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US in vicious circle of deep financial crisis
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A vicious circle is currently underway in the United States, and its reach could broaden to the global economy.

 

America's financial crisis has triggered a severe credit crunch that is making the U.S. recession worse, while the deepening recession is leading to larger losses in financial markets - thus undermining the wider economy. There is now a serious risk of a systemic meltdown in US financial markets as huge credit and asset bubbles collapse.

 

The problem is no longer merely subprime mortgages, but rather a "sub-prime" financial system. The housing recession - the worst in US history and worsening every day - will eventually see house prices fall by more than 20 percent, with millions of Americans losing their homes.

 

Delinquencies, defaults, and foreclosures are now spreading from subprime to near-prime and prime mortgages. Thus, total losses on mortgage-related instruments - include exotic credit derivatives such as collateralized debt obligations (CDOs) - will add up to more than 400 billion U.S. dollars.

 

Moreover, commercial real estate is beginning to follow the downward trend in residential real estate. After all, who wants to build offices, stores, and shopping centers in the empty ghost towns that litter the American West?

 

In addition to the downturn in real estate, a broader bubble in consumer credit is now collapsing: as the US economy slips into recession, defaults on credit cards, auto loans, and student loans will increase sharply.

 

US consumers are shopped-out, savings-less, and debt-burdened. With private consumption representing more than 70 percent of aggregate US demand, cutbacks in household spending will deepen the recession.

 

We can also add to these financial risks the massive problems of bond insurers that guaranteed many of the risky securitization products such as CDOs.

 

A very likely downgrade of these insurers' credit ratings will force banks and financial institutions that hold these risky assets to write them down, adding another US$150 billion to the financial system's mounting losses.

 

Then there is the exposure of banks and other financial institutions to rising losses on loans that financed reckless leveraged buy-outs (LBOs).

 

With a worsening recession, many LBOs that were loaded with too much debt and not enough equity will fail as firms with lower profits or higher losses become unable to service their loans.

 

Given all this, the recession will lead to a sharp increase in corporate defaults, which had been very low over the last two years, averaging 0.6 percent per year, compared to an historic average of 3.8 percent.

 

During a typical recession, the default rate among corporations may rise to 10 to 15 percent, threatening massive losses for those holding risky corporate bonds.

 

As a result, the market for credit default swaps (CDS) - where protection against corporate defaults is bought and sold - may also experience massive losses.

 

In that case, there will also be a serious risk that some firms that sold protection will go bankrupt, triggering further losses for buyers of protection when their counterparties cannot pay.

 

On top of all this, there is a shadow financial system of non-bank financial institutions that, like banks, borrow short and liquid and lend to or invest in longer-term and illiquid assets. This shadow system includes structured investment vehicles (SIVs), conduits, money market funds, hedge funds, and investment banks.

 

Like banks, all these financial institutions are subject to liquidity or rollover risk - the risk of going belly up if their creditors do not rollover their short-term credit lines. But, unlike banks, they do not have the safety net implied by central banks' role as lender of last resort.

 

Now that a recession is underway, US and global stock markets are beginning to fall: in a typical US recession, the S&P 500 index falls by an average of 28 percent as corporate revenues and profits sink.

 

Losses in stock markets have a double effect: they reduce households' wealth and lead them to spend less; and they cause massive losses to investors who borrowed to invest in stock, thus triggering margin calls and asset fire sales.

 

There is thus a broader risk that many leveraged investors in both equity and credit markets will be forced to sell illiquid assets in illiquid markets, leading to a cascading fall in asset prices to below their fundamental values. The ensuing losses will aggravate the financial turmoil and economic contraction.

 

Indeed, adding up all these losses in financial markets, the sum will hit a staggering 1 trillion U.S. dollars. Tighter credit rationing will then further hamper the ability of households and firms to borrow, spend, invest, and sustain economic growth.

 

The risk that a systemic financial crisis will drive a more pronounced US and global recession has quickly gone from being a theoretical possibility to becoming an increasingly plausible scenario.

 

(Shanghai Daily February 19, 2008)

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