Turmoil in Financial Markets
By Arnold Kling
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.
…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.