Imagine someone thinks their house is worth a million pounds. But this is pure fantasy, and it turns out that it's worth just £500,000. Has this person suffered a genuine loss? Is the difference between dream and reality a loss?
That's one question raised by the IMF's widely reported claim that the financial sector could lose $945bn on debt securities.
The word "could" is important here. This estimate, the IMF says, is "based on potential loan losses that have occurred since the subprime crisis began and over the next two years."
Truth is, though, that the number is much less spectacular than the papers think.
For one thing, it's much less than equity investors have lost. Worldwide, $5.6 trillion has been wiped off share prices since late October. Few serious people are much troubled by this.
And for another, it's not clear how important this is. Before the sub-prime crisis began, some CDOs were not so much marked to market as marked to fantasy. To this extent, banks' losses are the same as our homeowners losses. They are not so much a destruction of real wealth as a wake-up call.
Maybe too loud a call. Mark-to-market measures can overstate losses, if one prices securities at the low-point of the market, from which a recovery subsequently comes.
Instead, what matters is not the number attached to the losses - that's just a way of getting headlines - but the response to losses. A loss of, say, $5bn might - depending on who suffers it - lead, variously to: no change at all; a small tightening of lending standards; an abrupt withdrawal of credit; a spiral of losses as the fund is forced to sell even good assets in order to plug the whole; or massive widespread losses as the fund goes bust thus exposing many other traders to counterparty risk.
Which raises the question. Just how true is the conventional neoclassical view that financial liberalization allows risk to be borne by those best placed to take it? The truer this is, the more likely the effects are to be at the weaker end of the spectrum.
And today, we got some encouraging news on this front. HSBC's offer (with snags, natch) to match expiring fixed-rate mortgage deals shows just what should happen in a healthy financial system - the strong lenders should take up the business which weaker lenders refuse.
But let's be clear here. The $945bn figure is not important at all. The question is an an ideological one: is the financial system a source of stability, allowing risk to be spread efficiently, or is it instead a source of instability?
Am I right, I am not sure...?
Banks have treated the increase in paper value of these assets as a means to draw ever larger salaries and bonuses - A banker says, "I bought an asset which appreciated in value by 30 million last year, therefore I deserve a salary and bonus of 5 million. It matters not a jot that the appreciation was a figment of my imagination".
And now the value of these assets is shown to be lower, the banker is already out the window with his swag bag over his shoulder.
I am just not sure to which victim the swag belonged. Although it is clear shareholders carry the can - much like an insurer at a burglary.
Posted by: Mark | April 09, 2008 at 02:38 PM
Chris - I would appreciate your reflections on this proposal:
"[George] Osborne is therefore attracted to a proposal put forward last year by a former member of the Bank of England’s monetary policy committee, Charles Goodhart, whose effect would be to impose restrictions on how much banks can lend during years of strong economic growth and would ease those restrictions when the economic cycle turns down."
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/04/osborne_and_the_next_crunch.html
Almost anything Goodhart suggests about banking reforms commands serious attention and several other people, including Vince Cable, are mooting prospective radical reforms of the financial system without being any too specific about details:
http://commentisfree.guardian.co.uk/vincent_cable/2008/04/calling_time_on_the_system.html
Occasionally, in the context of dealing with Japan's deflation, news has emerged from there about suggestions that the central bank there might engage in market support operations for equity, which raises all sorts of fascinating questions about who or what is to select what equity to support?
Posted by: Bob B | April 09, 2008 at 04:37 PM
For interest, here is the text of George Osborne's speech at Harvard yesterday:
http://www.conservatives.com/tile.do?def=news.story.page&obj_id=143499
Posted by: Bob B | April 09, 2008 at 04:51 PM
Mark is spot on.
The current crisis raises some very serious issues about how shareholders control the bankers. Isn't government control just an excuse for shareholders not to exercise their responsibilities?
Posted by: Dipper | April 09, 2008 at 08:13 PM
For one thing, it's much less than equity investors have lost.
Yes but that's hardly and argument, Chris.
Posted by: jameshigham | April 10, 2008 at 04:38 AM
The banks like to blow a few billions every few years. It gives them the excuse to up their charges, screw their shareholders, and generally make us all miserable
Posted by: kinglear | April 27, 2008 at 06:29 PM