Excellent. So. to peple who are complaining about the way in which the risks of default are now spread throughout the financial system, Patrick Minford says:

The answer is No. In fact the spread of credit
outwards from the well-heeled is one of the great triumphs of modern
competitive finance.

By spreading the consequent
risks around many well-capitalised holders they can be absorbed by the
magic of ‘diversification’: by holding a wide spread of assets whose
risks are ‘not correlated’, the average risk is reduced as in ‘swings
and roundabouts’.

It was this principle at work
three decades ago that transformed company finance and governance
through making possible the ‘junk bond’; business has never looked back
as entrepreneurs could use ‘junk’ debt to take over large sleepy
companies.

So with the extension of credit to
people; of course it is well-known that there will be default at a
higher rate on this debt. But by opening up a market in it and
spreading it around this risk can be priced reasonably.

This
process is known as the ‘completing’ of financial markets. In
‘complete’ financial markets all risks that are not in principle
uninsurable can actually be insured either directly or indirectly
through the financial system.

This isn’t a fault in the system, it’s actually the whole damn point. That’s not to say that there isn’t a problem:

In fact what seems to have gone wrong is a failure of information in a rapidly developing financial environment.

It
seems not to have occurred to anyone that there would be a need to know
exactly what was in each securitised package – after all, the whole
idea was to spread risk around so that it became relatively innocuous.

So when the worries about sub-prime mortgages surfaced no-one did know; and then of course there was general panic.

However
the scale of any possible losses on sub-prime mortgages, even at its
very worst, is not very large on the scale of the total balance sheets
of the world’s banks.

Therefore had all parties
known what percentage they actually had on each particular balance
sheet this could easily have been priced; the bank’s share prices would
have been adjusted for the prospective loss of profits and normal
banking business would have gone on being done.

So
the remedy for the systemic problem seems rather simple and will
undoubtedly be adopted in future anyway: any CDO must have its contents
on the jar, so to speak.

While we do actually want the risk to be spread around we’d actually really like to know where it is spread around. And given the results of our not knowing this time, anyone issuing in the future is going to have to tell. So, we’ll end up with the system that we actually want. Widely dispersed risk with full information disclosure.

It might be that we don’t actually need any new regulation after all. Markets do indeed make mistakes, but they also tend to learn from them.