John Locke’s message

Unintended market consequences

18 August 2007

If only Alan Greenspan had read John Locke more attentively. The 17th-century philosopher, who doubled as a brilliant economist, was among the earliest exponents of the law of unintended consequences.

Fast-forward to 2001, the year in which Greenspan slashed US interest rates from 6 per cent to 1.75 per cent (they eventually fell all the way to 1 per cent). He was desperately and laudably trying to fight the twin effects of the collapse of the dotcom bubble and the fallout from 9/11. But while he succeeded beyond all expectations, staving off recession and covering himself in glory in the process, his actions also triggered a borrowing bonanza, a house-price boom and deeply imprudent attitudes to risk, laying the seeds of the current turmoil in financial markets.

Vast numbers of mortgages were extended to US borrowers with poor credit ratings, on the absurd assumption that interest rates would always remain low. Now that Fed rates are back up to 5.25 per cent, tens of thousands of sub-prime borrowers have started to default. At the same time, house prices in many poor areas have started to fall, cutting the value of lenders’ collateral.

It is not only those institutions foolish enough to have lent to borrowers who could never realistically be expected to repay that are being hit. Modern lenders never keep loans on their own books for long, preferring to sell them on to others. This is done by bundling large numbers of mortgages together into bonds called collateralised debt obligations (CDOs), which are subsequently sold to banks, pensions funds, hedge funds and other investors.

For years, credit rating agencies and others were convinced that CDOs were safe, with the risk of any individual default sufficiently diluted by the presence of many other, safer loans within the same bundle. But as more and more people have failed to meet their repayments, the value of CDOs has suddenly plummeted, exposing the naivety of many supposedly brilliant investors.

Many of the world’s most powerful institutions, from Goldman Sachs to Bear Stearns, are nursing massive losses, estimated at up to $200 billion globally. These could grow further as low, fixed-rate mortgage deals continue to expire and more Americans have to pay the market rate on their loans.

The worries soon proved contagious. Next to panic were investors who had loaded up on the cheap debt used to fund leveraged buy-outs. Worried by the possibility that all risky debt, not only sub-prime mortgages, may be more dangerous than previously thought, they took fright, leaving the banks that underwrite the big buy-out deals to take billions of pounds of debt on to their own books. This has led to the imposition by the banks of much more stringent lending conditions.