At this stage in the financial crisis, it is difficult to discern exactly where things are headed. However, let me give a general road map of how I see things shaping up.
The credit crisis started in August 2007 as a result of the dual realization amongst investors and global financial institutions alike that large credit writedowns due to subprime exposure were imminent and that nobody knew where that exposure lay. Therefore, at its core, the credit crisis has two specific proximate causes:
- Credit losses from the lending in the past business cycle upswing will be much larger than had been previously anticipated
- Due to derivatives, off-balance sheet exposures, poor disclosure requirements and the interconnectedness of the global financial system, it is unclear which institutions are most exposed to potential credit losses
The crux of the problem is unexpected losses and fear that those losses could be any- and everywhere. This will continue to be the case going forward, with significant implications for the financial sector and for the real economy globally.
History since Fall 2007
Rewinding to the fourth quarter of 2007. The monetary authorities had done great work in calming the credit markets after the initial shocks in August due to BNP Paribas’ fund freeze and again in October due to the collapse of Britain’s Northern Rock.
But, it was also then when the magnitude of losses first became apparent as large global institutions started to come clean with significant credit writedowns that necessitated new rounds of capital raising to bolster balance sheets. However, as the losses increased and it became apparent that poor credit quality was not limited to the subprime sector, the credit markets began to freeze up as banks’ mutual trust dissipated.
Bear Stearns then collapsed and the monetary authorities were again successful in calming things down quite a bit. However, it was in the summer that I believe this calm disappeared. Until then, banks were able to raise enough capital to recapitalize themselves after their writedowns because the magnitude of losses was believed to be contained.
But, in June, Lehman Brothers posted a $3 billion loss, sought $6 billion in capital and looked to shed $130 billion in assets. Just months before, Hedge Fund nemesis John Paulson had been derided by Lehman management for shorting the stock because of Paulson’s belief that Lehman was smoothing earnings to hide huge losses.
In July, a story broke in the German press, which first appeared in English on this very website about well-connected and reputable Bridgewater Associates study that credit writedowns would eventually reach $1.6 billion trillion and large losses were unaccounted for everywhere. Five days later IndyMac went bust and the world hasn’t been the same since.
The future
Fast forward to today and we have seen the nationalization of Fannie Mae, Freddie Mac and AIG, the bankruptcy of Lehman Brothers and Washington Mutual in the U.S. We have also seen nationalizations in Iceland, the UK, Denmark, France and the Benelux as well as crises and bank deposit guarantees in Ireland, Germany, Austria, Greece, Denmark and a host of other countries.
And despite what the monetary authorities have done, the credit markets are seizing up, letters of credit which control trade are being rejected, and stock markets are plunging. What will all of this mean?
First and foremost, this means that the real economy effects of the credit crisis will be much more severe than previously anticipated. Recessions have already been noted in places as far afield as Denmark, Singapore, the UK, and New Zealand. In all likelihood, Japan, the U.S. and Eurozone will all suffer major recessions due to the credit crisis. Few of the real economy effects from this have yet been felt. In recession, businesses go bust, people lose their jobs, consumers spend less, and credit defaults increase for businesses and individuals.
All of this translates into further credit writedowns from the following categories of debt, where credit excesses are concentrated in both North America and Europe:
- Residential Property (like Alt-A, Payment Option, Negative Amortization Mortgages)
- Commercial Property (Commercial Real Estate and Construction Loans)
- Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
- Credit Card Receivables and Asset Backed Securities
- Auto Loan Receivables and Securitized Auto Loan Bonds
But, in addition, the following categories will see increased losses due to the real economy recession in Europe and North America:
- Bank Loans (general loan quality will sour)
- Corporate Debt (As recession hits, some previously credit worthy corporates will fail)
- Prime Residential Real Estate Loans (this is all ready occurring)
As far as Asia and Emerging markets go, it bears keeping in mind that demand for commodities is slowing rapidly as major industrialized economies slow. Therefore, Asia, Latin America, New Zealand, South Africa and Australia will not be immune. We have recently seen enormous currency moves in Australia and South Africa that are harbingers of impending recession there. Moreover, signs of slower export growth are evident all over Asia from Japan to China to South Korea. Other economies in Latin America that are highly dependent on commodity exports like Mexico, Venezuela, Argentina, Chile or Brazil will not decouple. They too will see a slowing in their economies.
Ultimately, this credit crisis is going to create a global downturn that will be the most pronounced since World War II. From my perspective, the key to minimizing the down turn rests on how effectively policy makers respond with a coordinated global effort to the following categories:
- the need to unfreeze credit markets
- the need to re-capitalize and shrink the influence of near-bankrupt financial sectors
- the need to restore confidence to all capital markets globally
I started by saying that this crisis is at its core a crisis due to over-lending and the resultant credit losses magnified by distrust. Therefore, the solution is clear: policy makers must not only purge and re-capitalize the financial system, they must also restore confidence in global finance. Ultimately, it is confidence and trust that is the most precious quality we have lost.
It is my fervent hope that the G-7 and G-20 meetings this weekend bear fruit so that we can avert a more pronounced crisis.