Those who are older than the trading floor average will have seen this before. But what makes this credit cycle more complicated and perhaps more hazardous is the very thing that the former Federal Reserve chairman Alan Greenspan and others argued had made financial systems safer: the securitisation of credit. Securitisation brings benefits. But in these circumstances it will make the down cycle more severe and will transmit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.
Before securitisation, whenever the credit cycle turned down a bank’s loan officer could conclude, through his long relationship with the credit or a portfolio of them, that the market was under-pricing that credit. He could use the bank’s balance sheet to hold on to out-of-favour credits until the market stabilised. Banks have since earned fees for securitising credits and selling them on. Now, when credit prices fall and daily risk management systems scream that that risk should be sold, the fund manager with only a passing knowledge of the underlying credit and without a large balance sheet cannot hold on to it.
Over the past 20 years, governments built regulatory systems to avoid credit problems at one bank becoming systemic. These systems succeeded, but only by shifting risks elsewhere. A measure of this failure is that the instances of emergency rate cuts have become no less frequent. Think of 1987, 1989-92, 1995, 1998 and 2001-03. Today, the principal avenues of systemic risk are via investment losses, not bank runs.