Will she be right?

Perhaps the biggest question I get in relation to AussieMac and the evaporation of the 25 year innovation that was the trade in mortgage backed securities in Australia is: how did it just disappear? We don’t have a subprime issue and what is more, the risk profiles of these securities can be readily analysed. But yet the market has dried up.

But spare a thought for Iceland. Like Australia, there is no subprime issue. However, there has been a dependence on foreign capital or late. According to James Surowiecki in the New Yorker:

What got Iceland in trouble was something more subtle: its banks got their money primarily from international investors, making the Icelandic miracle heavily dependent on foreign capital.

In normal times, this might not have mattered, given the country’s solid economic fundamentals. But these aren’t normal times. The subprime crisis, in which investors realized that they had greatly underestimated the risks of lending to people with bad credit, has spawned a wider credit crunch: investors now suspect disaster behind every door, and even seemingly solid borrowers find credit much harder to come by. The subprime crisis was an earthquake that caused a tsunami: the quake has done plenty of damage on its own, but the tsunami looks set to do even more.

Iceland has been swamped by that tsunami because it trusted in the availability of global credit in time for that credit to evaporate. And the fact that Iceland has been so dependent on foreign investors makes those investors even more skittish about investing there: in markets, weakness often begets weakness.

Outside of the most rationalist economics, everyone knows that markets just don’t operate according to textbook efficiency. Investors can get spooked and arbitrage opportunities can be missed. Information on risk might not be investigated and in Grossman and Stiglitz’s famous words there can be an “equilibrium amount of disequilibrium.” The problem is, as I read the account of Iceland’s woes, I wonder how different Australia really is.