel II standards; package them up and reduce your credit risk by selling them on to someone else. The buyer receives a low risk investment backed by the underlying property – after all if a mortgage holder defaults one just repossess the home and sells it – and the reputation of the original lending bank – Triple As all round! The credit models seem faultless.
Unfortunately, it looks like the models do not work when the default rates get out of line. Too many people defaulting undermines the property collateral – and that assumes it was correctly priced in the first place – not something the originating bank is under pressure to do when it knows it is selling the risk on. Add a market reaction to downgrade all these instruments and a subsequent drying up of liquidity and you have – a crisis!
None of this was entirely unexpected. Edward Altman, Professor of Finance at New York University was waving flags in February (see Chase Cooper News, February 20th 2007). Neither is market volatility in one direction unknown – remember LTCM? Will we now see a revision of Basel II credit weightings? Will the US reopen the entire debate on the suitability of Basel II capital calculations?
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