The financial crisis that erupted in earnest on August 9, 2007, has not yet run its course. The correction of the global underpricing of risk from 2003 till early 2007, will manifest itself beyond the US subprime residential mortgage markets, the instruments backed by these mortgages and the institutions exposed to them. Higher-rated residential mortgages in the US and in Europe will suffer similar corrections. So will commercial mortgages and securities backed by them, securities backed by car loans and credit card receivables, and unsecured consumer credit of all kinds. Unsustainable construction, housing market and residential lending booms occurred not only in the US, but also in the UK, Spain, Ireland, the Baltic states and other CEE countries like Bulgaria.
Until quite recently, industrial country equity markets continued to perform well, unaffected by the re-appraisal and repricing of risk that has shaken many of the other markets for financial instruments. In the past couple of weeks, equity markets in most of the industrial world have given up all of their earlier 2007 gains and many are now trading in negative territory. No doubt some further equity market corrections are due, in the advanced industrial countries and certainly in some of the more bubbly emerging markets.
There remains pervasive uncertainty about the value of the credit ratings granted to complex structured products during the period 2003-2006, and about the value of the various enhancements the issuers grafted onto these products, including the credit risk insurance provided by the ‘monolines’.
Sovereign risk too is beginning to be repriced. Even within the Eurozone, the spread of 10-year Treasury bond yields over Bunds has increased from the 10 bps to 20 bps range to the 30 bps to 40 bps range for highly indebted, fiscally fragile countries like Greece and Italy. These spreads are likely to widen further when the budgetary positions of these countries worsen as the Eurozone goes into a cyclical downturn.
Emerging market risk continues to be underpriced. This holds for non-sovereign emerging market risk almost everywhere, including hot favourites like China. It holds for sovereign market risk at longer maturities for emerging markets without massive foreign exchange reserves, without significant production and export capacity in natural resources and with a history of weak fiscal discipline and populist policies. Argentina would be an example. This underpricing of emerging market risk is also due for an early correction.
So much for the bad news.
There are, however, also signs that the outline of a systemic stabilisation and recovery sometime in the second half of 2008 is beginning to take shape. Leading commercial banks are beginning to put their off-balance-sheet off-spring back on their balance sheets. HSBC’s announcement on November 26, 2007, that it was taking on its balance sheet $45bn of debt, much of it mortgage-linked, owned by SIVs it manages is, I believe, a harbinger of things to come.
The apparent failure of the Single Master Liquidity Enhancement Conduit, aka ‘Superfund’, proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury, to get off the ground, is another positive sign, because it supports the view that it is no longer acceptable or possible for private financial institutions to avoid the recognition of capital losses on assets held in SIVs, conduits and other off-balance-sheet vehicles, by selling them to each other at sweetheart prices. The enforced revelation of where the losses are, will reduce the uncertainty and fear about counterparty risk that have been killing liquidity in so many markets.
Money from the ‘New Global Moneybags’ – sovereign wealth funds from the Gulf and from other emerging markets – is beginning to find its way into some of the depressed financial markets and shaky financial institutions. Citigroup announced on November 26, 2007, that it had raised $7.5bn in new capital from the Abu Dhabi Investment Authority, albeit at near-‘junk’ rates of 11 percent. More deals like this will follow.
The monetary authorities that matter have learnt their lessons and are ready to provide liquidity on a large scale should the need arise. The announcement in late November 2007 by the Fed about its plans for year-end liquidity are an example of this greater official preparedness.
Most importantly, the credit boom of 2003-2006 has not led to a massive bout of over-investment in physical capital, except in a few emerging markets like China. The only sectoral exceptions in the industrial countries are residential construction in the US, Spain, Ireland, the Baltics and a few other emerging markets in CEE, and overexpansion of the financial sector almost everywhere. In countries that have been riding a housing construction boom, the contractionary effects of lower residential investment is now being felt (the US) or will be soon (Spain). But in the most systemically important of these countries, the US, residential construction accounts for barely 4.5 percent of GDP. The damage even a complete collapse of house prices can do through the residential construction channel is therefore quite limited.
There is therefore little threat of widespread excess capacity from the ‘supply side’ of the economy. The financial position (balance sheets and financial deficits) of the non-financial corporate sectors throughout the industrial world is strong. The bulk of the financial excess has stayed inside the financial sector or has involved the household sector.
The key question then becomes whether and to what degree the decline in housing wealth (in the US) and the general tightening of the cost and availability of credit will adversely affect household spending in the advanced industrial countries. While the sign of the effect is clear – consumption will weaken – its magnitude is not. The increasing cost and decreasing availability of household credit is likely to affect and constrain mainly those households wishing to engage in new or additional borrowing. The increased burden of servicing outstanding household debt, especially unsecured debt, is as likely to lead to higher defaults as to reduced consumer spending. Personal bankruptcy is, especially in the US, such an easy and relatively painless option, that it is the shareholders of the financial institutions that have made the unsecured loans rather than the households that took out these loans that will suffer the brunt of the financial impact of the increased cost and decreased availability of credit. If these shareholders are, unlike the defaulting borrowersty, typically not liquidity-constrained, the net effect on consumption should be mild. There can be further effects on spending through the credit channel if the financial institutions whose debt has been defaulted on become capital-constrained as a result and curtail further lending. As always, those most affected will be new would-be borrowers, households and corporates.
It is still likely, in my view, that the economic fall-out from the financial crisis will be contained mainly within the financial sector and the residential construction sector. It is clear that, following the overexpansion of the residential construction sector in the US and in a few European countries, and following the massive overexpansion of the financial sector just about everywhere during the past decade, there is now likely to be a retrenchment in both sectors, through lower employment, lower profits and lower valuations.
From the point of view of the efficient allocation of resources in the medium and long term, the relative (probably even absolute in the short run) contraction in the size of the financial sectors of the advanced industrial countries is a desirable development, as for a number of years now, the private returns in the financial sector have exceeded the social returns by an ever-growing margin. Too much scarce analytical and entrepreneurial talent has been attracted into activities that, while privately profitable and lucrative, were socially zero-sum at best. In the short run, this cutting down to size of ‘Wall Street’ and ‘the City’ will inevitably have some negative side effects for Main Street also. However, the entire financial sector in the UK accounts for only about 7.5 percent of GDP, and the banking sector for no more than five percent of GDP. A sectoral depression will be painful, but of limited macroeconomic significance. In the medium and long term, moreover, a more balanced sectoral allocation of the best and the brightest will be beneficial.
The short-run pain, concentrated in the financial sector, and especially in the commercial and investment banking sector and its off-balance-sheet offspring, is not suffered in silence. There is an army of reporters and newscasters standing by to report each groan and moan from every CEO whose bank has just written down another chunk of careless CDO exposure. But as long as the monetary authorities take their mandates seriously – including their duty to act, at a price, as lenders of last resort and market makers of last resort – and as long as the growing financial market hysteria does not spread to the real economy, the financial market kerfuffle should result in no more than a mild cyclical downturn around a robust upward trend.
In a market economy where asset markets and expectations about the future can have such a major impact on current economic activity, it is always possible to talk yourself into a recession or depression. Reducing the likelihood that a recession/depression born of fear and lack of confidence will take hold, when the fundamentals also support a much more positive outcome as an equilibrium, is the task of policy makers, especially central bankers, finance ministers and those in charge of avoiding trade wars. Let’s hope they are up to the challenge.