It’s now a full year since the first cracks appeared in the US subprime mortgage market. HSBC had first announced that it had problems in its subprime portfolio in the first week of February 2007.
A lot has happened since then. The first reactions to what has now come to be known as the subprime crisis were pretty hopeful: it was seen as a problem in one corner of a huge global financial system. But later revelations showed how the subprime virus has spread from one bank to another because of fancy derivatives. The developed markets have seen a full-blown credit crunch since August, and even exceptional intervention and interest rate cutting by the US Federal Reserve has done little to ease the situation. Some of the world’s best-known banks have seen profits tumble; the Chinese government has rescued many of them.
One year later, the US stands on the brink of recession and most other major economies face the prospect of lower growth this year. The problem has proved to be far more serious than what most believed a year ago.
The passage of a year has done little to improve matters. There is still little clarity about how deep the rot in the Western banking system is. The US Federal Reserve had initially estimated the potential subprime losses at $100 billion. That has proved to be way off the mark. The write-downs by banks till now have already topped the $150 billion mark. This week, the G-7 group of rich nations said credit-related losses could touch $400 billion.
If losses do indeed cross $400 billion, a lot of banking capital will be at risk. And this will affect the ability of banks to lend, leading to an even worse credit crunch. The worst prognosis is that the US could eventually slip into a Japanese-style deflationary spiral, with contracting asset prices and a wobbly banking system.
It is hard to say whether the darkest fears will prove to be true. But there is little doubt that the credit crisis has punctured several oversized egos in the financial system. While the calls for heavy government regulation of banks are a bit overdone, the events of the past few months have shown that banks are fragile institutions which need to be handled with care.
Else, their problems can pull down entire economies. It’s clearly too early to write off the entire Western banking system. But the past year has provided sobering lessons.
Is the worst over for the global credit market? Write to us at email@example.com