Confidence, Tricked

Since 2007, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we face.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in housing value would generate a paper loss of $5.75 trillion. With an estimated 1%-3% of housing wealth gains going into consumption, this could generate about a $60-$180 billion reduction in total consumption — a modest amount compared to U.S. gross domestic product of $15 trillion. We should have seen a serious impact on consumption, but there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but it did not by itself turn a housing downturn into a global financial crisis. How leveraged a bank can be depends on many factors — most notably, the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, this financial crisis was not a foregone conclusion.

There are two possible paths to resolving an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending and raise underlying capital. This can occur over many years, without much harm to the economy. The second path is more dangerous. If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices. These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to declines in their value.

A Similar Crisis in the 1990s

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998. For countries then, substitute banks (or markets) today. Both then and now, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

This emerging market crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession. Investors quickly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves. Their currencies fell sharply and their creditors suffered major losses.

From there, the contagion spread for no apparent reason to South Korea — which had little exposure to Southeast Asian currencies — and then to Russia. Russia was funding deficits through short-term ruble bonds, many of which were held by foreign investors. When short-term creditors panicked, the government and the International Monetary Fund could not prevent a devaluation (and a default on those ruble bonds). After Russia, the story repeated itself in Brazil. In December 1998, Brazil let its currency float, leading to sharp depreciation within one month.

In each case, creditors lost confidence that they could get their principal back and rushed to exit at the same time. In such an environment, any institution that borrows short and lends long is vulnerable to attack. The victims had one common trait: If credit were cut off, they would be unable to maintain their existing activities. Credit markets’ decisions became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.

How the Current Crisis Began

The evolution of the current financial crisis seems remarkably similar to the emerging markets crisis of a decade ago. America’s crisis started with creditors fleeing from subprime debt in summer 2007. As subprime default rates rose, investment-grade debt — often collateralized debt obligations built out of subprime debt — faced large losses.

The second stage began with the Bear Stearns Securities Corp. crisis in March 2008 and extended through the bailout of mortgage giants Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on their ability to roll over their short-term loans. Given sufficient panic, it can become impossible to roll over those loans. And in a matter of days, despite no major news, the investment bank Bear Stearns was gone, acquired by JPMorgan Chase & Co. However, while the U.S. Federal Reserve and the U.S. Department of the Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole — a pattern they would follow with Fannie and Freddie. As a result, creditors learned that they could safely continue lending to large financial institutions.

This changed on Sept. 15 and 16 with the Chapter 11 bankruptcy filing of Lehman Brothers Holdings Inc. and the “rescue” of the insurance and financial services company American International Group Inc. (AIG). Both events marked a damaging reversal of policy. Once Bear Stearns had fallen, investors focused on Lehman; again, as confidence faded away, Lehman’s ability to borrow money evaporated. This time, however, the Fed let Lehman file for Chapter 11 bankruptcy, a move that harmed creditors. Then, overnight, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors.

This change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. However, the implications for creditors and bond investors were clear: Run from all entities that might fail, even if they appear solvent. As in the emerging-markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose that access at any time. As a result, creditors and uninsured depositors at all risky institutions pulled their funds — shifting deposits to U.S. Treasuries, moving prime brokerage accounts to the safest institutions and cashing out of securities arranged with any risky institutions. The collapse of one money market fund (largely because of exposure to Lehman debt) and the pending collapse of others sent the U.S. Treasury into crisis mode. At the same time, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates shot up, and banks ranging from Bradford & Bingley plc in the United Kingdom to Fortis, based in Belgium and the Netherlands, were nationalized. From late September, credit markets around the world were paralyzed by fear that any leveraged financial institution might fail due to a lack of short-term credit.

Initial governmental responses to the financial crisis in the fall of 2008 were fitful, poorly planned and abysmally presented to the public. Only in mid-October, after every major European country and the U.S. government announced bank recapitalization programs, was enough financial force applied for the crisis in the credit markets to begin to ease.

Going Forward

Although the United States and Europe have grabbed most of the headlines, the most vulnerable countries in the current crisis are in emerging markets. While wealthy nations can use their balance sheets to shore up banks, many other countries will find this impossible. As happened in Latin America in the 1980s, or in emerging markets after 1997-1998, the withdrawal of credit can lead to steep recessions and major internal disruptions.

Four sets of countries stand to lose the most.

1. The over-leveraged. With bank assets more than 10 times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily could face a similar situation.

2. The commodity-dependent. Prices of oil and other major commodities have fallen as the economy has slowed and demand continues to fall. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate.

3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.

4. China. The global slowdown has already had a major impact on several sectors of China’s manufacturing economy. While China’s economic influence will only grow in the long term, a global recession could cause a severe crimp in its growth.

As of now, most forecasts indicate that we will experience a serious recession, perhaps comparable to the recession of the early 1980s but nothing like the Great Depression. However, most of the most pedigreed economists and policy makers have failed to anticipate the serial effects that the crisis has had. It may yet have more surprises for us.