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This time the crisis is different

This time the crisis is different
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First Published: Wed, Apr 09 2008. 12 40 AM IST

Updated: Wed, Apr 09 2008. 12 40 AM IST
After the collapse of mortgage institutions such as Countrywide in the US and Northern Rock in the UK and hedge funds such as Carlyle Capital, it’s now the turn of investment banks to go belly up.
On Friday, the New York Federal Reserve Bank stepped in to rescue Bear Stearns, while credit default swaps (the cost of protection against default) on the biggest banks soared after the bailout, with plenty of speculation on who’s next on the list. Lehman Brothers received a $2 billion (Rs8,100 crore) unsecured line of credit from 40 banks on Friday. Experts are predicting that the crisis will lead to record losses for insurance companies. This is no mere stock market correction—it’s a systemic financial crisis.
Many compare the current crisis with that faced by Japan after its land and stock market bubble burst in the early 1990s. A 2005 study by the Federal Reserve Bank of Cleveland cited the Japanese experience and concluded that banks “became reluctant to let their borrowers default, because recognizing those losses would wipe out their entire capital and render the banking system insolvent... So banks and regulators took a gamble. Banks went on restructuring non-viable loans by reducing interest rates and extending their maturity. They also offered new credit lines so that borrowers could pay their overdue loans. The hope was that these businesses would recover in time or the banks would build enough capital to absorb the losses. But the gamble did not pay off. Extensions followed one another, and losses snowballed. As a result…non-performing loans on the books grew from 40 trillion yen in 1995 to 88 trillion yen in 1998 (about $725 billion, or 18% of GDP).” The parallels with the current crisis are obvious.
The same study also points out that one of the preconditions of a systemic banking crisis is that “depositors have difficulty determining whether new information about the quality of assets at one bank has implications for the quality of assets (and by implication, solvency) of their bank.” Substitute “depositors” with “investors”, and we have an exact description of the current situation.
What of the future? An earlier housing crisis in the US in the 1980s was resolved by the government bailing out the savings and loan associations (which were essentially mortgage banks), but the cost of that bailout was a mere $150 billion.
Current estimates of the ultimate losses from the credit crisis go all the way to a trillion US dollars. While that sounds huge, it’s slightly more than 7% of the US gross domestic product (GDP). The costs to Japan as a result of its credit crisis have been almost three times as much, measured as a percentage of GDP. After the Asian crisis, recapitalizing the Indonesian banking system cost taxpayers 58% of Indonesia’s average GDP during 1998-2001. And while the US Fed’s measures to bail out ailing institutions has drawn flak, it’s worth recalling that after the banking crisis in Norway in the early 1990s or the South Korean crisis in the late 1990s, the government became owner of half the banking system. Nobody believes in free-market capitalism during a crisis.
What about the stock market? Nouriel Roubini, who has been predicting a US recession since 2006, recently pointed out that the Bear Stearns collapse was Step 9 of the 12 steps to a financial disaster he had outlined last month. Step 9 talked of “non-bank financial institutions that look like banks in terms of liquidity/rollover risk would go bankrupt.” Roubini’s Step No. 10? “Further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.” And going by recent trends, no market will be immune. Risk aversion has gone up after the Bear Stearns news, with yield premiums over US treasury at their highest levels since June 2005. Emerging market stocks will reflect that increase in risk aversion.
Is there still the lingering hope that, after the dust settles, investors will flock to places where there’s relative growth after the dust settles? Perhaps, but it may take a long time for the dust to settle. After the announcement of the bailout plan for the US savings and loan crisis in February 1989 and in spite of a series of rate cuts, it wasn’t until early 1991 that the US market started to rally. As for Japan, the Nikkei is currently trading at less than a third of its value reached in December 1989.
During the bull run of 2003-07, many optimists said, “This time it’s different”. While they were wrong about the boom, they could be right about the bust.
Write to us at marktomarket@livemint.com
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First Published: Wed, Apr 09 2008. 12 40 AM IST