'The Panic Of 1907' Versus The Sub-Prime Crisis

Source : The Straits Times, Aug 29, 2007

(SINGAPORE) The unfolding of the sub-prime crisis that has jarred financial markets in the last two months 'has a long way to run', said Robert Bruner, dean of the University of Virginia's Darden School of Business and co-author of the book The Panic of 1907.

In a close parallel to recent events, the book chronicles and analyses a liquidity crunch that hit Wall Street almost exactly 100 years ago, which led to the formation of the Federal Reserve System.

Speaking in an interview with BT yesterday, Dr Bruner compared the situation then to contemporary affairs. He said today's crisis is 'still early in the process', though the next couple months is likely to provide information and other signals that could bring matters to a head.

One reason is that hedge funds - the influential wild cards of hot money in today's financial system - must report on a monthly or quarterly basis, and they are due to do so in August or September.

If funds with major loans from established financial institutions reveal huge losses, it would cause widespread fears about the institutions' soundness, and institutional depositors, the 'hot money' in the system, would shift their capital into US Treasury bonds, said Dr Bruner. 'We could see a prominent institution perhaps not collapse but sold under involuntary conditions.'

Although the sub-prime mortgage sector is only a fraction of the credit market, 'what's important is not the total supply of credit but the behaviour at the margin', he said. This refers to corners of the world's financial systems that contain risks investors are not aware of - such as with Thailand's banks in 1997 or Russia's sovereign debt in 1998.

Today, it refers to to hedge funds that are 'by and large well-run but from whom we see periodic collapses', like with Long Term Capital Management in 1998 and Amaranth last year.

'We don't have any transparency about the global hedge fund industry and have no way of knowing what difficulties may lurk,' he said.

The Fed's meeting on Sept 18 to discuss the benchmark interest rate will provide another important signal. 'If they raise rates, they are saying the crisis has passed. If they lower, its clearly a signal that things are a lot worse than we imagine,' said Dr Bruner.

So far, the Fed has played a cautious game and save its most potent weapon, though it has lowered the discount rate - at which it makes short-term loans to banks - and signalled it is willing to throw liquidity into the market. The Fed is the 'best informed player in the US capital markets right now' but 'may not have many more options', Dr Bruner said. He expects Asian markets to remain robust, especially in sectors with sufficient liquidity. But economies like China and Japan also depend on the willingness of the US consumer to keep spending, he said.

'We are at the very beginning of what is the heavy consumer spending season of the entire year, from now till end of the calendar year. We will know probably in the next 30 days how buoyant the US consumer feels.'

A few recent statistics, such as lower demand for boxcar shipments from the West Coast to the Midwest, and lower shipments from Asia, suggest that importers are stocking at a lower rate, he said.