Editor's letter: Rock and roll

“Well, at least nobody can complain about another dull summer in the
financial markets,” as Jules Stewart puts it in the opening to his article about
the impact of the sub-prime debacle on the credit rating agencies – and that was
even before Northern Rock started to crumble.

It seems like a waste of a perfectly good crisis to blow it on a mid-size
bank with a better-than-average mortgage book and an arrears record about half
that of the housing finance industry. There was nothing wrong with the bank’s
assets; its sub-prime customers were all ‘introduced’ to a subsidiary of Lehman
Brothers, earning Northern Rock a fee – and no balance sheet exposure. The
problem was that Northern Rock was one of the most active participants in global
debt markets: according to one measure, it ranked 7th ($56.9bn) in the world for
borrowing activity, borrowing almost $57bn in the 12 months to 30 April 2007

– far, far above its ranking in the global bank league tables. This is a level
of finance churn of gargantuan proportions. At its heart lies not the amount of
debt but the under-pricing of risk.

The Bank of England has ruminated in recent months on the topic of risk
premia, though not, it would seem, in any way that caught the attention of hedge
fund operators or securitisation experts. Now, as market interest rates head
north and central bank rates start tumbling south, we’re starting to see a huge
risk premium being demanded even on the rates that banks charge each other. (If
banks don’t trust other banks, why should the rest of us?)

Markets often forget, but they rarely forgive. Yes, that’s the right way
round, I think. Markets have prejudices and hold grudges and penalise those who
disappoint them. Northern Rock was spinning far too many plates at one time, and
it was lucky that the Bank of England was prepared to step in and catch the
rotating crockery before it smashed to the ground. But all the betting is that
the mortgage lender isn’t going to be allowed to play with the good china
again, and that it will fall into the arms of a larger player. Then the markets
will forget about Northern Rock and all the sub-prime casualties and go and find
something else to give it a hyper-active surge, ignoring new types of risk and
taking them on far too cheaply.

As our resident pundit, HSBC chief economist Dennis Turner, puts it, “Markets
have a remarkable knack of going from boom to panic without the good sense to
stop off at the intermediate stage of normal.” That’s true. But then, it’s
always been true. From tulips to dotcom equities to leveraged buyouts, there’s
always a market somewhere, sometime that’s running ahead of itself. But then,
all markets are like seesaws: they’re much more fun when they go up and down.
Nobody would want to play on them if they stayed in perfect equilibrium.