Risk Trading, Risky Debt and Financial Stability

Stephen Kealhofer

In 1980, financial markets traded securities, principally stocks and government bonds. In the mid 2000s, they primarily traded risks; securities were a distant second. An astonishing change.

Before the 1980s, there was not very much risky debt. Corporations almost solely issued investment grade debt. Banks were just in the process of making a lot of bad loans to foreign governments, but they did not think they were risky. The risky debt that existed was consumer debt: credit card and mortgage debt. The former was carefully doled out to the better borrowers at exorbitant rates; the latter was all insured by the government. Twenty-five years later there was a burgeoning supply of risky corporate debt, risky sovereign debt and risky consumer debt. In fact, the financial industry was just in the process of originating US$2 trillion of sub-prime mortgages.

In the 1980s, banks, even in money centres, were distinct from investment banks. They primarily made loans to governments and businesses – large, medium-sized and even small businesses – although the latter usually with government guarantees. Twenty-five years later, money centre banks and investment banks had become largely