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Economic Monthly Report

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Crisis of confidence in financial markets

Mon, Oct 8 2007, 11:29 GMT
by La Caixa Economic Research Dept.

La Caixa

A pin lies on wait for every bubble and when the two eventually meet a new wave of investors learns some very old lessons.» This is the way the well-known investor Warren Buffett describes the end of periods of speculative fury financial markets periodically undergo. Let’s remember the latest periods going from the stock market crash in 1987 to that in 2000, not forgetting the crisis of savings institutions in the United States at the beginning of the Nineties, the Mexican crisis in 1994, the Asian crisis in 1997 and the Russian bond crisis or the Long-Term Capital Management hedge fund crisis in 1998. Not to omit the impact generated in 2002 by the collapse of Enron. The bare bones of crises are similar in them all – as a first stage, an excessively bullish market with a progressive disdain for risk; a disagreeable and unexpected surprise that sharply breaks this dynamic; in a final stage, a loss of confidence, a flight to quality, problems of liquidity and restrictions on credit up to the moment when it is considered that there has been a sufficient correction.

A new financial crisis broke out in August. There had been an early warning at the end of February when the markets were jolted by a sudden lack of confidence. But this was a brief episode brought about by fears of an economic recession in the United States which were soon discarded. This time it is serious. The «pin» mentioned by Warren Buffett is the same as that in February: the US mortgage crisis combined with financial engineering with a touch of folly. The crisis in sub-prime mortgages, a financial heading that includes mortgages of low credit rating, those that are granted to customers with poor solvency, higher risk of default or those about which their ability to meet monthly loan payments is not really known. This is a relatively small market (around 13% of the total mortgage market in the US) but which has shown very sharp growth in recent years. This growth was the result of the boom in housing prices which relaxed requirements when it came time to grant loans and of the actions of a group of mortgage brokers that are not deposit-taking entities like banks and therefore are subject to fewer regulatory requirements.

For the past year and a half, the US real estate market has been immersed in its biggest crisis in the last 15 years. A dip of this size in housing was traditionally capable of unmasting the economy as a whole and sending it into recession. Up until now this has not been the case, thanks to the strength of private consumption and the support of very easy monetary and financial conditions. How, then, do we explain the sudden upsets in all markets? Why is the storm reaching financial institutions in Europe and Asia?

The key lies in the financial engineering applied, a result of which has been the impossibility of knowing where the risk in sub-prime mortgages stands and how it stands.Mortgage brokers do not maintain the mortgages in their balance sheets but transfer them to commercial or investment banks which in turn package them in blocks and issue securitized bonds that are (or were) placed in investment funds, insurance companies, treasurerships, etc. Risk is thus broadly spread both among types of investor and geographically. Default of sub-prime mortgages not only brings about a collapse in this market but sets off great uncertainty because there is hardly any information about where the bonds may be.

The financial system is based on confidence and this is what is broken down in a crisis like the present one. A number of US mortgage institutions have failed while banks both inside and outside the United States have announced specific failures. Investors are reluctant to take on new risks so that liquidity is reduced, the granting of credit is more selective and interbank interest rates rise. The stock markets drop and non-financial companies encounter more problems in issuing bonds.

What is more, the crisis of confidence comes at a critical moment. The bubble was blown up very high.More than three years of rising stock markets, risk premiums at all-time lows and abnormally low volatility all increased the possibility of seeing one of those periods of correction that end up taking place in the markets. The prolonged stage of international growth, with the rise of the emerging nations, the strength of the US consumer, high corporate profits and still very easy financing terms made up a solid base for five years of economic exuberance.

What will happen now? The immediate consequence has been an increase in risk aversion (risk premiums have risen although not that much), a correction and an increase in volatility in the stock markets and a drop in yields on government bonds. The central banks have already swung into action in order to halt the spiral involving the flight to quality and to ensure the liquidity of the system. Should the crisis continue, monetary policies will have to be eased. No monetary authority wants to be blamed for failing to act in the face of the possible failure of the system. Once the markets have been sorted out it will be time to introduce the regulatory reforms needed, reforms which could have avoided the crisis, especially in the field of sophisticated loan derivatives, the valuation of risks involved and the protection of consumers.

