Source : The Straits Times, Mar 19, 2008
WHAT is happening in global financial markets? How could US financial markets - the world’s largest, richest, deepest, most sophisticated and supposedly best-regulated - get into such bad shape? Why has this affected global markets? What is the likely impact on the ‘real economy’ in Asia?
The problems we see now have been brewing for many years. Foreign money flowing into the US following the late-1990s Asian financial crisis - famously called a ‘global savings glut’ by current US Federal Reserve Bank Chairman Ben Bernanke - and the Fed’s own cheap-money policy following the tech boom-and-bust of the early 2000s, led to very low interest rates.
Together with financial market deregulations, cheap money led to a wave of financial market innovations, such as the now infamous ’sub-prime’ mortgages. Traditional financial institutions such as banks sought to realise higher-return investments in a low-rate world, including by creating and spinning off hedge funds which could take higher risks.
Sub-prime mortgages are simply mortgages extended to high-risk borrowers with weak credit histories who otherwise would not be able to borrow to buy housing. They are usually offered easy payment terms initially, which can then escalate as a result of ‘adjustable interest rates’ linked to external market events having nothing to do with the individual borrower’s repayment performance.
To limit the risks to themselves of extending these sub-prime loans, US lenders packaged them together with lower-risk ‘normal’ mortgages. They then ’sliced and diced’ the packages into mortgage-backed securities or collateralised debt obligations (CDOs) which they sold to other financial institutions.
The theory behind this was the well-established financial principle of ‘risk diversification’: By mixing high-risk sub-prime loans with lower-risk debt, and then widely distributing the ownership of the new assets through many institutional owners, the risk inherent in any individual asset for any single investor would be minimised.
Even better, the risk of default on these asset-backed securities was insured by insurance companies, including specialised bond insurers - so-called ‘monoline insurers’ like Ambac and MBIA. Credit rating agencies like Moody’s and Fitch usually gave these loan securities the same triple-A (very safe) rating enjoyed by blue-chip banks like UBS, HSBC, Citigroup and Merrill Lynch that issued or purchased them. Such securities - now ’safe’, liquid and tradable - became highly desirable in investment portfolios, and were accepted as collateral for other loans.
So, if only 1 per cent of a loan security is at risk of turning bad, the market belief was that the safety of the other 99 per cent would prevent the whole security from suffering a loss in value if that 1 per cent did turn bad - that is, become uncollectible.
Unfortunately, given the way these securities were structured, there was no way of isolating the potentially defective 1 per cent to assess its risk in the pricing of the entire security.
This uncertainty has led to a loss of confidence in the value of the entire security. The 99 per cent of low- or average-risk loans in the security has now been ‘contaminated’ by the high-risk 1 per cent, instead of diluting it.
A plunge in the value of the loan security (because the 1 per cent does, or is feared might, default) then cascades through other financial instruments, such as derivatives based on the security (traded by hedge funds). Financial institutions which hold or insure the security are also affected.
In addition, fund managers may be required by their own rules and government regulations to rebalance their portfolios to hold less of such ‘contaminated’ securities.
This adds further to their price declines and the capital and income losses of their investors.
The potential ripple effect of monoline insurers defaulting is particularly great, since they insure all bonds, not just sub-primes, leading to the current attempt by some of their largest bank customers to bail them out.
Bonds that lose their insurance are automatically downgraded, forcing some funds to sell them for their rules do not allow them to hold securities with low ratings.
Effect on US economy
A SIMILAR situation in the UK has already led to the collapse and nationalisation of one bank (Northern Rock) and the closure of many investment funds. This is ironic, given that the ‘Anglo-American’ financial system had hitherto been lauded as representing the ‘best practices’ that others should strive to emulate.
If the only problem was US sub-prime mortgages, the damage would be limited and very small. Sub-primes account for only about 5 per cent of US mortgages, and the vast majority of them are being properly serviced, with mortgage holders making their mortgage payments on time.
Home mortgages as a whole are only a minor part of the US financial sector, which in turn is only 12 per cent of GDP, about the same as manufacturing. (Manufacturing has been sluggish for years without dragging down the rest of the economy). The US accounts for only 25 per cent of global financial markets and 20 per of the world economy, while US residential housing contributes only 5 per cent to total US GDP and less than 25 per cent to private fixed investment.
Unfortunately, the problem in the US residential housing market goes beyond sub-prime mortgages. Years of record-low interest rates led to excess demand and overbuilding in this sector. American consumers stopped saving out of current income, believing that the market values of their homes - the single largest capital asset owned by most households - would continue to rise forever, and ‘build equity’ for them without the need to reduce consumption.
Worse, many became addicted to home equity loans, which allowed them to borrow against the (rising) value of their homes, eroding any potential savings! Ballooning credit card debt - undertaken because of the ‘wealth effect’: that is, people ‘felt rich’ because of the growing value of their homes, so were more willing to borrow - added to record indebtedness. With the cheap credit extended to them by foreign savers as well as the US Federal Reserve, Americans rushed out to buy goods and services to fill their large new homes, the economy sucked in imports as it grew, and the US current account deficit (the excess of imports over exports) expanded to record levels.
The sub-prime mortgage crisis was only the first prick in the US housing and debt bubble. The bubble was bound to burst.
