Markets, Systemic Risk, and the Subprime Mortgage Meltdown

Because systemic risk is positively correlated with markets, investors cannot diversify it away.
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The subprime mortgage meltdown is undermining financial market stability and has the potential to cause a true systemic breakdown, collapsing the world's financial system like a row of dominoes. I use this crisis to demonstrate that existing protections against systemic risk, which focus on banks and largely ignore financial markets, are anachronistic and misguided. Because companies increasingly access financial markets without going through banks, an effective framework for containing systemic risk must focus on markets.

In a forthcoming article, I have examined financial-market anomalies and obvious market protections that failed, seeking insight into the subprime mortgage crisis. The crisis can be explained in large part by three categories of factors: conflicts, complacency, and complexity. Running throughout these categories is a fourth factor, cupidity; but because greed so ingrained in human nature and so intertwined with the other categories, it adds little insight to view it as a separate category.

For example, the excesses of the originate-and-distribute model of mortgage securitization -- under which mortgage lenders sell off loans as they are made which are then packaged into mortgage-backed securities and sold to investors -- can be managed by avoiding conflicts, such as aligning the interests of the mortgage lenders and investors. The excesses of the form of complacency perhaps most responsible for the subprime mortgage crisis -- widespread investor infatuation with securities that have no established market and, instead, are valued by being marked-to-model--have at least in the near-term been discredited by the losses associated with the subprime crisis itself. Complexity, the third category, was a central culprit responsible for the failure of disclosure in the subprime crisis, but viable solutions appear to be second best.

The subprime crisis, however, is increasingly likely to trigger an even more systemic collapse of our financial markets for reasons that go beyond these categories. The risk of this collapse ("systemic risk") is, more generally, regarded as the risk that an economic shock -- in the present case, the subprime mortgage crisis -- can trigger a chain of market and/or financial institution failures, resulting in increases in the cost of capital or decreases in its availability. Because systemic risk is positively correlated with markets, investors cannot diversify it away.

Governments in the United States and abroad are seriously concerned about the subprime crisis and its potential systemic consequences. The near-failure of Bear Stearns is just a recent example of these consequences. I will use this crisis to demonstrate, however, that existing protections against systemic risk are insufficient.


In the past, regulators have thought about systemic risk primarily in terms of institutional failures -- in the Great Depression, for example, bank failures; and in the 1990s, the near-failure of hedge fund Long-Term Capital Management ("LTCM"). Yet companies increasingly obtain their capital from financial markets, not from banks or other financial institutions. This shift, referred to as disintermediation, makes financial markets increasingly central to any examination of systemic risk. Some financial leaders are already beginning to call for an expanded focus on markets.

The subprime mortgage crisis confirms the importance of this expanded focus. The crisis was triggered not by institutional failure but by market failure. Once investors realized that highly-rated subprime mortgage-backed securities could lose money, they began shunning all complex securitization products, including asset-backed commercial paper which was thought to be almost as safe as cash. The impact of this crisis then extended beyond mortgage -- and asset-backed securities to the auction-rate securities market, which many regarded as highly-liquid and secure, and to credit markets generally. This, in turn, is causing market participants to avoid financial institutions, such as investment bank Bear Stearns, with large portfolios of these securities.

Existing protections against systemic risk are failing in the subprime crisis because they focus almost exclusively on banks, not markets. And general regulatory protections against market failure -- primarily disclosure under the securities laws, and the "market discipline" approach of the current Administration -- are not directed against systemic risk per se.

More tailored financial-market regulation is needed because systemic risk is somewhat unique. It results from a type of tragedy of the commons in which the motivation of market participants "is to protect themselves but not the system as a whole. . . . No firm . . . has an incentive to limit its risk taking in order to reduce the danger of contagion for other firms." Even if market participants were able to collectively act to prevent systemic risk, they might not choose to do so because the externalities of systemic failure include social costs that can extend far beyond market participants, such as widespread poverty, unemployment, and crime. Market participants will not want to internalize these costs and thus will take an insufficient amount of care in preventing them. Therefore, like a tragedy of the commons, the benefits of exploiting finite capital resources accrue to individual market participants, each of whom is motivated to maximize use of the resource, whereas the costs of exploitation, which affect the real economy, are distributed among an even wider class of persons.

