Debt markets: Cause and effect

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The way in which debt assets are marked to market has intensified the liquidity crunch. Far more should therefore be done to rethink the process.

Along with the New Year should come some hindsight into the debt market horror that was 2007. Looking back, the obvious question will be "How on earth did things get that bad?" As Christian Noyer, governor of the Banque de France, pointed out at Euromoney’s recent Fixed Income Forum in Paris, the direct cost of the sub-prime crisis itself is about $250 billion, which is less than one year of profits for the world’s 40 biggest financial institutions. So why has the effect of this crisis been so disproportionate to its cause?

The culprit is exactly the process that was meant to disperse risk, not generate it: disintermediation. The concept that the dispersal of risk across the capital markets was a good thing evaporated along with the first signs of trouble in the US mortgage market. But why was the reality so different to the theory? How could so many bright minds have got it so wrong?

The increasing importance of buyers such as CDOs and hedge funds in the fixed-income market had sharply altered the balance between investors that are risk absorbers and those that are risk amplifiers. CDOs and hedge funds are risk amplifiers; they buy on rating and sell at the first sign of trouble. Risk absorbers, such as pension funds, have the ability to take a longer-term view. The rise of structured credit in recent years meant that when the extent of the problems in US sub-prime mortgages became apparent, there were many more risk amplifiers than there were before.

But that is not sufficient to account for the staggering dislocation that has been witnessed over the past six months. The impact has been so severe not only because of there being so many more risk amplifiers, but also because the risk absorbers have been forced to become risk amplifiers too.

The reason for this? Marking to market. When long-term investors are made to mark to market, they cannot absorb risk, and are forced to act as amplifiers. Is it clear that a 20-year pension fund should mark to market in the same way as a short-term money manager does if the consequences are going to be this catastrophic? The mechanistic sellings of the last half of 2007 have shown the damage that marking to market can wreak.

The market urgently needs to revisit the concept of marking to market in debt. There should be greater account taken of its unintended consequences. Maybe there is an argument for regulators to distinguish between investors – with short-term buyers having to mark to market and long-term investors not. Maybe more account should be taken of who is holding the asset? The risk that an asset presents will be affected by the liabilities of the investor holding it – maybe regulators should consider that. This credit crunch has harshly exposed the risks embedded in vehicles that fund short-term and invest long-term, and they are unlikely to resurface in their present form again. But why should investors with matching assets and liabilities be subject to the same marking practices as those with an asset liability mismatch? Suggestions have even been made that funds should just be restricted in terms of the ratings of assets they buy, not of those they hold.

The regulators have so many fish to fry at the moment that any wholesale revision of how marking to market works is not at the top of the agenda. But surely a way must be found to tackle the kind of forced trigger-selling that has swept the market. Noyer at the Banque de France neatly summed up the problem that the whole market faces: "Liquidity depends on valuation, valuation depends on price and price depends on liquidity".