Opportunities in smallcaps header image 2

Central Banks in the mortgage business?

April 21st, 2008 · No Comments

On Sunday, the Bank of England (BoE) announced that it was branching out, into the mortgage business. Do they see an opportunity here in this market in steep decline? No, of course not. It’s actually a sign of how bad things have gotten.

Central banks are responsible for the value of the currency, both internally (that is, guarding against inflation) and externally (managing the exchange rate). They’re also responsible for overseeing the banking system (and some central banks, like the FED in the US, is also responsible for maintaining economic growth).

Oversight of the banking system has not been their forte, recently, with the FED under Alan Greenspan especially guilty (although he’s washing his hands in innocence and getting paid for it handsomely on the lecture circuit, these days).

Deregulation has been the fashion, and although that can produce good results, it’s often forgotten that markets actually need regulation as well. Markets can only work well if they function in the right institutional environment. If not, thing can go bad pretty easily (in economic terms this is known as increasing transaction cost, which doesn’t sound nearly as alarming as it should).

For instance, a buyer must be sure he gets what he’s promised, a seller must be assured he gets paid, any conflict needs to be sorted out, often by a third party. Hence institutions like contract law adn the justice system. Justice outcome also need to be enforced, hence the police system, etc. etc., you get the picture.

Another fundamental problem besetting markets is so called ‘asymmetric information ‘. If buyer and seller do not have the same knowledge about the service or product that is being transacted, incentives to take advantage of such knowledge advantage are in place.

You buy a second hand car, but is it really such a bargain as the salesperson argues? Hard to know for sure. The economic analysis of this situation (in terms of asymmetric information) actually won George Akerlof a Nobel prize in economics (The Market for Lemmons ).

So, if one party to a transaction has much more knowledge than the other, they might take advantage of that. With increasing complexity and specialization, the occurrence of this type of situations is on the up.

One instance is the mortgage market . Deregulation opened up the path to providing mortgages to people who previously did not have access to it, slogans like ‘the ownership society’ made everybody feel good about it, and cutting up mortgages in little pieces and selling them off on markets as securities evaded normal banking regulations and made risk ‘disappear’, like magic.

Many welcomed all this. Risk would be sold of and spread. However, many of those mortgages had all kinds of nasty provisions that those who bought them did not fully understand. And the housing market started to cool just when the super-low ‘kicker’ rates ended in many contracts, putting a lot of those first-time house owners in problems. They were the first victims of asymmetric information .

Bad as that was, things really got nasty as the defaults on the payments on those mortgages reverberated through the system. The financial products concocted to spread the risks of default in mortgages are so complex that markets in them work only on a few base assumptions are fulfilled, basically, a few heuristics as a shortcut to see through the fog of the complexity.

Nobody can describe it better than top economist and NYT columnist Paul Krugman :

  • "Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs."

These securitized markets melted down because parties were no longer sure what exactly they were buying. They could buy a Lemmon? How to price the risk? Is the selling party not taking advantage to load off some? It spread to other markets as well, as financial institutions were loath to do business with one another because they did not know how creditworthy they were. Risk became systemic and markets melted down.

In the end, Central Banks are starting to take on those risky and complex assets, like the BoE moving into the mortgage business. Whether it’s enough to stop the rot remains to be seen.

Tags: Opinion