Before the crisis that began last July, economists had already expected foreigners to become reluctant to lend more to the US. The interest return they were getting on dollar assets was falling and the value of these assets was declining in foreign currency terms as the dollar fell. Furthermore, the risk for foreign countries concentrating their foreign exchange reserves in US Treasury bonds - issued by the US government to fund its record budget deficits - was increasing
As foreign capital inflow slows, the dollar will fall and inflation will pick up, fuelled by the falling dollar, which raises import prices. In these circumstances, US interest rates should rise, making borrowing more expensive and ‘cooling off’ the economy. A slower-growing economy would then deflate the housing and other asset bubbles, reduce inflation, and shrink the current account deficit, helped by a weaker dollar making exports cheaper and imports more expensive.
This process is already under way, but it has been complicated by problems in the financial markets. The inability to assess risk and correctly price mortgage-based and other ‘innovative’ securities has led to a serious ‘credit crunch’. Lenders are demanding much higher risk premia (interest rates) for their loans - or worse, becoming reluctant to lend at almost any price.
Unchecked, this could restrain new investment and consumption, and push even otherwise healthy borrowers into default, worsening the downward spiral of debt write-downs and falling asset prices.
In parts of the US, housing prices have already fallen below the value of home-own-ers’ mortgages. Meanwhile, the adjustable rates on these mortgages have shot up. As a result, many people are simply walking away from their properties . This has led to record foreclosures and further housing gluts and price falls - not to mention, hits to the balance sheets of banks which issued the mortgages.
The credit crunch and associated loss of consumer and investor confidence also hurts the stock market. Falls in the value of individuals’ and households’ stock portfolios, as well as of their homes, create a ‘negative wealth effect’. Feeling poorer, people reduce their spending, further slowing down the economy and threatening a deeper and longer recession than would result from a pure ‘business cycle’ downturn.
Ostensibly to forestall a recession, the US Federal Reserve and some other central banks have pumped credit into the system by providing commercial banks with access to more loan funds, and by lowering interest rates - aggressively and repeatedly in the case of the US.
These policies have been criticised for several reasons:
They delay the necessary deflation of asset bubbles by prolonging the easy-money conditions which led to the bubbles in the first place;
They worsen price inflation, which is already being pushed up by the falling dollar and rising commodity prices;
And they create ‘moral hazard’ by bailing out financial market actors from the consequences of their own risky behaviour, which they are then more likely to repeat in the future.
Such loose monetary policy - and the associated fiscal stimulus that has been enacted by the US government - can be justified only if a severe and prolonged recession is otherwise likely.
Until recently, such a severe recession - as opposed to a mild and short-lived one, such as was experienced in 2001 - was considered unlikely unless conditions in the financial markets get much worse.
This possibility cannot yet be determined with any certainty. But the US Fed is sufficiently worried that it has taken the unprecedented step of bailing out one financial institution - Bear Stearns - and offering to buy up to US$400 billion (S$550 billion) of the mortgage-backed securities that none in the private sector want to hold right now.
If one looked at the broad numbers, the US economy is not doing too badly. Though it has slowed down and housing is in a serious slump, unemployment remains relatively low and the weak dollar has led to an export boom, reviving the previously moribund manufacturing sector. Moreover, US corporate profits are likely to be at least partially sustained by continued rapid growth in emerging markets, led by China and Asia. Europe outside of the UK is also not doing badly.
Effect on Asia
A US recession - two quarters of negative GDP growth - is probably inevitable now, but it would not be all bad, including for Asia. A reduction in American consumer spending, while it would hurt growth, would have salutary effects in reducing inflation and debt burdens, and the current account deficit. A fall in US imports from Asia would encourage Asian governments and businesses to move more quickly away from their hitherto neo-mercantilist (export-promoting) policies toward serving domestic Asian markets.
Asia’s banks and other financial institutions are relatively insulated from the problems of the US and UK financial markets, since their ‘less sophisticated’ banks were not allowed by regulators to buy offshore CDOs.
Asian economies also have ample supplies of capital from their high domestic savings; hefty foreign exchange reserves; continued, if shrinking, current account surpluses from commodity and manufactured exports (which go increasingly to each other rather than to the US); and flows of portfolio capital leaving the credit-risky and slow-growth US for Asia. A credit crunch is not likely here.
The bigger economic risk for Asia is probably not imported recession from the US, but rather accelerating homegrown inflation and asset bubbles. These are fed in part by domestic monetary authorities continuing to favour low exchange rates, in their attempts to preserve exportcompetitiveness by trying to keep pace with the sinking US dollar. This policy aggravates imported inflation, whereas more rapidly strengthening currencies would reduce it.
Allowing currency appreciation would also ease the necessary and inevitable transition away from export dependence towards production structures more focused on the expansion of Asian domestic consumption and investment. That would help fulfil the much-vaunted ‘de-coupling’ of Asia from the troubled US economy.
We are not there yet.
The writer, a Singaporean economist, is professor of strategy as the Ross School of Business, University of Michigan
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How the current financial crisis developed
Cheap money led to low interest rates, which encouraged sub-prime mortgages and consumer debt.
Sub-prime loans were packaged with lower-risk ‘normal’ mortgages into mortgage-backed securities. Such securities became highly desirable in investment portfolios. But market uncertainty has led to a loss of confidence in the value of such securities.
A plunge in their value has cascaded through other financial instruments like derivatives.
Financial institutions which insure such securities - monoline insurers - have also been affected.
The potential ripple effect of monoline insurers defaulting is particularly great, since they insure all bonds, not just sub-primes.
The ensuing credit crunch affects businesses and households - the ‘real economy’.
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