The credit crisis is making a spectacular comeback.
Credit default swap spreads, which measure the cost of insuring companies against default, have widened again. Less than four months after the bailout of Bear Stearns Companies Inc. by the US Federal Reserve, we’re now seeing a far bigger rescue effort, this time by the US treasury, proposing to guarantee the debt of two major refinancing institutions that back almost half of US mortgages.
The sums being talked about are astronomical—the two US mortgage institutions, known as Fannie Mae and Freddie Mac, are estimated to hold around $5 trillion (Rs216 trillion) worth of mortgages. The US Federal Deposit Insurance Corporation has recently been forced to take over a failed mortgage lender in California called IndyMac Federal Bank FSB, which will cost it between $4 billion and $8 billion.
Questions are now being raised about the health of the hundreds of regional banks in the US, with analysts predicting that as many as 150 banks could fail in the next few months. From being limited to a few Wall Street investment banks, the credit crunch is now spreading its tentacles across the US financial system. And despite the lifelines, in spite of the acceptance by the US central bank of junk as collateral for repos and despite the assurance of the authorities that they are willing to do all it takes to help them, the credit markets are once again on the brink. The markets are no longer certain that the Fed’s or the treasury’s medicine will work.
The last few months have taught us that global markets remain inextricably linked to the US markets and that the credit crisis, by making banks cut down on lending, reduces leverage and lowers risk appetite, leading to a sell-off in emerging markets such as India. And the regulators’ efforts to bail out tottering institutions by giving them unlimited credit weaken the dollar, adding to the upward pressure on commodity prices and inflation, especially in emerging markets. The credit crisis affects us all.
So how bad can it get? Will the financial disaster lead to a meltdown in the real economy as well? What will be the costs of the crisis?
Several studies have pointed out that the subprime problem is one in a long line of banking crises that have affected countries all around the world. They turn out to be so common that, back in 2002, World Bank researchers Gerard Caprio and Daniela Klingebiel identified 113 systemic banking crises (defined as much or all of bank capital being exhausted) that had taken place in 93 countries since the late 1970s. And just to keep the current mess in perspective, it’s worth noting that during the savings and loan crisis in the US in the 1980s, as many as 1,400 savings and loan institutions and 1,300 banks had failed in the US. That clean-up cost around $180 billion, or 3% of the US gross domestic product (GDP), and is dismissed by the researchers as a “borderline and smaller (non-systemic) banking crisis”.
What were the costs of these economic calamities? They vary widely, with developing countries being the worst hit. The Asian crisis, for instance, is estimated to have cost Indonesia about half its GDP, closely followed by Thailand, where it cost more than 30% of its GDP. Among industrial countries, Japan has been the worst affected, losing about one-fifth of its GDP in its attempts to get back on its feet, but banking crises have erupted in Norway, Sweden and Finland (apart from numerous “non-systemic” crises). Asset prices fell by almost 80% in several countries during the Asian meltdown.
How did these countries solve the problem? The methods used to resolve them were all broadly similar. A World Bank discussion paper points out that many of them used asset management corporations and most of them used, after an initial period, fiscal stimulus and monetary policy to foster economic growth.
Will the current crisis in the US follow the long and painful path of other such crises? In their recent paper, Is the 2007 US sub-prime crisis so different? An international historical comparison, Carmen Reinhardt and Kenneth Rogoff suggest that if the US does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more special than the most optimistic theories suggest. “Indeed”, they write, “given the severity of most crisis indicators in the run-up to its 2007 financial crisis, the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one.”
That’s because, as the Bank for International Settlements’ annual report points out, the recent tightening of credit markets has taken place against the backdrop of very large increases in debt, particularly of US households. Says the report, “If past episodes of credit market crises are any guide, the macroeconomic impact of this tightening is likely to be considerable. The 1989–92 US credit crunch was, for instance, seen to have aggravated the recession in 1990. Following the pre-crisis peak, real bank credit to the US private sector contracted for a lengthy period.”
What’s more, we didn’t have record oil prices back then, nor did we have a plethora of derivatives. Nor did we have globalization. It’s scary that in the appendix to their paper, Reinhardt and Rogoff give, as one of the examples of a US-triggered banking crisis that affected countries all around the world, the Wall Street crash of 1929 and the Great Depression. The developing countries listed as affected at the time: Brazil, Mexico, Argentina, China and India.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com