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From the Subprime to the Ridiculous

It is somewhat misleading to label the present crisis a "subprime crisis". This suggests that when banks make subprime loans, that is, practise financial inclusion, they are apt to get into trouble. Some commentators have even gone so far as to warn against political pressure for financial inclusion in India. It is not exposure to subprime loans that is a problem; it is the loss on subprime related securities that explains the sheer magnitude of the present crisis. The evolution of the crisis shows that the world did not fully absorb all the lessons from the collapse of the hedge fund, Long-Term Capital Management in 1998. When do episodes of financial stress have a measurable impact on the real economy? Over the past 30 years, 60% of the financial stress episodes that led to downturns were banking-related events.

HT PAREKH FINANCE COLUMNnovember 8, 2008 EPW Economic & Political Weekly12From the Subprime to the RidiculousT T Ram MohanIt is somewhat misleading to label the present crisis a “subprime crisis”. This suggests that when banks make subprime loans, that is, practise financial inclusion, they are apt to get into trouble. Some commentators have even gone so far as to warn against political pressure for financial inclusion in India. It is not exposure to subprime loans that is a problem; it is the loss on subprime related securities that explains the sheer magnitude of the present crisis. The evolution of the crisis shows that the world did not fully absorb all the lessons from the collapse of the hedge fund, Long-Term Capital Management in 1998. When do episodes of financial stress have a measurable impact on the real economy? Over the past 30 years, 60% of the financial stress episodes that led to downturns were banking-related events.Damn those tickers on the TV screen, the ones that record the ups and downs of stock prices. For good or ill, financial markets set the mood for the economic lives of nations. When financial markets tumble, people quickly think the world is crashing around them.The subprime crisis is no ordinary financial market crisis. It has been labelled a “once a century” event. That must explain the apocalyptic headlines in the media- about “the end of capitalism”, another “Great Depression” and so on. How justified is the widespread gloom? This question raises two corollary issues. One, the general issue of the impact of financial markets crashes on the real economy. Two, the particular issue of the impact of the present crash on the US and the global economy. Since the impact of the present crash is now expected to be signi-ficant, the regulatory lessons of the crisis are the subject of considerable debate. Let us begin with the impact of finan-cial markets on the real economy. There is a presumption that when there is a crash in the stock market – and by this, one means a decline of, say, more than 10% in a short period – that is a warning of seri-ous problems in the economy at large. This presumption rests largely on the traumatic aftermath of the Crash of 1929 in the Unit-ed States, which was followed by the Great Depression. As students of economics know, it was not the crash so much as the faulty policy responses to it that triggered the depression. The US Federal Reserve unwisely tight-ened monetary policy and the resultant lack of liquidity caused bank failures. Banks were allowed to fail – in itself a significant policy lapse. There was a failure to activate counter-cyclical fiscal policy. On top of it all, the US resorted to protectionism which caused other nations to react likewise and this again had a major impact on trade and growth. T T Ram Mohan (ttr@iimahd.ernet.in)is with the Indian Institute of Management, Ahmedabad.As the very different responses to today’s financial market crisis make clear, big policy lessons have been learnt and practised since. That is one reason why subsequent financial market crashes have not uniformly led to major recessions or even a downturn – the crash of 1987 in the US is one example. Another, more funda-mental reason is that financial market crashes are not necessarily followed by economic declines. TheIMF’sWorld Economic Outlook (WEO) of October 2008 surveys the evidence on financial stresses and downturns. TheWEO analyses 17 episodes of financial stress in the advanced economies during the past three decades. One crucial finding is that nearly half of financial crashes do not im-pact in a big way on the real economy. What isfinancial stress and how do we measure it? The WEO has devised an index called the Financial Stress Index (FSI) that enables a rigorous measurement.– The FSI is constructed as an average of the following indicators:– Three securities market related variables: corporate bond spreads, stock market returns, and time varying stock return volatility;– One foreign exchange variable: time-varying effective stock exchange rate volatility.Using these seven variables, the FSI is constructed for each of the 17 countries in the IMF sample. An episode of financial stress is identified as a period when the index for any country is more than one standard deviation above its trend. On thisbasis,the IMF identified 113 episodes of financial stress in the past 30 years in the 17 countries. Of these, 43 episodes were banking-related, 50 reflected primarily turmoil in the financial markets and 20 reflected turmoil in the foreign exchange market. The IMF went on to investigate how many of these episodes were followed by an economic slowdown and how many by a recession – and what explained the differences in the impact on the economy. It found that of the 113 episodes investigated, 29 were followed by a slowdown and 29 bya recession. The remaining 55 episodes were not followed by an economic downturn. In other words, nearly half the episodes of
