The fallout from the subprime crisis continues to affect OECD economies. What caused the crisis and how might policymakers respond?
Financial market turmoil is at extreme levels and threatens economic growth in the OECD area and beyond. A near-term recession is likely in some countries, though the ultimate economic impact will depend on the ability of policymakers to soften the “credit crunch” now unfolding through the balance sheets of financial institutions.
At the origin of this crisis are the losses caused by increasing defaults in US subprime mortgage loans, most of which had been securitised and distributed to investors globally. Policymakers’ responses to the crisis have been geared towards stimulating the economy and calming the markets, and regulators are discussing ways to enhance transparency and improve risk management.Excessive leverage has been the key characteristic, particularly with respect to subprime mortgages and the securities based on them. Four causal factors have been at play. First, excess liquidity resulted in asset bubbles, particularly in housing and mortgage-based securities. These asset bubbles encouraged speculators to borrow, while the (rising) asset value of collateral comforted the lenders.Second, there were clear gaps in regulatory and accounting standards regarding the treatment of “off-balance sheet” financial vehicles and lending practices.Third is the key role rating agencies have played in the securitisation process. Normally banks assess credit and retain it as private information. But to sell these credits into the capital markets requires external ratings to allow investors to assess the risk-return profiles of these assets. The now well-known transformation of riskier securities into vehicles with prime and triple-A ratings greatly smoothed the way for the boom in a whole range of structured products, like collateralised debt obligations, asset-backed commercial paper conduits and so on.Fourth, notwithstanding all of this, there were notable failures in the corporate governance of financial intermediaries. Some banks stayed clear of these high risk products, and some managed to reduce their exposures significantly prior to the crisis, but others rushed headlong into major exposures, lured by fast profits and fees.It is the confluence of these factors which has made this crisis so serious, and the situation now leaves policymakers little choice. Attempts to unwind holdings of illiquid mortgage-backed securities has already led to price collapses, and with mark-to-market accounting (linking the balance sheet value of financial products to current market prices), this has forced massive write-offs and heightened insolvency risks for well-known banks, as the Bear Stearns episode in the US and the bank run on Northern Rock in the UK well underlined.Central banks have had to step in with new liquidity operations, extending the definition and time frame for collateral they are accepting in their dealings with banks. The aim is to keep markets functioning, as banks have refused loans to each other due to uncertainty about which firms are at risk. However, insolvency is the core of the problem: the insolvency of home owners who took on mortgages in the expectation of capital gains that did not materialise, and the insolvency
of financial institutions that either managed their risk poorly or were too reliant on short-term wholesale funding of their balance sheets.Banks are highly-levered institutions, with large funding liabilities and asset portfolios, with a thin sliver of capital in between. It does not take much to wipe out this capital if funding declines or asset write-offs occur, forcing banks (in the absence of new capital injections) to de-lever in order to meet capital rules or, in extreme cases, into bankruptcy. Restrained balance sheets of banks, can shut down financial intermediation, and directly affect GDP. Consequently, policies that facilitate the re-building of capital are vital for addressing solvency problems.The OECD has increased its estimate of the ultimate mortgage-related losses from US$300 billion last autumn to a range of $350 billion-$420 billion now. About $90 billion of the likely ultimate losses are directly associated with US banks that play a key role in the intermediation process. Left to itself, this could result in substantial de-leveraging, as happened in the early 1990s.The first line of defence, therefore, is to cut interest rates in order to help bank margins and earnings, while also encouraging cuts in dividend payouts to retain more earnings. It would take banks 6 to 12 months to recapitalise through earnings, depending on the extent of these cuts and any new balance sheet expansion they might be able to undertake.
Expanding bank balance sheets to support economic growth requires not only offsetting losses, but also building capital for the normal growth in their own businesses. To speed up the process, helpful capital injections have come from sovereign wealth funds and hedge funds–groups that are prepared to take more risk at times when others are not. Banks have already been quite successful in raising some of the capital they need, but the environment remains challenging and more injections will be required.A final line of defence is the use of public money to shore up bank balance sheets. But as this would create moral hazard in banking for the future (by attenuating the consequences of risky behaviour and encouraging more such behaviour later on), it is a last resort–as with the case of Bear Stearns–to avoid damage to the real economy.The subprime debacle is not confined to the United States, since European institutions too bought a substantial share of the subprime securities, and on average European banks are less well capitalised than their US counterparts. The current crisis could also spill over into equity derivative products, which are also more widespread in Europe, as is exposure to foreign currency loans in some countries, with currency risk increasing.Let’s not forget that while corporate balance sheets are generally in good shape, there is a “fat tail” of corporate over-borrowing built up through leveraged mergers and acquisitions. A pressing worry is that the de-leveraging that will accompany the losses on subprime mortgages and related securities, if not handled well, could spill into other asset classes (such as corporate bonds, equity derivatives and the like)–a scenario that policymakers would do well to avert.References
©OECD Observer No 267 May-June 2008