Institutional Risk Analytics recently published an interview with William H. Janeway, managing director and senior adviser at Warburg Pincus.

In that interview, Janeway asks an important question: How is it that around $200 billion in subprime mortgage losses in the US resulted in around $10 trillion (and still counting) of losses in global wealth? He proceeds to answer his own question. To do that, he draws upon the work of Prof. Gary Gorton of Yale University (“The Panic of 2007", National Bureau of Economic Research, working paper No. 14358) and offers two explanations:

“First step was that subprime was distinctive. For subprime mortgages to be confirmed, to make any sense from a credit perspective, then home prices had to continue rising indefinitely. Not just stay the same and not fall. So that meant that they were going to go bust sooner or later. Second, by the time you get to the collateralized debt obligation (CDO) let alone to a CDO-squared, the buyer of whichever tranche could not even in principle, much less in practice, see through the layers of securitization and deals to observe the underlying cash flows."

To these two explanations, I would add the third explanation, which is embedded in explanation No. 2: that is the global scale of the leveraged bets taken not just on US subprime mortgage-backed securities, but also on local assets in each country.

Thus, the bursting of the housing and housing finance bubbles in the US precipitated the inevitable global deleveraging. Unfortunately, it took on a deadlier dimension due to two additional factors. One was the off-balance sheet nature of the leverage and the second was the dollar hoarding by US financial institutions, precipitated by the collapse of Lehman Brothers.

After the collapse and the stage-managed rescue of Bear Stearns, it must have been clear to the regulators that most of the banks’ gearing took place outside the balance sheet. That is why, even with write-offs, leverage ratios did not come down. The more they wrote off, the more debt they had to bring back on to their own books since many of the off-balance sheet vehicles were no longer solvent. US regulators—the Federal Reserve and other?agencies—must have at least sensed that the problem was complex because much of it was hidden.

Given the opacity, it is highly likely that they did not have enough information to assess or quantify the magnitude of the impact if Lehman Brothers failed. Now, it is one thing to say that they were making decisions on letting Lehman survive or fail over a weekend and, therefore, they did not have much time to form estimates of global repercussions before making decisions. This is unconvincing because the US enjoyed two months of relative tranquillity between March and May after Bear Stearns was rescued. That was sufficient time for US authorities to estimate potential losses in the remaining institutions’ books and construct many meltdown scenarios. They utterly failed to see the impact of the collapse of Lehman Brothers on panic-stricken financial institutions that knew about the skeletons that they had kept hidden. The prospect that they might be allowed to fail pushed them to hold back on all inter-bank transactions domestically and abroad.

What was nothing more than a severe equity market sell-off, turned into a full-blown currency and economic crisis in much of the developing world. They are yet to recover from it and the end is far from nigh. This will destabilize local politics and societies in many developing countries and that will spill over into the global arena.

The US economy has no potential for growth in the next two years, stuck as it is in a world where there is no mortgage equity withdrawal (MEW) for households to finance consumption. Some estimates without MEW show that the recession of 2001 would have seen GDP contract for two years in 2001 and 2002. Now, 2009 and 2010 could see a similar growth scenario—without MEW, but with massive fiscal stimulus—as in 2001. The risk is that this scenario is not pessimistic enough since there was no deleveraging or rising unemployment of this magnitude in 2001-02.

In such a situation, it might have helped to have other parts of the world grow. The behaviour of US banks after the collapse of Lehman Brothers has snuffed out that prospect entirely. One possible way out of the situation is massive debasement of the dollar. The question is when, and not if, this becomes a reality.

Timothy Geithner, a man who was party to all the decisions in the current crisis and to all the bailouts with their global consequences, will take office as treasury secretary in January in this context. Did I hear someone say that the more things change the more they remain the same?

V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at