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW november 8, 200813financial stress did not have any serious economic impact.Banking-Related CrisesSo, we need to understand when financial stress has a serious impact on the real economy and when it does not. Perhaps the most important finding in the IMF study is that about 60% of financial stress episodes that are followed by downturns are banking-related. The magnitude of slowdowns and recessions following banking-related stress is greater than that with other types of financial stress. A plausible corollary is that where financial market crashes do not impact significantly on the banking system, the real economy is unlikely to be greatly affected. No great mystery as to why this is so. A stressed banking system means huge losses in banks and an erosion in bank capital and, quite possibly, the failure of many banks. In either case, the supply of credit con-tracts. Credit contraction, in turn, leads to an economic downturn. In the event of banking failures, the credit contraction and the consequent downturn can be sharp. The message is clear: take care of the banking system and the real economy takes care of itself.The role of banks in explaining financial stress must seem something of a puzzle in the advanced economies where the impor-tance of banks in the financial system has receded with time. When non-bank sources of finance have become so important, why would banking stress matter so much? Where capital markets are dominant, surely banking stress should matter less?Quite the contrary, the IMF finds. This is because banks have a symbiotic relation-ship with securities markets. Banks con-tinue to fund non-bank financial inter-mediaries. Financial stress occurs because financial institutions’ leverage tends to be through repurchase facilities. Banks, in turn, depend on market-based funding sources to finance their assets (such as certificates of deposit and commercial paper). The behaviour of financial intermediaries tends to be pro-cyclical: institutions overextend their balance sheets through excess debt when the going is good; when there is a shock, there is de-leveraging. This sort of pro-cyclical behaviour is most typical of investment banks. An expansion in assets goes hand in hand with increased lever-age – exactly what we saw in the build-up to the subprime crisis. In theory, banks’ behaviour should be less pro-cyclical because they are in the business of using retail deposits to make long-term loans and you cannot suddenly increase access to retail deposits. But, the IMF finds that in financial systems where capital markets are highly developed, banks tend to exhibit more pro-cyclical behaviour. TheWEO does not explain why this is so – and this is an important lacuna in its analysis – so let me venture an explanation. This also brings us to the second issue we raised at the outset, namely, the impact of the present financial market crisis on the US economy and the implications for regulation. Why has the financial market crisis in the present instance led on to a banking crisis?Investors willalways be comparingbanks’ return on equity with that of investment banks and other financial intermediaries. When investment banks ratchet up their returns through pro-cyclical behaviour, banks will find it hard not to follow suit. Banks do this on the liabilities side by resorting to wholesale funds in greater degree; on the asset side, they increase investment in securities. When banks’ behaviour tends to mimic that of securities markets participants, they will be vulner-able in the same as market participants are to the ups and downs of marketsBanks’ tendency, under the pressure of investors, to indulge in the same pro-cyclical as other intermediaries, perhaps, explains why slowdowns and recessions tend to be deeper in economies with more arms-length financial systems – that is, systems where financial markets are more devel-oped. In the present crisis, banks have suffered greatly because they were ex-posed to the same securitisation portfolios to which that investment banks and others were exposed. There is a world of difference between banks having loans on their books and having securities. Loans are not subject to mark to market accounting; securities are. As investment banks, dependent on whole-sale funds, rushed to liquidate their port-folios, the values of securities plummeted sharply. Banks holding securities portfolios have taken a big beating. The IMF’s Global Financial Stability Report (GFSR, October 2008) has statistics on the relative risks of loan exposures with securities exposures. Financial institutions have suffered losses of $425 billion on all types of loans, including corporate and leveraged loans. Of this, banks’ share is estimated at $255-290 billion. This is an order of loss that banks can easily with-stand especially since banks have raised nearly $500 billion in additional capital after the crisis erupted in 2007.It is the losses on securities that are prov-ing harder to manage. These losses are esti-mated at $945 billion in October 2008 with banks’ share amounting to $ 725-820 billion. Thus, total losses on loans and securities amount to $1.4 trillion ($425 billion on loans plus $945 billion on securities). In the accompanying table, drawn from the GFSR, we show only loans and losses related to the housing sector and to what might be regarded as subprime-related securities. When we compute losses as a proportion of exposures, the numbers are revealing. As the table shows, losses on subprime loans – widely touted as the villain of the piece – are a mere $50 billion and 15% of outstand-ing subprime loans. It could be argued that subprime loans tend to have an impact on other loans as well as defaults on housing loans leading to a collapse in housing prices. So, in the table we have included losses on subprime, alternative documentation (altA), prime and commercial real estate loans together. These are together a mere 3.6% of loans outstanding. Thus, loan losses by themselves cannot explain the sheer magnitude of the crisis we face today. Losses on SecuritiesIt is losses on subprime related securities that have led to matters going out of control. Asset-backed securities and collateralised Base Case Estimates of Writedowns on Select US Loans and Securities($ bn) OutstandingOctober% EstimatedLossesSubprime 3005016.7Alt-A 600355.8Prime 3,800852.2Commercial real estate 2,400 90 3.8Consumer loans 1,400 45 3.2Total loans 8,500 305 3.6Asset backed securities 1,100 210 19.1ABS CDOs 400 290 72.5Total 1,500 500 33.3Source:Global Financial Stability Report (October 2008, IMF).
