Bill Emmott - International Author & Adviser


The real meaning of the credit crunch
Exame - November 2007

When finance ministers, bankers, central bankers and economists gathered in their thousands for the annual meetings of the World Bank and International Monetary Fund in Washington, DC, in mid-October, the mood was very different in private discussions than it was in public or in print. The public mood was upbeat. The private mood was rather gloomy.

This may be because with the English language and the world’s largest economy, American voices tend to dominate, especially in their capital city, and the prospects for the American economy have changed much more since the August credit crunch than have those for other economies. But also it was because the officials and the bankers are putting a brave face on a worrying situation.

Formally, the IMF’s forecast for the world economy in 2008 suggests that little has changed. After worldwide GDP growth of 5% in 2007, the IMF forecasts a slowdown merely to 4.8%, which will be barely noticeable if it turns out to be accurate. Admittedly, the United States itself is expected by IMF economists to lose almost a full percentage point of growth, achieving 1.9% instead of the 2.9% that was previously forecast, but this is expected to be counterbalanced by strong growth in the emerging markets.

Yet anyone who listened to any discussion in a private meeting or seminar, even one involving the chairman of the Federal Reserve Board, Ben Bernanke, received a rather different impression. That impression was, like the IMF’s forecasts, cloaked in words that emphasised that so far the economic data has not been too bad. Yet alongside those words could be found the language of trauma: a financial trauma that is still under way and the consequences of which remain impossible to forecast.

Thinking back to 1990, when Japan’s financial crash began, the atmosphere a few months after the crisis began was quite similar to that today. It was clear that a financial trauma was occurring: equity prices were collapsing at an unprecedented rate. Yet the so-called "real" economy seemed to be unaffected by the drama in financial markets. In fact, Japan continued to enjoy quite healthy economic growth for two whole years, until the end of 1992. By then, however, the financial and "real" economies were becoming connected again, as the equity crash spread into property prices, and as banks found themselves forced to cut their lending and call in their collateral from many borrowers.

This time, the financial drama has taken place in the residential property market first, and then more widely in credit markets. But as time passes since the drama first became apparent in early August, what is becoming clearer is that like in Japan the central actors in the drama are commercial banks. And that is why the mood is becoming gloomier.

The eternal truth about banking

In recent years, many analysts have raised concerns about developments in the credit markets. They worried that credit was becoming underpriced, with risky borrowers being given lending terms only a little costlier than safe ones. They worried, too, that the boom in innovative credit products, based on the securitisation of loans and the sophisticated slicing and dicing of financial instruments, was making it much harder to know how much risk was being taken and which institutions were taking it.

But there was one big source of reassurance. It was that in modern capital markets, the risk was now being dispersed more widely than before, with insurance companies and pension funds taking on their share. Even if some institutions were to turn out to have accumulated too much risk, their losses were unlikely to be dangerous for the financial system and economy as a whole. The bad old days, when risks were concentrated in the commercial banks, and when bank failures could lead to a major contraction of lending, were gone.

The big lesson since August is that this was wrong. In fact, commercial banks have held on to much more of the risk than was previously thought. They did this in two ways: by creating special "off balance sheet" vehicles of their own to carry the risk and, they hoped, profit from it; and by retaining a large obligation to subsidiary firms to whom they had passed their risk, and which they could not afford to allow to collapse when the credit crisis began.

That is why the most sensational proposal of this crisis has come from the three biggest American banks, led by Citigroup, under pressure from the US Treasury: the proposal to create a new $100 billion-plus fund to buy up the currently unsaleable complex securities in order to prevent their values from crashing and the losses from having to be realised on the banks’ own balance sheets.

That proposal, however, is also reminiscent of events in Japan in the 1990s. It is an attempt to buy time and to avoid admitting to the reality that, in current market conditions, the banks’ have lost huge amounts of money on these complex mortgage- and asset-backed securities. In Japan, the finance ministry assisted banks in falsifying their accounts by evaluating non-performing loans as if they were still being serviced and repaid. But that did not change the reality that the loans were in fact duds.

The danger with the Citigroup proposal is that the same will happen, if the proposal ever succeeds in getting off the ground: the value of these securities will fall further as conditions in the housing and other credit markets worsen, and as investors’ trust in the truth of banks’ accounts gets eroded even further.

However much it is cloaked by clever mathematics and sophisticated financial packaging, the reality of finance is unchanged: that the value of a debt depends on the likelihood that the borrower will repay the underlying loan. The reality of banking is also unchanged by modern financial markets: banks make profits by taking risks, borrowing short-term from depositors and the money markets and using the money to take on long-term, hopefully high-yield lending. Securitisation did not change this, at least not greatly, as if it had done banks’ profit margins would have been small.

The good news is, however, that banks have been profitable, and have also accumulated a lot of capital. It also remains true that globalisation stands a chance of stabilising the world economy, by providing demand in the emerging markets to limit the global downturn. But the credit crunch in America and Europe looks like turning into a banking crisis. As that becomes manifest, the chances of a recession in America and a sharp slowdown elsewhere will rise.


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