Book review: The Fall of the House of Credit, by Alistair Milne

The logic of Milne's microeconomic explanation for the banking crisis is compelling; his conclusions less so.

by John Kay.
Last Updated: 25 Oct 2010

There are already more books about the credit crunch than solvent banks, ranging from racy descriptions of how bond salesmen plied their trade in German brothels to clunking accounts of the intricacies of risk-management models and debt-based securities. This book is at the heavy end of the spectrum, as the credentials of the author suggest. Milne, an economist, has worked on the supervision of financial institutions at the Treasury and Bank of England, and is now reader in banking and finance at Cass Business School.

If you want a serious, clear and authoritative guide to the crisis, this book is as good as it gets. Milne writes extremely well, both in his prose style and in his clarity of exposition of complex issues, and his book shows no signs of the speed with which it was written. The author not only knows his CDO from his ABS but can ensure that you will too. He moves comfortably between macroeconomic issues of global imbalance and the microeconomics of securitisation, regulation and risk management within the financial system.

Milne describes two broad explanations for the crisis. The mainstream view starts with the macro-economics. Asia ran a big trade surplus, matched by corresponding deficits in the West - primarily in the UK and the US. Trade surpluses were matched by capital inflows into the debtor countries. These inflows not only financed excessive consumption but fuelled asset-price bubbles, especially in the housing market. The bubbles burst, leaving banks that acted as intermediaries in the process with large losses from excessively risky lending. They responded with indiscriminate withdrawal from both good and bad lending, plunging not only debtor but creditor countries into recession.

Milne prefers an alternative explanation, focusing on the microeconomics. What happened inside banks is key. He examines the creation of tranched mortgage-backed securities (MBSs).

In tranching, business risk is divided into more and less safe components, with compensating differences in expected return. The idea is as old as the business loan.

In Milne's illustrative example of an MBS, a single pool of mortgages was divided into 12 tranches of escalating riskiness. Banks engaged on a massive scale in a trade in which they funded senior tranches of securitised products with short-term borrowings, benefiting from an interest margin that they believed made the instruments low-risk. When, after the sub-prime crisis, confidence in the value of securitised products evaporated, banks couldn't refinance their borrowings and the system imploded.

For those who emphasise the macroeconomics, the remedies are macroeconomic too. You must address the risky lending and its consequences for both over-indebted households and over-lent banks.

For those emphasising the microeconomics, the remedies are principally microeconomic. Milne stresses that much of the difficulty banks encounter lies not with toxic assets - the riskiest layer of securitised products - but with slightly tainted ones, the senior tranches, which they hold in large quantities. For him, the fundamental problem is not that such assets are impaired but that panicky investors no longer trust them. He advocates large-scale insurance by government of senior asset tranches. Then the banks will start lending again.

I'm not sure the options are so distinct. Unsustainable macroeconomic imbalances made unpleasant global adjustments inevitable, while the microeconomic foolishness of banks made a financial crisis inevitable. In 2007-08, these weaknesses coincided to created that perfect storm. And are more senior tranches of asset-backed securities sound but seriously undervalued? I don't know, and nor does Milne or anyone else - which is why the market in them is so thin.

Milne wants to believe that matters are fundamentally okay because, like others, he desperately wants to keep the show on the road. But the general rule of the market economy is that failed firms with failed business models are left to fail. That process of failure and rebirth gives a market economy its dynamism and promotes the kinds of innovation that offer consumers new products and services.

The major banks in Britain today were the major banks in Britain at the end of the 19th century. No other industry shows that stability. We gave banks a deal in which relative freedom from product market competition was tolerated in return for economic stability. The banks reneged on that deal, and we should tell them it is off. We should break up banks and establish smaller institutions in a more competitive market.

The Fall of the House of Credit: What went wrong in banking and what can be done to repair the damage?

Alistair Milne
Cambridge University Press

Economist John Kay is the author of The Long and the Short of It (Erasmus Press, 2009)

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