Can the sub-prime crisis rock the international financial system? What role can central banks play in this?

We have been following the US sub-prime crisis for quite some time. I always wondered as to why Prof. TT Ram Mohan has not written on the subject for a long time. Here it comes today. And he seems to be grudgingly accepting (vindicating my stand) that the problem can be serious and perhaps pose some systemic risks. Though he did not say it in these words, this concern seems to be there somewhere back in his mind.

His article poses and answers two very good questions. Take a look at it here. In the process of knowing the answers, we can get our fundas right.

How could the sup-prime crisis rock the international financial system?

• Banks are exposed to the sub-prime crisis not directly, but through derivative instruments known as CDOs. Hedge funds hold the riskier part of the CDO (Collateralized Debt Obligations) tranches. Their holdings of CDOs form a high proportion of their portfolios. As a result, hedge funds are extremely vulnerable to a problem in sub-prime mortgages. Because hedge funds are highly leveraged (meaning, they are able to obtain loans in the ratio of 20:1. That is for every dollar of rupee they bring in, they are able to obtain a loan of 20 dollars) a small drop in value of assets suffices to create bankruptcy.
• The perception that a hedge fund is on the verge of bankruptcy triggers redemption calls from investors. Lenders too want their money back. This forces the hedge fund to liquidate assets. When this happens at several hedge funds, there is a wave of selling. Panic grips the markets quickly. Risky assets begin to get dumped as investors seek refuge in government securities. All of a sudden, assets become highly correlated. The risk management models that financial institutions use, compel them to reduce market exposures. This leads to more selling, more bankruptcies.

But is there any clarity as to the role that has to be played by the Central banks? He opines that there is a certain clarity.

o First, as long as commercial banks are not threatened, they must provide liquidity but they must not bail out insolvent institutions.

o Secondly, central banks must provide liquidity at an appropriate price. Anything less amounts to a bailout.

o Thirdly, central banks must not cut interest rates unless there is a clear indication that the problem is spilling over into the real economy. This is because, cuts in interest rates amount to a bailout of impudent investors and creates a moral hazard.

Is this all looking like Greek? Don’t worry, understand as much as you can and move on. If you have Economy and Finance as optionals, it is quite likely that a person like TT Ram Mohan may grill you in the interview.