Individual market participants also may choose to act selfishly because their returns are assured whereas a systemic collapse is not necessarily inevitable. LTCM, for instance, knew there was a risk of failure if the markets became irrational but chose to stick with models that made it money. Ignoring a possible greater risk for the sake of personal gain is not unique to the world of finance. Before the Challenger disaster, engineers knew of the risk that the rubber O-rings might fail at cold temperature and argued that the launch should be delayed until warmer weather. Engineers also identified the potential for wing damage before the Columbia disaster. In both cases, however, NASA administrators appeared to have been less concerned about the possible safety risks than about the impact on their personal reputations of canceling flights.

So what can we do? It would be ideal to eliminate the risk of systemic collapse, ab initio. This could be achieved by preventing financial panics, since they are often the triggers that commence a chain of market failures. For example, doubt arising over a financial market's future liquidity can trigger a stampede to sell first while the market is still liquid, thereby inadvertently destroying the market's liquidity. Contractual counterparties rush to try to close out their positions, causing prices to drop sharply, which in turn leads to a vicious cycle in which prices plummet and investors lose confidence.

It is impossible to prevent financial panics because they "can be set off by any number of things." In the context of the subprime mortgage crisis, for example, scholars and politicians talk about imposing "suitability" requirements on mortgage loans and otherwise restricting "predatory" lending. But these types of solutions not only potentially increase the cost of credit and restrict its availability but, more importantly, fail to address the next financial crisis, which may be unrelated to home values or mortgages.

A more fundamental, yet targeted, regulatory response to systemic risk is to try to ensure market liquidity. Although ensuring liquidity cannot always prevent financial panics that trigger systemic risk, it can address any systemic problem by diminishing the vicious cycle caused by financial panics. This broad-spectrum capability is important in a world where financial intermediation evolves at a speed faster than one can anticipate.


So how can regulation ensure market liquidity? Although there are various possible approaches, I believe the most effective is to create a governmental liquidity provider of last resort ("LPOLR"). By advertising its willingness to purchase securities in panicked markets and, when necessary, actually purchasing such securities, such a liquidity provider can reduce doubt over future market liquidity, thereby avoiding a stampede to sell and the resulting vicious cycle of plummeting prices. This is radically different from so-called "liquidity injections" by the U.S. Federal Reserve in response to the subprime mortgage crisis, which do not actually ensure market liquidity but merely provide a more attractive borrowing environment for banks.

Any regulatory proposal must, however, take cost into account. There are, theoretically, two primary costs in establishing a LPOLR. The first is moral hazard -- the greater tendency of people who are protected from the consequences of risky behavior to engage in such behavior -- which would result from the LPOLR assuring speculative investors that their investments would be safe if market prices ever collapse. The second cost is the shifting of the economic burden from market participants to taxpayers, who effectively would fund the LPOLR's purchases. Both of these costs can be managed and arguably avoided, however. To mitigate moral hazard, the LPOLR could follow a policy of "constructive ambiguity" under which it has the right but not the obligation to purchase securities, and the rules by which it decides whether to purchase would be uncertain to third parties. (This contrasts sharply with the moral hazard resulting from the Fed's bailout of Bear Stearns.) To further mitigate moral hazard and to avoid shifting costs to taxpayers, the LPOLR should purchase securities only at a deep enough discount to ensure ultimate repayment of its investments, ideally at a profit, while stabilizing market prices well below the levels paid by speculating investors.

Even if these costs cannot be completely eliminated, I would contend that a LPOLR should be justified because of the devastating effect of a systemic collapse of the financial system. For example, just taking into account direct, not social, costs, the tab from the subprime mortgage crisis -- even if it doesn't cause a full systemic collapse -- "could run up to $500 billion" globally. When there is a risk of catastrophic events or large, irreversible effects but the actual level of risk is indeterminate, regulators often apply a precautionary principle that presumes benefits will outweigh costs.

One may ask: If a LPOLR can profitably invest to stabilize markets, why won't private investors do the same, eliminating the need for a governmental liquidity provider? At least part of the answer is that individuals at investing firms engage in herd behavior, not wanting to jeopardize their reputations and jobs by causing their firms to invest at a time when other investors have abandoned the market. A governmental LPOLR is needed to correct this market failure.

Who should act as the LPOLR? In a U.S. national context, the Federal Reserve Bank could act in this capacity. In a foreign national context, the obvious contender would be the nation's central bank. In a multinational context, however, the choice is less obvious. One possibility is the International Monetary Fund (IMF), which sometimes takes on this type of role by providing liquidity to troubled countries. Other possible choices include one or more national central banks, such as the U.S. Federal Reserve Bank or the European Central Bank, although any national central bank acting as a LPOLR would face possible conflicts of interest between its national and international responsibilities. My goal, however, is less to suggest who should act in these capacities than to urge that one or more governmental organizations do so before it's too late.

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