Dr Norbert Walter Chief Economist Deutsche Bank Group Frankfurt, Germany September 15, 2007

Dr Norbert Walter is the Chief Economist of Deutsche Bank Group and the head of Deutsche Bank Research. Team Latte has been following up his research, interviews and articles in the areas of exchange rates, interest rates and other international economic issues, especially growth and development issues in the emerging markets. Recently, Team Latte's Rahul Bhattacharya caught up with him to have a very quick exchange regarding some of the events unfolding in the credit markets.

Team Latte :
Some noted journalists and economists think that the credit markets today have become " market for lemons" - to quote George Akerlof's famous 1970 paper on information asymmetry.

The buyers of used cars cannot differentiate between "good cars" and "bad cars" ("lemons") and hence end up paying only the price of an average car, thereby prompting the sellers of the good cars to withdraw from the market and eventually causing the market in used car to disappear. In a market where the seller has more information about the product than the buyer, bad product can drive the good ones out of the market and eventually causing the market in that product to disappear completely. This is the "crisis of lemons". The credit derivatives, which are engineered out of loans and bonds, are becoming “lemons”.

Would you agree with this? Can a severely asymmetric market - like that between buyers and sellers of credit derivatives - make the entire market to disappear?

Dr. Norbert Walter:
I would not agree with this statement. In Akerlof's world the buyer does not have expertise to assess whether the used car is of good or bad quality. Because of this information asymmetry, sellers of good quality cars may find it difficult to sell their cars at a fair price. They leave the market for second-hand cars because the price they would receive is too low. The credit/derivate market is different to Akerlof's car market for three reasons. First, rating agencies help to assess the quality of those products and have expertise to evaluate the fair price. Second, the interest rate creditors with a high creditworthiness have to pay on their debt is still lower than the one bad borrowers have to pay. In fact, we still have separate markets for high-grade and speculative-grade investments. Third, at least professional investors do know about the risks when they invest in bad quality assets in order to obtain higher returns.

Team Latte:
Banks have traditionally warehoused risk. Indeed, that is the primary, if not the sole function of a commercial bank. But with the advent of financial engineering and the financial derivatives banks have been able to parcel out that risk and sell it to third parties. This has resulted in risk - credit and counterparty risk - being diffused across financial agents and intermediaries in the economy. It has become extremely difficult to estimate how risk is sitting on any one party's balance sheet.

Within this context do you see a fundamental shift in the basic role of a commercial bank? How prepared are today's banks and financial institutions to manage credit and counterparty risk?

Dr. Norbert Walter:
Obviously, banks' role in the credit markets has changed from a pure originate-and-hold in the distant past towards an originate-and-distribute approach. Nonetheless, the taking and management of risk remains one of the key functions of modern banks. The partial transfer of credit risks away from their own balance sheets enables banks to do more business, but the overall level or risk has not necessarily declined. Anyway, in light of the current credit and liquidity squeeze some banks may ask themselves how successful they really were in getting rid of the risks. The past two months have shown how even banks without direct exposure to the US sub-prime mortgage market found themselves exposed to the fallout, e.g. via credit lines to off-balance sheet SIVs or conduits. Although banks have generally improved their risk management in recent years they are currently struggling with a transparency problem as they do not know who ultimately holds all the risk. The money market tensions are showing this mistrust between banks.

Team Latte:
Nouriel Roubini, Professor of Economics at the Stern School in New York University , has predicted dire consequences for the current turmoil in the credit markets. He thinks that today the firms and individuals, especially in the Western hemisphere, face an insolvency problem, and not just a liquidity problem, such as the one faced during the LTCM failure in 1998.

How serious do you think this current problem (credit crisis) is? And in terms of the economic consequences (or fallout) is Asia (excluding Japan ) any different from the Western and G7 countries?

Dr. Norbert Walter:
In my opinion the current disruptions in international credit and money markets could have serious adverse affects on economic activity if the tensions intensify further and develop into a general tightening of credit conditions. In the case of households, I would agree with the statement that a non-negligible number of US households are financially overstretched and may face insolvency. Especially in the US sub-prime mortgage market delinquencies have already risen significantly, no doubt the US financial sector in particular, but also some of its investors and clients will ultimately pay the bill for loose credit policies in the past years. However, one should bear in mind that the US sub-prime market accounts only for a small share of the overall mortgage market (around 14%) and hence the deterioration of credit quality is still a limited problem. With regard to the non-financial corporate sector I do not see any broad-based insolvency or illiquidity problem as profit growth has remained fairly strong so far, internal liquidity seems ample and balance sheets generally sound. The main task of central banks will be to avoid domino-effects and to safeguard financial stability by providing extra liquidity as long as necessary to support the functioning of money markets.

At the current junction, it is too early to quantify the economic consequences for emerging Asia . However, this region seems well prepared to resist the current credit market correction thanks to the large amounts of foreign exchange reserves and generally sound debt policies. Nevertheless, should US and with it world economic growth dip dramatically, many export-dependent emerging markets would also feel the pain.

Team Latte:
A lot of practitioners, including some well known economists, have blamed the Federal Reserve in the U.S. for either not responding soon enough to the formation of asset price bubbles in the economy or responding with inadequate policy measures. This argument is an old one and it surfaces every time there is a financial crisis.

Do you think that Central Banks should really care about asset price bubbles? Isn't the sole purpose (at least in a textbook context) of a Central Bank to simply maintain price stability in the economy?

Dr. Norbert Walter:
I agree that central banks should not only care about consumer price stability but also watch asset prices closely to avoid asset price bubbles and their associated costs for the real economy. With regard to their current mandate of achieving consumer price stability over the medium term, central banks have been very successful in the past decades. One pre-condition for their great success is that consumer prices can be measured relatively accurately and that the functioning of goods & services markets is well understood. While the price of a financial or non-financial asset can be generally observed quite easily, it is more (and sometimes extremely) difficult to assess whether the price of a stock or a corporate bond is "fair" or in other words justified by fundamentals. Although the fair price of a stock can be gauged on the basis of financial ratios such as the price/earnings or the dividend yield ratio, all assessments of financial instruments are based on expectations and we all know that expectations are highly uncertain and may change quickly. Although central banks should carefully watch asset price developments (what most of them are already doing implicitly), it is questionable if it would be wise to give them an explicit mandate over achieving "asset price stability" or preventing "asset price bubbles". Such an extra mandate would open the door for high costs of wrong decisions as it may eventually force central banks to pop assumed (but possibly not actual) stock or real estate bubbles and hence may unnecessarily cause damage to the real economy. For this reason, I would suggest to leave the mandate of central banks as it is.

However, especially the US Federal Reserve Bank should ask itself whether it was really needed to leave interest rates at such low levels for such a long time after the burst of the IT bubble. Although the current liquidity squeeze is at least partly the late fallout of the extremely accommodative monetary policies in the past years, it has also exposed some weaknesses in financial supervision. The current transparency problem (where nobody knows who ultimately holds all the risk) and the observed mistrust in interbank lending gives food for thought for regulatory reform.

The interested readers may visit Dr Walter's web page in English: Walter's Web Wisdom; www.norbert-walter.com

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