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Debt markets: Cause and effect

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.

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