After the storm...

Thanks to the concerted efforts of central bank cash injections and the Fed's decision to cut its discount window by half a percent, extend loans to as much as a month and make it clear that even sub prime paper would be accepted as collateral, things look like they are going back to normal. The root of the current crises stems from the innovative changes in the way in which debt is created. Over the last decade we have seen an explosion in the issuance of asset backed securities whereby a relatively illiquid market of loans against some type of collateral are pooled together, divided into quality tranches and securitized. This has worked wonders for those who have traditionally had difficulty in obtaining financing. It has also proved beneficial to investors by allowing them to tap into new market segments in a risk controlled manner (given that many borrowers are pooled together and therefore diversified). But these instruments carry a large drawback in the form of a lack of transparency. The investors do not know what percentage of what they hold will default. That might not matter when things are going well. But when you have a problem such as the recent sudden surge in delinquencies in a sub prime market that came about because lenders, who got accustomed to a low interest rate environment, got carried away with their lending, things can very rapidly turn sour. Liquidity dried up almost instantly because the lender did not know if the borrower was exposed to this toxic market. Confidence was also eroded with the collapse of the Bear Stearns hedge funds considering they had very high ratings. It will be interesting to see if this time around the Fed will take any measures to improve transparency.