HT PAREKH FINANCE COLUMNnovember 8, 2008 EPW Economic & Political Weekly14debt obligations on asset-backed securities account for a staggering $500 billion in losses – or nearly 33% of the exposures on these instruments. These were instru-ments that often had subprime loans as just one underlying component in a package of securities. These securities were held in large amounts by institutions such as invest-ment banks and hedge funds that funded themselves in the wholesale market. When defaults on the underlying subprime loans turned out to be higher than expected, prices of these securities fell. Institutions suffered losses on the securities portfolios they were holding. There was a rush to exit, which caused prices to fall even further. In the panic that followed, there was simply no market for many of these securities – they turned out to be illiquid and hence no market prices were available. Many have had to be valued using rough methods that tend to exaggerate losses, meaning the prices of these securities thrown up by these methods were lower than were war-ranted by the default rates on underlying loans. As banks were also holding these securities, they were exposed to the same losses as other financial institutions.Individual banks used securitisation as a means of getting loans off their books and on to other institutions. But other banks were among those who invested in these securities, so the banking system as a whole remained exposed to them. As a result, the behaviour of non-bank financial institutions exposed to subprime related securities has had a heavy impact on banks as well. It is somewhat misleading, therefore, to label the present crisis a “subprime crisis”. This suggests that when banks make sub-prime loans, that is, practise financial inclu-sion, they are apt to get into trouble. Some commentators have even gone so far as to warn against political pressure for financial inclusion in India. That would be an unwar-ranted conclusion to draw from the present crisis. As explained above, it is not exposure to subprime loans or even to housing sector loans in the aggregate that are a problem; it is subprime related securities that explain the sheer magnitude of the present crisis.To complete the chain from subprime loans to a financial crisis, several links have to be brought in: incorrect credit rating, holding of illiquid securities by leveraged institutions dependent on wholesale funds, flawed mark-to-market accounting and poor design of managerial incentives. It is the securitisation of subprime loans, not subprime loans themselves, that explains why we have a crisis on the present scale.In light of our analysis, the WEO’s comment on the role of securitisation in the present crisis must seem quite an understatement: However, as the current crisis underscores, the trend towards securitisation in more-arm’s-length systems, while permitting portfolio diversification to offset the costs of monitoring the idiosyncratic risks that are inherent in traditional relationship-based systems, does not eliminate the need for banks and markets to independently assess the risk of their exposures. Re-learning from LTCMWe are in some ways re-learning an im-portant regulatory lesson highlighted in the failure of the hedge fund, Long-Term Capital Management (LTCM) in 1998. The US Fed had to orchestrate a rescue of the fund at the time. It was asked why the Fed did so when its responsibility was limited to banks. The reason given was that while the failure of a hedge fund in itself was not material, the failure of LTCM was bound to impact on banks. Banks were exposed toLTCM in three ways: they had given loans to LTCM; they were counterparties to derivatives trades carried out byLTCM; and they held the same illiquid assets thatLTCM did. A failure of LTCM, it was contended, would be the equivalent of a nuclear holocaust in the financial world. One obvious regulatory lesson was that banks’ exposure to highly leveraged institutions (HLIs) must be monitored and all banks must know the cumulative exposure to a given institution. This has been done but it is clearly not enough. Banks can contain loan exposures to HLIs but they will still be linked toHLIs by reason of holding identical securities portfolios. Either banks’ investment in securities or certain kinds of securities must be limited; or HLIs themselves will need to be subjected to regulation so that they do not end up infecting and endan-gering the banking system. One set of HLIs, investment banks, has already been dealt with: the bigger invest-mentbanks have either disappeared or mergedwith banks or will soon be merged with banks. A regulatory proposal that has been talked about is containing securitisa-tion by requiring banks to hold a minimum proportion of loans on their own books. This will ensure that banks bear most of the risks attendant on loans instead of palming off these risks to others and will act as a check on imprudent lending. But this may not be enough. Banks can still be exposed to market risks on invest-ment portfolios. After all, the investments that posed a threat to banks in the LTCM crisis were not securitisation portfolios. Clearly, we will need to expand on the regulatory lessons learnt in the LTCM debacle. Impact on Real EconomyWe have seen how the banking system came to be caught up in the present crisis. And we know that where the banking system is stressed, the impact on the real economy is significant. How severe can we expect this impact to be? TheWEO compares the current episode of financial stress to six well-known episodes of banking related stress that occurred in advanced economies during the 1990s. These episodes occurred in Finland, Norway, Sweden, the United Kingdom, US and Japan. An examination of the medians and averages of selected macroeconomic variables in theUS and the euro area today with those in the six episodes indicates that the current imbalances and adjustments are smaller today than in the earlier six episodes. There are other mitigating features. One is that corporate balance sheets are much stronger. Two, the policy stance in the US has been more pro-active. Three, banks have moved quickly to augment their capital. The WEO was, perhaps, written before subsequent developments that are not mentioned – moves in the US and the euro area to inject government capital into banks, more gener-ous liquidity support and guarantees of inter-bank liabilities and deposits in the euro area. Household imbalances and the size of the US mortgage market remain problem areas. The IMF’s assessment is that the US down-turn may become more severe and turn into arecession whereas the euro area could get away with a slowdown. The IMF does not say this but it is reasonable to suggest that neither the financial stress indicators nor the policy responses point to anything like another Great Depression, never mind the headlines.

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