Wind down the market in five-legged dogs


Banks should retire to the traditional and profitable business of taking deposits to make loans: the business we want them to do and the business they really understand.

Abraham Lincoln posed the question: “How many legs does a dog have if you call a tail a leg?” Honest Abe’s answer was four. A tail is still a tail even if you call it a leg.

The world of finance is a bit more complicated, but not much. How can a package of loans be worth more than the sum of their individual values? The amount borrowers pay is just the same even if you call the loans an asset-backed security or a collateralised debt obligation.

Securitisation in lending may add value by allowing the risk characteristics of the new instrument to be precisely tailored to the risk characteristics sought by the buyer. This account was espoused by many academics, especially those in love with the efficient market hypothesis. Not many people in the financial services industry felt the need to offer a social rationale for activities that were so obviously profitable. But if they did, it was the same story: such packaging and repackaging led to more efficient risk allocation.

There is something in that argument. But could there be tens of billions of dollars a year of profit in it? Could the advantages of slightly more elaborate differentiation of an already wide range of fixed-interest products really be so large? If differences in risk appetite determined the market, you would not expect the list of institutions that bought securitised products to be so similar to the list that sold them.

Another account is favoured by economists less convinced of market efficiency and more impressed by information asymmetries. No one is sure what complex packages of loans and securities are worth. You need models to value them, and only fools derive certainties from models. You might expect that undervaluation would be as common as overvaluation, and in general you would be right. But there is a twist. It is not people who undervalue securities who buy them, but people who overvalue them. The errors of market participants affect prices in one direction only.

This mechanism – a variant of the notorious “winner’s curse” – explains why packaging can be rewarding for the issuer. But the apparent value added is illusory. The buyer loses what the seller gains. It may, however, be some time before the buyer catches on. George Akerlof famously explained what the eventual secondary market would be like in his Nobel Prize-winning study of “the market for lemons”. Trading would be thin and prices would be below the average intrinsic value of the goods. This is exactly what we see today.

To think that today’s market conditions are exceptional, and that yesterday’s euphoria represented a normal state of affairs, is a fundamental misconception. On the contrary: in market equilibrium, opaque products sell with difficulty and at a discount. A barrel of apples whose quantity and quality can only be guessed at should sell for less than the combined value of the apples, and does. There was never an economic rationale for structured products on the scale on which the financial services industry created them. They were the result of a frenetic search for commissions and bonuses.

Nor should we be impressed by the argument that since a large fraction of mortgages was turned into mortgage-backed securities, an adequate supply of mortgages depends on securitisation. That argument confuses the mechanism of supply with the source of supply. You might as well suggest that since 25 per cent of groceries are bought on Friday, closing stores on Friday would reduce our food consumption by 25 per cent.

The objective should not be to revive the originate and distribute model of banking, which has demonstrably failed, but to secure its orderly winding down. Banks should retire to the traditional and profitable business of taking deposits to make loans: the business we want them to do and the business they really understand. The British government plans to provide insurance for new asset-backed securities. That is like helping a junkie to detox by guaranteeing drug supplies until the local dealer resumes normal service.

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