By Debasish Roy Chowdhury (China Daily)
Updated: 2007-08-23 07:16

Share markets across the globe have gone into a tizzy. Central banks on either side of the Atlantic and beyond have been forced to launch one of the most coordinated operations ever to breathe life into a market choking on a tightening credit squeeze.

As the world gropes for answers to understand the real magnitude of the earthquake rocking the financial world that epicentered in the US housing mortgage sector, the crisis brings home an uncomfortable truth: there is actually very little information in what we call the information age.

For, what we see at play today from New York to Hong Kong is nothing but the market-destroying power of information asymmetry.

The origin of the current market volatility is the US subprime loans, or the high-interest loans made to less creditworthy buyers who do not qualify for regular market rates. Lenders sold these subprime mortgages to financial institutions which repackaged them as bonds and sold them in credit markets worldwide.

As the cost of borrowing kept increasing with rising interest rates in the US and the property bubble there burst, defaults on the underlying subprime mortgages began to mount, sending shock waves through the entire financial market triggered by fears about major financial institutions' exposure to these bundled bonds.

This has in turn fostered a climate of fear and suspicion in the credit market that has led to the evaporation of credit in certain sectors and rising interest rates in others, raising the specter of an economic slowdown and a consequent sell-off of stocks.

From the bundling of the bonds to the credit problems they have spawned, the subprime crisis has been dogged by asymmetric information at every step. In economics, information asymmetry occurs when one party has more information than the other in a transaction.

Three US economists, George Akerlof, Michael Spence, and Joseph Stiglitz, were awarded the Nobel Prize in 2001 for their work showing how asymmetric information can lead to market failure. The mess that we now see in the financial markets is thus hardly a surprise.

Information asymmetry can lead to moral hazard and adverse selection. Moral hazard occurs when distribution of risk influences behavior. For example, a person with car insurance may be less concerned about theft and less prone to secure its protection as he/she has transferred car theft risk to the insurance company. In case of subprime lending, moral hazard occurred both in the process of origination of such mortgages and their eventual passage to the wider credit market.

A major change in the US housing mortgage market over the years has been the emergence of a broker-led system, in which brokers help home-seekers secure loans and charge a fee for it. Bigger the loan, bigger the fee. This leads to a moral hazard situation in that brokers try to ensure a big, rather than a safe, deal.

Moral hazard plagues lenders as well. Lenders pass on the subprime mortgages to other financial institutions who package them into mortgage-backed securities and collateralized debt obligations (CDOs), which are nothing but bundles of securities with varying yields and credit ratings. A CDO is typically formed by bundling together 100 or more bonds and other securities, including home mortgages.

These mortgage-backed securities are then sold to hedge funds, banks, pension funds or other financial institutions that want to diversify their risks. So the bank that makes the original high-risk subprime lending transfers the risk to bond buyers.

A new International Monetary Fund study finds the move from bank-based lending to this capital-markets-based lending system has indeed created perverse incentives for reckless lending. Since the bank advancing the original home loan does not retain the mortgages it originates, it has no incentives for due diligence and monitoring.

The result of this dispersion of credit risk is that, until 2003, most mortgage originations were "prime conforming" loans, which were purchased by two government-sponsored housing enterprises (GSEs).

By the end of 2006, less than half of all originations met the GSEs' "conforming" criteria. Last year, the so-called "liar loans" that require little or no documentation of the borrower's financial condition and often involve overstated claims reportedly accounted for 45 percent of all subprime originations.

Even the esoteric world of bond trading fell prey to information asymmetry. It is now becoming increasingly clear that many investors who bought these securities had no idea what they were getting into.

Securitization theoretically reduces risk by spreading the loss. But with the collapse of the $800 billion market in bonds backed by subprime mortgages, such bonds have lost a chunk of their value.

Subprime mortgage securities made up about $100 billion of the $375 billion of CDOs sold in the US in 2006. Investors who bought these CDOs still do not have a clear idea how hard they have been hit. And the market does not know who have been hit.

Many CDOs are created by investment banks for specific clients and as they are hardly traded, their price is set with the help of fancy computer-generated models based on subjective assumptions, not through trading in secondary markets.

This opacity is the reason nobody wants to touch structured credit instruments any more. Attempts to sell these financial instruments have been mostly unsuccessful, with traders, even when they are interested, offering a pittance. French bank BNP Paribas has suspended three of its funds precisely because of this valuation problem.

In fact, all types of debt, even gilt-edged CDOs with no subprime component, have become difficult to sell. This brings us to the adverse selection aspect of asymmetric information. If buyers are not sure about the worth of what they are buying, they will keep paying less even for good products, to the point that it makes no sense for the seller to sell these products, leading to market failure.

With credit drying up, causing interest rates (price of credit) to rise, the European Central Bank took the unprecedented step of giving banks unlimited access to its funds at 4 percent base rate to keep the money flowing.

The banks responded by taking in as much as $127.45 billion the very day. The ECB has kept injecting billions of dollars since, as have the US Federal Reserve, the Bank of Japan and central banks of Australia, Canada and Russia.

The Fed went a step further last Friday by cutting the discount rate by half a percentage point, helping markets worldwide to bounce back. The last time the Fed enacted an emergency rate cut was in 2001 after the Internet bubble burst and the September 11 terror strikes occurred.

In an unusual move, it also announced that it would provide discount lending for up to 30 days. This allows banks to borrow directly from the Fed rather than other banks too nervous to part with their money at this point.

Despite the apparent success of these cash injections that seem to have brought the bulls back into the market, this response again raises the risk of promoting moral hazard that so characterizes the subprime crisis.

By bailing out the markets, the central banks are in effect bailing out the consumers who recklessly took out loans to finance homes they were in no position to afford, the mortgage lenders who did not care two hoots about the credentials of their borrowers, and the investors who bought the fancy bonds without trying to understand the risks involved.

The concerted central bank effort to mitigate a global credit squeeze is thus in effect a reward for the wayward ways of all the subprime players, a move that only encourages more recklessness in the future.

Rather than bringing the castles in the air down to earth, the monetary guardians are adding more floors to them. The next time the fall comes, the thud could be a lot louder.

The author is a senior editor with China Daily

(China Daily 08/23/2007 page11)