Outside View: Share-shy investors pay for dealing with the devil they didn't know

As the world's stock markets succumb to the credit crisis, and they wrestle with fears of an economic downturn, they might reflect that the crunch is the flipside of a boom in structured credit that can at least partly be traced back to their own boom and bust at the start of the decade.

Investor distaste for equities helped fuel the extraordinary surge in the structured credit markets. The question now is whether the responses of investors and policy-makers to the current downturn will prompt a longer-term switch back to equities.

To answer this, it is worth reflecting on why structured credit grew so quickly. Much attention has been paid to the role of the US Federal Reserve. It is blamed for cutting, and keeping, interest rates too low in its efforts to maintain US economic growth after the stock market bust of 2000-01. Likewise, the investment banks are accused of developing new securitised and derivative-based instruments that concealed an underlying lack of credit quality – something that was rudely exposed when US housing hit trouble.

However, little attention has been paid to the point that the demand for these new instruments was fuelled by investors' reluctance to buy equities after their earlier bust. The search was on for alternatives that would preserve capital while delivering robust returns. This is not to say shares did not do well out of the generalised boom in asset markets that began in 2003. But the surge in stock prices was underpinned by an extraordinary surge in corporate profits, which meant equity valuations remained moderate. Meanwhile, investors satisfied their appetite for more returns by buying increasingly complex structured credit instruments that compensated for falling yields by employing ever more leverage and taking on more credit risk.

The snag was that investors and, worse still, many of the issuers, were not aware of just how much risk was involved. While the combination of investor over-optimism, excessive leverage and lax credit has been a recipe for market crises in the past, the complexity, opacity and scale of the structured credit markets have made this crisis especially shocking and unpredictable. That commentators can question the fate of the $45 trillion credit default swap market, one which barely existed a decade ago, gives some idea of the extent of the uncertainty.

Of course, hindsight is always in more plentiful supply than foresight. But recognition of the uncertain fate of the structured credit markets, whose problems now extend well beyond sub-prime mortgages, does give us some clues as to what is going to happen. To understand this paradoxical assertion, you need only recognise that the ultimate duty of the central banks is to preserve the functioning of the financial system.

This means that once a crisis gets beyond a certain point, swift action to ease policy and support the financial markets, and key players within them, becomes the priority. This has happened in the US, with fears of inflation taking a back seat when the Federal Reserve cut its key funds rate. Moreover, fiscal policy is now also being called on to provide support to activity via tax cuts or additional government spending. Policy makers in Europe have not quite reached the same point, although they surely will if the efforts to support the US economy and ease the credit crunch fail.

Even though the depth of this downturn remains in doubt, the travails of structured credit will surely lead to changes. Just as investors were wary of equities in the last cycle, they will be reluctant to return to markets that now cause them so much grief. Once the worst of the downturn is in view, the simplicity of equities will look appealing.

Meanwhile, with the ratings agencies tarnished, investors will develop other sources of credit analysis. They will also be looking for banks originating credit securities to retain more exposure, so they have "more skin in the game". And there will be demands for greater transparency and liquidity in the structured credit markets. The longer it takes for financial intermediaries to deliver this, the longer the swing back to "plain vanilla" equities will last.