The credit crunch


Postcards from the ledge Dec 19th 2007 From The Economist print edition

There is certainly a path out of the gathering banking crisis, but no guarantee that the world economy will find it

A CREDIT crunch, a liquidity squeeze, a subprime meltdown—the shape-shifting menace that has vexed the world in 2007 has been all these things. But now it looks like becoming a banking crisis as well. The grievous experience of two centuries of financial busts is that when the banking system is in difficulties the mess spreads. Straitened banks lend less, sucking money out of the economy. In rich countries that threatens to tie down companies and give ailing housing markets a kicking. The data barely show it yet, but the financial malaise could yet be aggravated by a broader economic malaise.

Back in October it briefly seemed as if the summer's turmoil was abating. But a month later investors' confidence took a giddying turn as the weakening American housing market jeopardised the banks' capital. In December the leading central banks acted together to jolt the money markets into life. On December 18th the European Central Bank lent almost €350 billion ($500 billion) to tide banks over the new year. And yet most fear-meters, including, crucially, the price banks have to pay for funds (see chart), still register chronic anxiety.

This raises two broad questions. How gravely will the economy suffer? And what will become of the financial innovation that promised so much, but has proved so treacherous?

Subprime suspect For answers, start in America's housing market, where the crisis had its origins. Subprime borrowers will probably default on $200 billion-300 billion of mortgages. That is a lot of money, to be sure, but hardly enough to imperil the world economy. For that, you need the baroque superstructure of mortgage-backed derivatives that enabled investors to bet on the housing market. From a mathematical viewpoint, the combined profits and losses on these derivatives will, by definition, cancel out, so they should not add anything to the total underlying loss. But that is only half the story. Individual investment vehicles may have sustained huge losses, especially if they borrowed heavily: it is the fear that your counterparty might be in that predicament that is gumming up the markets.

In theory the damage is safely contained off banks' balance sheets. But then, in theory American house prices never fall. The banks have belatedly discovered that they cannot just abandon their failing progeny of SIVs, conduits and the rest—at least if they want a reputation worth having. Worse, the banks now facing up to these contingent liabilities have not had to set aside capital in case of trouble—that gap in the regulations was precisely what made it so attractive to get their investments off the balance sheets in the first place.

November marked the stomach-churning moment when investors realised that the housing market was falling, that the losses would be big, that the banks would end up owning them, and that they had not put capital aside for the job. To make a bad case worse, nobody knows which bank is sitting on which liability. Every bank is suspect and any bank seeking to raise money by selling a position is more suspect than ever. As fear has played upon this lack of information, the money-market funds have gone on strike, cutting off the interbank markets' main source of cash, and the (embryonic) market for complex mortgage-backed derivatives has closed. It is an alarming mix of hiatus and distress.

If you put all that together, it is easy to see why an economy burdened by debt and a housing bust is in extra danger. Starved of funds and facing not just losses but lawsuits (see article), the banks are hoarding liquidity and capital. That can create a vicious circle. As the system of leverage that magnified credit collapses in on itself, borrowing becomes harder and demand falters. The rot can spread from housing to other areas, such as commercial property and credit-card debt. If the money-market funds then withdraw even more of their longer-term lending from the banks, then banks will need to conserve yet more capital. And so it goes dismally on.

Just take the hit Nobody yet knows whether the extreme borrowing in the credit boom was a sensible result of the powerful new machinery of debt, or the sort of excess still unwinding in Japan: the lawyers will argue about that. But if the downward spiral takes hold, America will end up in recession and so quite possibly will Europe. The need is to break the chain—which leads back to the financial system. It urgently needs attention.

The markets will not recover until lenders believe the banks have credibly owned up to their losses. Sometimes this is best done when a bank chief has quit, as at Merrill Lynch. Often, the reckoning is more convincing when the bank has absorbed its off-balance-sheet ventures—as at HSBC and Citigroup. That is a risk, because it can weaken the banks' capital base and because the assets can fall further in value. But it is better than leaving the mess to fester and investors to fear the worst. Some banks will need fresh capital. UBS sugared a huge loss by announcing billions of dollars of new capital from government-backed funds in Singapore and the Gulf. Citigroup took $7.5 billion of Abu Dhabi's money. Others are sure to need help—and may well turn to sovereign wealth funds, too.

There is an irony in seeing state-owned investors bail out capitalism's most ardent exponents; back when money was plentiful, the government outfits were rebuffed. But the banks are less choosy now. Moreover, the frenzy of innovation around debt and securitisation got out of hand. Risk was supposed to be bought by those best able to afford it, but often ended up with those seduced by yields they did not understand. Mathematical brilliance was supposed to model risk with precision, but the models evaporated along with the liquidity that they had failed to quantify. Rating agencies were supposed to serve the market, but their first loyalty seems to have been to the issuers who were paying their fees.

Finance now needs a flight to simplicity—to tame the jungle of investment vehicles, to reform the rating agencies, and to price liquidity risk. In a few cases regulation, chiefly aimed at transparency, looks justified. But do not expect the ethos of finance to change—or even wish that it were so. The system will purge the worst complexities of the past few years of its own accord. The tools of modern finance are too valuable to be cast aside. Securitisation makes assets easier to sell. Derivatives, used well, increase financial flexibility. And opportunists with names like Goldman Sachs and Cerberus are just the people to pick over the carcass of the credit boom and make a market where none exists today. When they put their billions to work, you will know the corner has been turned.

Back to Ben Until that moment, the burden will fall on the central banks. They have tried to help by tinkering with the technical operations that supply liquidity (though they keep overnight interest rates on target by draining money elsewhere). By and large, this has failed: the banks' problems are not technical, but real.

Monetary policy matters far more and central banks must weigh the short-term danger to the economy against the medium-term threat to their own standing as inflation fighters. If the economy looks likely to weaken, further interest-rate cuts will be needed. But the effect of any rate cut will be lessened by those wide, fear-induced spreads in the money markets. And the severity of the slowdown is unknown. If central banks overestimate this and cut too much, it will fuel inflation, already stoked by demand in the emerging economies. Inflation is above target in the euro zone and (by a shade) in Britain and rising in America. It is a recipe for repenting at leisure.

The hope is that the credit markets unblock themselves and that buoyant emerging markets buy rich-world exports and recapitalise rich-world banks. The fear is that this crisis will assume yet more guises before it takes its leave—especially if politicians try to seize control. Bankruptcies, recession, litigation, protectionism: sadly, all are possible in 2008.