No Going Back To Days Before Sub-Prime Crisis Emerged

Source : The Business Times, December 13, 2007

By ANTHONY ROWLEY
TOKYO CORRESPONDENT

HOPE springs eternal and those who fail to understand the sub-prime mortgage crisis have been content to substitute hope for common sense (let alone logical thinking) by expecting a few interest rate cuts to restore things to 'normal'. Thus, the failure of the US Federal Reserve to make more than a nominal further cut in rates this week offended, if not to say angered, those market players who are clamouring for quick-and-easy solutions.

The late and great economist John Maynard Keynes once spoke (in a somewhat different context) of the futility of 'pushing on a piece of string' at one end, and expecting by so doing that some positive impulse will be transmitted to the other end. Cheaper credit does not make bad credit good, nor does it make shell-shocked lenders more willing to lend or traumatised borrowers more eager to borrow.

The financial system in the US and elsewhere, where fallout from the sub-prime crisis has been heavy, is not going to revert to the status quo ante. It is pointless to hope that the bubble can be re-liquefied and set floating again simply by making money cheaper.

Before things settle back to some sort of stability, asset values will need to adjust fundamentally and financial systems have to be restructured. This, obviously, is going to take some time - several years possibly - given the size and complexity of the securitised structures that are unravelling from day to day, even if the spotlight is being kept off what is going on by official anxiety to avoid any panic reaction in the markets.

In the meantime, the likely impact upon the global real economy of financial system distress seems to be as little understood as the original crisis was.

The sub-prime crisis has been blamed on all sorts of things. Some argue that it came about as a result of Bank for International Settlements requirements for banks to maintain minimum capital-to-asset ratios. This gave them an incentive to reduce assets as well as to boost capital, and many of them did so by shifting assets 'off balance sheet' into 'structured' investment vehicles that are about as transparent as limousines with tinted glass windows.

Others say that the sheer greed engendered among financial market practitioners by the practice of granting obscenely large bonuses drove them into an orgy of 'deal' making, regardless of the consequences.

In its Economic Outlook published last week, the Organisation for Economic Co-operation and Development (OECD) said that 'the origins of the final turmoil were lax lending standards for US mortgages, particularly in the sub-prime market. The consequences were magnified by information failures; in particular, the complexity of financial products linked to sub-prime loans made it difficult to assess asset values and the location of risk exposure.'

All this 'exposed inherent weaknesses in the expansion of securitisation and (in the way that) banks and other credit institutions have been able to issue credit without carrying it on their balance sheets'. 'Credit originators had little incentive to properly assess credit risk; investors in secondary markets for loans did not have enough expertise or experience to assess risks and rating agencies' assessments proved to be far too optimistic.'

Conditions in credit markets remain tight, the OECD observed. 'Money markets have not resumed normal functioning and the reassessment of structured product risk and exposure is not complete. The prices of US mortgage-backed securities have continued to fall, with damage spreading into tranches with most risk protection. Bank balance sheets seem generally robust but will likely have to re-absorb bad debts, some of which were held off balance sheet.'

Finally, the OECD noted, 'securitisation that has allowed credit to grow without affecting banks' balance sheets has stalled since the beginning of the crisis'. Anyone who feels that explanations of what is going on are just too technical to understand should at least take notice of this last sentence.

Credit makes the world go round, at least in Anglo-Saxon societies where the very thought of saving what you earn, and spending only what you save, is considered to be an outdated precept that offends against economic growth. If credit-generating institutions in such societies are suddenly burdened with bad credit to the point where they are no longer willing to lend, then the systems are going to slow down or seize up.

It was thus surprising to hear IMF managing director Dominique Strauss-Kahn suggesting this week that the impact of the sub-prime crisis on US consumption and labour markets had so far been moderate - and therefore that the impact on the global real economy might also be muted. Could Mr Strauss-Kahn possibly have forgotten that the Western world lives on credit and that credit is now fast drying up?