My column in last week’s Australian Financial Review was about the spreading crisis in financial markets. In the same week, we saw the first indication* that the crisis was spreading to the market for credit derivatives. The possibility of a full-scale financial crisis arising from these markets, which financial market bears have been talking about for years. Whereas the losses from sub-prime loans and related derivatives markets are likely to be in the hundreds of billions, the nominal volume of outstanding contracts in the credit derivatives markets is in the tens of trillions, and interest rate swaps are in hundreds of trillions.
Such amounts cannot possibly be repaid by anybody, so a breakdown in these markets would imply either wholesale bankruptcy or a government rescue involving the abrogation of existing contracts on a scale unprecedented in history. Either way, as noted in the article, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.
The latest news from the US suggests that a recession in 2008 is highly likely, if indeed it has not already begun. Employment is falling, consumer confidence is slumping, and indexes of activity in the service sector, which accounts for the bulk of economic activity, have declined sharply. The housing sector is at the centre of the decline, as a wave of defaults on subprime and other nonstandard loans has produced the first nationwide decline in home prices since the Great Depression.
At this stage, it is impossible to forecast the length and severity of any recession. It is, however, safe enough to predict that the US economy will return to positive growth in due course. Within a few years at the most, income will surpass its pre-recession peak. If the recession brings about an unwinding of the massive imbalances in trade and capital flows that have built up over the past decade, it may even yield some long-term gains.
The picture is much less clear for the financial sector, the excesses of which have brought about the current crisis. The crisis has effectively killed the subprime loan market, and produced a drastic contraction in the associated market for mortgage-backed securities, and derivatives of those securities such as collateralized debt obligations (CDOs).
With residential mortgage-based CDOs now almost unsalable, concern has now focused on other credit derivatives. Delinquencies are already rising on CDOs backed by commercial real estate loans, and new issues of such CDOs have ground to a halt. The panic is now spreading to student loans, leveraged commercial loans and a range of collateralized loan obligations.
The cycle of default, downgrade and debt deflation has not stopped there. During the boom, so-called ‘monoline’ insurers which were supposed to confine their business to a single activity, the provision of guarantees for municipal debt, extended themselves to insuring the AAA status of mortgage-backed CDOs, many now worthless. As a result, the main insurers Ambac and MBIA seem certain to lose their own AAA ratings and therefore their capacity to write new business.
A new competitor established by Warren Buffett of Berkshire Hathaway may partially replace the existing firms, at least for municipal bonds. But, the capacity to turn risky debt into AAA-rated assets through insurance is unlikely to return any time soon.
The problems are even worse for the rating agencies that issue the AAA (and lower) ratings on debt. The value of agency ratings was cast into doubt in the stock market bubble of the late 1990s when they gave investment-grade ratings to shonky enterprises like Enron and Worldcom, providing no warning to hapless bondholders until it was to late to escape from the inevitable collapse.
In the epidemic of unsound and outright fraudulent lending that generated the current crisis, the availability of AAA ratings for dubious credit derivatives played a crucial role. Thousands of these assets have already been downgraded, and large-scale defaults appear certain.
The failure of ratings agencies has some implications for Australia. During the 1980s, the good opinion of the ratings agencies was taken as a critical indicator of national economic health. Even today, the economically dubious decision of the NSW government to sell its electricity asset has been sold on the basis of the supposed need to maintain the state’s AAA rating.
Given this massive demonstration of incompetence, the idea that US rating agencies should sit in judgement on Australian governments, none of which has ever defaulted on obligations to foreign creditors, is simply laughable.
With so many pillars of the financial system displaying weak foundations, it is natural to wonder how the problems will be resolved. The general assumption is that, as with the real economy, the financial sector may contract briefly during the coming year, but will then resume its rapid expansion.
But the scale of the problems now becoming apparent suggests that the financialisation of the economy has exceeded the capacity of financial markets to manage risk. If so, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.
Such a development would have some bad effects, in reducing the range of options available to households and businesses to manage risk. But it would also reduce the danger of dubious financial innovations undermining the stability of the financial system as a whole.