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nt of the U.S. credit market. But already in December 2007,
the Economist estimated that losses stemming from mortgage loan insolvencies
would sit between $200 and $300 bn. In April 2008 the IMF predicted losses of
$565 bn on mortgage loans and on related securities, and $945 bn including loans
and securities related to commercial real estate, consumer credit and corporate
loans. Now the IMF has revised its estimate further to $1400 bn. How could it happen
that bankers, central banks, international institutions and economic experts
made such macroscopic mistakes in insolvency estimates? And how can it be that
they are still so uncertain as to their real extent?
The Origins of Uncertainty
The uncertainty originates from the same roots of this crisis, that is from the opacity
of the securitization with which banks ‘packaged’ and then sold their credits
in structured bonds, often after slicing them in different risk tranches. In this
process, only roughly synthesized information was transmitted to the market concerning
the underlying loan portfolio or its tranches. So there was a great loss of
information that would have helped to evaluate the credit risk of those portfolios.
Since structured bonds and the derivatives written on them were massively
bought by banks, insurance companies and trust funds, the uncertainty concerning
their value turned into uncertainty regarding the amount of losses and toxic
assets hidden in bank balances, and made it difficult or impossible for them to
obtain liquidity or raise fresh capital. Indeed, extreme uncertainty generates fear,
and fear generates paralysis. This is best illustrated by the case of Lehman Brothers,
The price of transparency
Marco Pagano
University of Naples Federico II and CEPR
8 October 2008
123
the large investment bank that played a central role in the securitization process.
When Lehman entered distress, the primary U.K. bank Barclays was the only institution
that showed interest in buying up Lehman, but for fear that its balance
sheet hid more losses and toxic assets than those declared, they asked for a guarantee
from the U.S. Treasury against this risk. As the Treasury refused to offer a
guarantee, Barclays held back and Lehman failed. One might say that this bankruptcy,
the largest in U.S. history, is the outcome of uncertainty. It cannot be ruled
out that Lehman would have been solvent if only their assets and liabilities could
have been properly evaluated.
The uncertainty generated by lack of transparency is also at the root of market
illiquidity. Since June 2007, the market of structured bonds basically froze and
even the liquidity on the money markets rarefied. The reason behind this event
too is the fear generated by uncertainty: investors were afraid of buying securities
that could hide more insolvent loans than expected, so if they had liquidity they
preferred to hoard it. This market paralysis in turn worsened the situation of
banks, making their assets illiquid and forcing them to curtail credit.
Uncertainty can even explain the swinging and ill-timed behaviour of U.S. policy
makers: on September 8, the Treasury nationalized agencies such as Fannie
Mae and Freddie Mac, who guarantee most of the U.S. mortage loans. The Treasury
had already obtained Congress authorization in July and at that time had insisted
there would be no need for