The subprime crisis

Résumé du document

Edward Gramlich in his presentation during the Jackson Hole yearly central bankers symposium of August 31, 2007, said that, 'productivity often improves in fits and starts, in other words, booms and busts play a prominent role. In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and financial boom. The 20th century saw another financial boom, a stock market boom, a post-war boom, and a dotcom boom. The details differ, but each of these cases feature initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices cannot keep up, and many investors lose a lot of money. When the dust clears, there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around the benefits of productivity'. Indeed, the current financial crisis is another episode of excess investment due to unwarranted expectations of the results of an innovation. Investors thought the financial innovation they were using protected them from any risk. The slicing up of dubious loans and their repackaging minimizes risk by spreading it. It does not eliminate this risk, and that is what investors had forgotten. But that is not the whole story, and Gramlich acknowledges it when he said, 'the subprime market was the Wild West'. It is the lack of adequate regulation, that allowed for predatory lending and 'no-doc' loans, which, combined with the financial innovations of the last decade, was the major source of the subprime crisis. The quantity of liquidity available in the market is an amplifying factor, for when liquidity is high, interest rates are low and the appetite for risk goes up. In a liquidity scarce market, there would never have been a market for residential mortgage backed securities (RMBS); therefore, there could not have been a subprime crisis.

Extraits

[...] The second difference between financial issues and insurance markets is that unwarranted lack of confidence, like excessive confidence, can hurt the economy through the financial accelerator. One related advantage in central bank intervention is that solvent institutions will need to hold less cash because investors know they are backed up, so they can take on more productive but illiquid assets. To solve the liquidity crisis, central banks have used several tools. First, the Fed cut back its rates, while the ECB refrained from raising its own rate although it had made clear early this summer that it intended to do so. [...]

[...] In a liquidity scarce market, there would never have been a market for residential mortgage backed securities (RMBS); therefore, there could not have been a subprime crisis. Once default rates reached higher levels, the portion of the financial system that was built around it collapsed. Markets dried up, confidence fled as the opacity of the whole system prevented informed decision-making. Highly leveraged conduits turned to the banks which had created them when they found it impossible to roll over their debt. Central bankers intervened forestall a liquidity crisis. After months of deteriorating financial conditions, the United States' economy seems to have plunged into recession. [...]

[...] All this means that those holding MBS face big capital risks. Banks' conduits hold 25% of these assets and hedge fund who have borrowed a lot from banks hold 50% of the global 1.3 trillion dollar CDO. As of late December, the Guardian reported that Wall Street banks had written off over 15 billion pounds which are to be compared to the 4 billion dollars of the Long Term Capital Management crisis of 1998. b. Loss acknowledgment by banks is part of the solution but should be complemented by fiscal help to subprime borrowers Banks acknowledging their losses clarifies the situation, thus helping to restore confidence to the financial sector. [...]

[...] Indeed, the 1997-1998 crisis shocked newly developed and quickly developing countries. From 1994 to 1996, yearly capital flows to Asia nearly doubled, climbing from 60 to 104 billion dollars. Asian banks borrowed short using those dollars and lent long in their local currency, oblivious to the exchange rate risk because of governments' guarantee to keep the local currency pegged to the dollar. But, when in 1997 capital flows retreated to 70 billion dollars, governments could not hold the peg against a strengthening dollar, making it impossible for Asian banks to roll over their debt. [...]

[...] The debate is that if there were opportunities at home they would invest there. How to create such potentialities would take us to far from our subject and into development economics but it is the only long term rational solution if you consider these countries as states. If however you regard these states' rulers as individuals, then it is logical for them to invest where the highest risk adjusted yields are provided, and that is in already developed OECD countries. [...]