What will happen in the real economy? The stock market crash in 1987, which created so much concern at the time, passed almost unnoticed by consumers and companies. On the other hand, the bursting of the IT bubble in 2000 brought about a notable slowdown in the world economy.Where do we stand now? In the case of the United States, the real estate crisis up to this point had brought about something similar to a slowdown half-way through the cycle. After recording growth of 3% in 2005 and 2006, gross domestic product (GDP) in the first quarter of 2007 rose by a mere 1.5%. In the second quarter, however, economic activity showed something of an improvement going up to 1.9%.

A number of factors suggest that, if the financial upsets get worse, they could notably worsen the US economic situation. The US consumer, a basic support for the economy, shows a negative savings rate that could bring about a major slowdown in consumer spending if confidence should collapse. After a long stage of profits and financial exuberance, companies could move into a stage of stagnation in investment and job creation. This is a negative scenario which, for the moment, we would discard. On the one hand, in macroeconomic terms, the downward course in real estate would seem close to ending. In addition, the course of household and corporate spending does not have to be very greatly affected by the direct effects of what is largely a financial crisis. Finally, monetary and fiscal policies have some margin for action that, no doubt, will be put into operation in case of need.

In Japan and Europe, the effect of the financial upsets should be much slighter and restricted to the financial system. Where do the risks lie? The first is in the possibility of a major slowdown in imports by the United States which would affect the main players in international trade – the Asian and European economies. Secondly, there is the fact that a cooling off in prospects accompanied by increased rigidity in loan markets would not come at an opportune time when the economies of Japan and the Euro Area, while growing above potential, are showing a fairly notable slowdown profile. On the other hand, a slowdown in world growth would immediately produce a downward correction in raw materials prices, which would give support to the sustaining of incomes in the developed economies and allow some easing of financing terms.

In the case of Spain, the direct impact of the sub-prime mortgage crisis will be imperceptible. The economy continues to growth strongly with rates of increase in GDP at 4%. Nevertheless, it is true that the cyclical high in the current growth stage is now behind us. Economic activity has been gradually easing since the first quarter, following a slight rise at the end of 2006. According to the National Institute of Statistics, the easing off in economic activity in the second quarter was due to national demand, given that the foreign sector maintained its negative contribution to GDP at 0.9 percentage points. The performance in the foreign sector was the result of an increase in both exports of goods and services and imports. The slowdown in national demand was due to most components with construction investment being the most notable. In any case, this sector still grew at a notable rate (4.6% year-on-year in the second quarter). The maturing of the prolonged expansionist stage in the real estate sector was already to be seen in the housing market but public works and industrial construction are showing notable strength. On the other hand, capital goods investment is proving extraordinarily expansionist, with an increase of 13.0% in the past year, palpable evidence of the confidence of companies in future prospects.

Household consumption, in turn, is moderating steadily, a trend in which the rise in interest rates is no doubt having an influence, although we should point out that consumer confidence improved slightly in July and such a relevant indicator as car sales stopped going down in year-on-year terms.

An important support for household consumption is job creation which in the first half-year has continued to show very strong. According to figures from National Accounting, employment grew at the rate of 3.2% year-on-year at the middle of 2007, without any sign of slowing its growth rate.We do see something of a slowdown in the labour market in the latest figures for registrations with Social Security and registered unemployment.

Finally, the prospects for Spain’s economy are for a slowdown over coming quarters to rates of around 3%, something that we already were counting on at the beginning of the year. The sub-prime mortgage crisis may have some adverse affect on US growth, perhaps slightly affect the international economy, but it should not significantly change the course of Spain’s economy.

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Published on  Mon, Oct 8 2007, 11:39 GMT