Understanding the Current Financial Turmoil

When I teach introductory economics, I take pride in using current news stories to demonstrate the relevance of the subject. For example, two years ago, my class at George Mason University began just as Hurricane Katrina struck the Gulf Coast, and the resulting spike in gasoline prices gave the story an economic hook.

This year, those students who are interested in current events (sadly, many of them are not) would be aware of turmoil in financial markets. Financial markets are outside the scope of my usual introductory curriculum, but this year I feel that I owe it to my class to offer an economic perspective.

The Value of Financial Intermediaries

A financial intermediary is a company, such as a bank or a hedge fund, that manages money for investors. For example, think of a bank that uses investors' deposits to fund mortgage loans to individual homebuyers.

Suppose that you want to borrow $400,000 to buy a new home. Your plan is to pay back the loan gradually over a period of many years. I would not lend you that money, for a number of reasons. I do not want my money tied up for such a long time. I have no expertise in appraising your home, so I do not know whether $400,000 exceeds the value of the property. I cannot afford to take the sort of loss that I would incur if it turns out that you cannot repay the loan.

The fact is that I do lend money to people for home mortgages. However, I do so through financial intermediaries. For example, the money I have on deposit at a bank can be used by the bank to fund mortgages. I do not have $400,000 on deposit, but the bank can combine my deposit with other deposits. I am not planning to keep my deposit at the bank for 30 years, but the bank can allow me to access my money whenever I want without having to call in its mortgage loans. The bank has appraisers and mortgage underwriters who are experienced at assessing the loan's viability. Finally, the bank is able to spread the risk of a default across enough borrowers so that even if you fail to repay the loan, the bank itself does not go under.

When financial intermediation is deep and competitive, borrowers pay low rates. In the mortgage market, for example, interest rates have been under 10 percent for many years. On the other hand, pawn brokers tend to charge much higher rates. Even though they are making loans based on collateral, pawn brokers are not as competitive or sophisticated at spreading risk.

The Risk Premium

One economic measure of the value of financial markets is what I might call the "risk premium." The risk premium is the amount by which the interest rate on the loan exceeds what is needed to adjust for the probability of default.

For example, suppose that it is possible to lend money for a year to a borrwer who has no risk whatsoever at an interest rate of 5 percent. On the other hand, suppose that if you borrow $100,000 for one year, the chances are one out of ten that you will default on the principal (but you will pay the interest). That means that on average the bank will lose $10,000 on the loan. If the bank charges an interest rate of 15 percent, then in one year it will get $115,000 if you pay up and $15,000 if you default, so that on average it will get $105,000, which is exactly what it would get lending to the no-risk borrower at 5 percent.

The bank is likely to charge you a higher interest rate than this expected breakeven rate of 15 percent. For example, it might charge 16 percent. The one percent difference between 16 percent and 15 percent is what I call the risk premium.

The entire difference between the 16 percent rate that the bank charges you and the 5 percent rate that it charges a no-risk borrower is a combination of two things: 10 percentage points are what I would call a default premium, and 1 percentage point is what I call the risk premium. Often, financial writers lump the two together under the term "risk premium." Terminology aside, it is important to distinguish between what I am calling the default premium and what I call the risk premium.

When the risk premium is low, financial markets are working very well. When the risk premium is high, then borrowers are unable to obtain credit at a reasonable rate.

Hide and Seek with Risk

In order for financial intermediaries to lower the risk premium, they develop skills at evaluating risk and changing the ways that risk is packaged to investors. This involves an element of hide-and-seek. Investors obtain insulation from risk through various layers of protection, without understanding how those layers of protection work. As an individual, you do not really know what makes your bank deposit secure (government deposit insurance is the ultimate backstop in that case).

More importantly, managers of large pension funds do not really know what makes some of their investments secure. For example, when they invest with hedge funds, those hedge funds are filled with exotic and complicated securities. It is impossible to know exactly what sorts of risks these hedge funds are taking--they have to keep their investment strategies secret for competitive reasons. The pension funds have to trust that the hedge fund managers know what they are doing.

The Recent Turmoil

What seems to have happened over the past year is that the hide-and-seek process in the financial intermediation process for mortgage loans to risky borrowers got out of hand. Some institutions wound up with more default exposure than they were expecting, based on the information that they could obtain from rating agencies or other parties. With some institutional investors burned in the sub-prime mortgage market, this has caused other institutions to question their own portfolios: which of our investments might have more potential to default than we have been allowing for? What if it turns out that bond ratings are less reliable than we thought?

The net result is that risk premiums, which had been trending down in recent years to historically low levels, have bounced back up in the past several weeks. This adversely affects companies, such as Countrwide Financial, that rely on their strong credit ratings to be able to finance their portfolios using low-cost debt. A small increase in the risk premium faced by Countrywide can cause an enormous drop in its profit margin.

Sebastian Mallaby calls this "irrationality" on the part of investors. Instead, I think of it as a breakdown in trust of the financial intermediation process. This breakdown is occurring not so much at the level of the average consumer, but among large institutional investors. Money managers who a year ago were willing to accept low risk premiums for securities are no longer willing to do so. No one is really sure whose tools for evaluating default probabilities are reliable and whose tools are not. Until financial intermediaries can re-establish the reliability of their estimates of the likely performance of various credit instruments, institutional investors will be skeptical of the hide-and-seek process. This will keep the risk premium high, with adverse effects on housing and business investment.

What Next?

Changes in the risk-premium tend to cascade. When the risk premium falls, financial intermediaries look for more profit opportunities. Their lower cost of funds allows them to compete to lower the risk premium for other borrowers. That is how sub-prime mortgage lending was able to gather momentum from 2003 through 2006.

When the risk premium goes up, financial intermediaries that have been very profitable suddenly find themselves squeezed. As their viability suffers, investors become wary and the risk premium rises further.

The question now is whether the financial markets will establish a new equilibrium soon or whether there will be further shocks leading to further increases in the risk premium, leading to more shocks, etc. If the equilibrium scenario unfolds, then Mallaby is correct and there are many bargains available to investors. But that could turn out to be a "picking up nickels in front of a steamroller" strategy if the adverse scenario were to unfold.