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Markets in turmoil

It was not for nothing that the greatest of economists John Maynard Keynes said, "Markets can remain irrational longer than you can remain solvent". Recently there has been a surge of irrationality that has turned the markets into casinos. To return to rational behaviour we need to consider why markets behave at times like drunken gamblers.

Debt

Banks used to behave rationally. If they lent money they took every reasonable step to ensure that those that borrowed were able to repay the loan. But things have changed. Largely through the "products" designed by hedge fund managers banks no longer see the need for due diligence. The banks have neither the need nor the desire to keep the loan until it is paid off.

Instead they parcel a large number of loans into a single product and sell shares in that product to all and sundry. Since the product is an amalgam of loans that often range from the sensible to the downright stupid the investor is effectively investing blindly.

Brokers

The next major change is that the banks no longer negotiate the loan themselves. They outsource to external brokers who dole out the bank's cash on a commission basis. The result is that a growing share of loans and mortgages are "subprime" — a fancy word for "bad". The brokers, who like the banks, will have no long-term interest in the loans see them as a source of revenues only — so that to them a bad loan is, ironically, as good as a safe loan. This is why we now read of Ninja loans. (The borrower has no job, no income and no assets, but he offers income to a broker who in turn has no responsibility — only a cash box). Until recently there has been an excess of cash in global markets chasing too little business. The result is that the normal rules of inflation ensure that the cost of investing in these new and blind products rises and for a considerable time — until the bubble bursts — hedge fund managers and banks live in happy ignorance of the simple fact that sooner or later there will be a reckoning.

Ethics or pragmatism

Normal morality may suggest that we should experience the consequences of our actions. The trouble with the present system is that the hedge fund managers that designed the product, the banks that made the bad loans and the brokers that negotiated on the bank's behalf bear little or none of the cost of their folly.

Certainly there will be a migration of cash from a few hedge funds and they will go to the wall; similarly those banks that have been a little slow off the mark will not have had time to offload some bad debt. The brokers will face a future in which the golden goose of subprime loans will lay no more golden eggs of commission in the short-term at least. But this will be a minor clearing out of malpractice. It could also lead to an international "credit crunch" that in turn could lead to a global recession. The global system cannot afford a credit crunch, particularly when there remains so much cash in the system. Idle cash serves no purpose. Active investment drives global trade and prosperity.

The Fed

Ben Bernanke at the Fed was faced by a dilemma. He could either ease the situation resulting from the folly of the banks and risk rewarding irrational behaviour, or he could take the ethical stance and risk a possible global recession caused by a credit crunch. He had a precedent.

When Russia defaulted in 1998 there was a similar risk of a credit crunch bringing about a global recession. Then, in spite of rising inflation the Fed cut interest rates in order to feed cash into the markets.What Bernanke did this time was to be pragmatic and careful. He reduced the "discount rate" at which banks can borrow, enabling them to make up any cash shortages without rewarding their folly. As I write he has left the central bank interest rate at the level that the Fed believes will counter inflationary pressures.

National banks

While commercial banks licked their wounds or counted their profits national banks took action to stave off potential disaster. They released considerable sums of taxpayer's money into the markets to reduce the effect of cash that was rapidly migrating to bonds and other safe investments.The European Bank, the Bank of Japan and others were active. The Bank of England remained aloof. In the long-term it may be seen that the Bank of England served its country best.

The take away

Most, if not all countries that have bourses have regulators, but regulators do not always regulate. They looked away and while they looked financial products of unbelievable obscurity were created by people out to make a quick profit at the potential expense of global trade and, at a more domestic level, investor's often small capital and savings for old age.

It should have been obvious to all that the value of housing in the USA and elsewhere could not continue an astronomic rise that might, just might, justify some questionable loans. Disaster nearly occurred because those that should have been watching were asleep at the switch. Regulators in America, Europe, the Middle East and Asia must wake up and fulfil their responsibilities. Governments must ensure that they do so. Even now disaster may have been delayed rather than averted. One observer has suggested that cash is to markets as oil is to a car. If we allow cash to run dry then as happens when oil runs dry things begin to go wrong. Even if the oil is replenished before major damage is experienced harm may have been done and may for a while be hidden. We may not be out of the woods yet.