It’s far too soon to say how the current market turmoil will play out. The subprime virus has now spread across all continents and asset classes. And until we know how large the losses are and who is sitting on them, the markets will be volatile. The uncertainty could continue for months. But it’s already becoming clear who is to blame for this debacle. Here’s my take on some of the victims and villains.
Ratings agencies
In the wake of the dotcom bubble, it was analysts who were in the firing line for producing duff research designed to boost their bank’s corporate clients; post-Enron, the spotlight was on auditors, who were blamed for turning a blind eye to their client’s accounting skulduggery. This time round, it could be ratings agencies, such as Moody’s, Standard & Poor’s and Fitch that end up in the firing line. Their job was to rate the creditworthiness of the bundles of mortgage loans sliced and diced by the investment banks, who also happened to pay their wages. A huge proportion of these securities ended up being rated AAA – which ranked them as safe as bonds issued by the bluest of blue-chip firms. Yet many now look likely to end up worthless. The agencies have a lot of explaining to do.
Investment banks
There’s no doubt a lot of banks were playing a cynical game with subprime mortgages and other debt besides. The problem was their role in all this was as middle man; they provided the alchemy by which dodgy home loans to the least-creditworthy people in the US were somehow turned into AAA-rated securities – and then they sold them on. As a result, they had no incentive to delve any deeper into the quality of the underlying loans than necessary to persuade the ratings agencies. Still, the banks will pay a high price for their cynicism – there will be lawsuits galore, and they are likely to lose money too. Most banks are heavily exposed to the subprime crisis via their residual holdings and their lending to the hedge funds.
European banks
The big question during the early stages of the subprime debacle was, who owns all this toxic waste? Hundreds of billions of dodgy mortgage loans were awarded, yet no one knew who was exposed. Now it turns out that large amounts of the most toxic debt was stashed away in off-shore, off-balance-sheet, special-purpose vehicles (SPVs) sponsored by unsophisticated, greedy European retail banks. These SPVs were used to provide supposedly low-risk, high-interest cash accounts to everyone from companies to local authorities to retail investors and were backed up by giant loan guarantees from the banks, which they may now have to honour. That’s brought the crisis back into the heart of the banking system – hence last week’s emergency intervention by the European Central Bank. For capitalism to operate as it should, the worst offenders should be left to go to the wall. But judging by the way German banks rallied to bail-out stricken IKB, don’t bet on it.
Subprime borrowers
People talk about the greed of Wall Street, but it’s easy to forget that this crisis was caused by the greed of those who took out mortgages they could not afford. These are the biggest losers from the sub-prime debacle; millions are likely to have their homes repossessed. Of course, our delicate sensibilities can’t cope with the idea that people are responsible for their own misfortunes, so we are obliged to see them as victims – the implication being they were too ignorant to understand the risks they were taking and needed protection. The problem with this sort of talk is that it leads to the wrong conclusions. Astonishingly, I listened to a senior Wall Street figure last week tell me that he thought the US government should bail out these homeowners. Rewarding the borrower while punishing the lender like this strikes me as dangerously socialistic nonsense. On the other hand, if Wall Street bankers wanted to pass the hat round to help out their less-fortunate compatriots, that might focus minds.
Hedge funds and private equity
The tragedy for hedge funds and private-equity groups is that they didn’t cause this crisis, but may yet end up among its biggest victims. Private-equity groups rely on lashings of debt to make their deals stack up. But the debt markets are now closed and when they reopen, no one expects the days of easy borrowing to return. That means new deals will be harder to pull off, existing investments will be tough to exit and returns will fall. Meanwhile, problems are starting to emerge in the hedge-fund world. A few giant so-called quant funds, which use computer-generated trading programmes to invest across different asset classes, have run into difficulties and started to dump shares. Some, such as the Goldman Sachs Alpha fund, are sitting on big losses. The combination of private-equity deals under water and hedge funds trading well below their high-water marks raises an intriguing possibility: some of those masters of the universe used to trousering huge pay packages on the back of juicy fees and lucrative carried interest may soon find themselves effectively working for free. Now there’s a thought.
Simon Nixon is executive editor of Breakingviews.com