Inside Risks

• Author: Simon Johnson
• Position: Economic Counsellor and Director of the IMF's Research Department
• Pages: 54-56

Page 54

It has become conventional wisdom that many of the financial sector problems of the past year had their origins in the "mispricing" of risk. There is, no doubt, an element of truth to this view, particularly during the boom years because key financial players seem to have underestimated important risks.

Yet it's also the case that, since July 2007, some of our most reliable indications about the exact nature of rapidly emerging financial problems have come from these very same markets for risk. In fact, looking back over the past six months or so, it's now apparent that these markets have given us a quicker and more accurate heads-up about potential macroeconomic issues than have many conventional macroeconomic indicators.

Specifically, you can see the market's view on the default probability of various securities from the price of so-called credit default swap (CDs) spreads. The idea is that if you want to hold a security and protect yourself from the risk of a default, you can effectively buy insurance through this market-actually, you buy the option to sell (or "put") the security to someone else if it defaults. The CDs spread is the price (or effective premium) of that insurance. Because many of these CDss are traded in liquid markets, the price of this insurance is updated in a rapid and transparent manner.

You can insure against default in many types of securities, and, overall, this is a large market (some estimates put it at about $45 trillion outstanding). But the prices that have been particularly informative of late are CDs spreads for banks and, more recently, for corporates. These prices move in reaction to news (and rumors, of course), and they have to be interpreted with care. Still, there was and is a great deal of information in these prices if you look carefully. Remember, these are market perceptions, but, especially with respect to banks, we've been reminded repeatedly since the summer that perceptions can quickly become realities.

If the market thinks that an individual bank or set of banks has become more likely to default, the CDs spread goes up. If some banks appear less likely to default, CDs spreads go down. Think of it as a kind of bank-level financial thermometer that can indicate who has a fever and who may get one next.

IKB and Northern Rock depart

The major surprise or, perhaps, even shock...