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Economics Weekly

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Will the US sub prime mortgage crisis derail global economic growth?

Tue, Aug 21 2007, 06:31 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Sub prime crisis result of low interest rates, plentiful liquidity and low appreciation of risk...
The evolution of the current state of affairs in credit markets happened thus: US mortgage loans were packaged and sold on by commercial banks into capital markets. As the US housing market boomed so too did the demand for, and the quantity of, these loans. They were in turn collateralised and loaned on by the capital markets to other niche players and packaged in the newly expanding CDO and CLO markets, which developed quickly due to very low rates of interest, in an environment of plentiful liquidity. And computing power had increased enough to make engineering these new financial instruments viable. The circle was squared by the credit agencies validating these loans by giving high credit ratings to these instruments but some were based on high risk loans in the lower credit quality end of the mortgage market, some of which have now turned bad. As sub prime defaults rose alongside the rise in US interest rates from 1% to 5.25% so concerns spread and risk repricing began in the global financial system, see charts a through to d.

...but sub prime is not the real reason for current turmoil: risk appetites have changed...
But to ascribe all recent financial market turmoil to US sub prime issues and overexposure to the US financial markets is, to say the least, missing the real issues. Not all of the world’s banks and financial sectors have large sub prime losses on their books and are being forced out of a range of global financial markets as a result. What is actually happening is that investors have generally become more risk averse and so are not betting so much on speculative markets or products. This has halted the 'carry trade' as investors worry about margin calls and the need to have liquidity. Indeed, we would argue that financial markets are normalising, so the yen was too weak relative to fundamentals, the AS$ was too strong as was the NZ$ etc. If the credit crisis is leading to more realistic pricing of risk, and bringing these asset classes closer to equilibrium values, then that is actually good news for stability going forward. But this is not to say that large amounts of money are not at stake, with some US $1.5 trillion of subprime loans of which about 10-15% may default and with a recovery rate of 50% therefore implies losses of around $100-150bn may be possible. Estimates also suggest that there could be a further $56-65bn of losses from low grade corporate debt and LBO loans, based on current default rates, making a total of possibly well over $200bn.

...central bank action should not stand in the way of process of risk repricing...
The theory of what central banks should do in situations like these was described a hundred years or so ago by Walter Bagehot, which is to lend money but at penal rates and not to help those in difficulty through their own actions unless the problem affected the whole system. Therefore, central banks are right in injecting funds into the markets to make sure there is liquidity. This should continue so that good creditworthy companies are not impacted, but they should not bail out those who have made wrong bets. To do otherwise would lead to ‘moral hazard’ and investors will likely take even greater risks in the future.

...Global growth and 'economic fundamentals' such as employment and interest rates favourable...
Charts e and f help support the argument that the fundamentals of the global economy are still sound; solid growth, relatively low interest rates and a low longer term cost of borrowing for companies and abundant liquidity, some injected by the central banks. This means there is no underlying problem in the global economy; with falling rather than rising defaults rates, solid profit growth and companies running financial surpluses. In this sense, the current crisis is more clearly a long overdue market repricing of risk. This period of very low risk pricing was down to 5 years of exceptionally low interest rates, owing to low global inflation as a result of increased trade with China and India who effectively exported deflation to the rest of the world. Now that this period of maximum price deflation is over and interest rates are rising, so credit spreads are also widening. This is what should happen and central banks should not stop the process by reproducing an artificially low interest rate environment, especially one that cannot be sustained for very long. Indeed, the risk from cutting rates in the current environment is that it then creates a situation where inflation becomes a problem in 2008 or 2009 and then interest rates have to be raised sharply thus creating the very crisis that official are trying to avoid but at a time of weakening growth.

...but there is a chance that the current contagion could spread further, so central banks should stand ready to cut interest rates though we do not believe they will have to
How could contagion spread? This could happen if the present problem were to lead to banks and capital markets not providing funds for perfectly sound businesses: a credit crunch. That would lead to less investment, lower employment and so to weaker consumer spending growth. If perceptions were that non financial companies were being badly hit then this could lead to an even sharper fall in equity prices and a loss of confidence from highly indebted consumers that might then cut back on spending and so weaken economic growth even more, perhaps creating a vicious downward spiral. As this also implies weaker inflation, then the central bank should cut interest rates. But our view is that we are not yet in that situation. Instead, with inflation now rising in China and India, monetary reflation in the developed countries runs the risk of leading to a bout of future global inflation, which would lead to an even greater economic shock than at present. But if growth does get hit by a credit crunch, then interest rates should, and will no doubt, be cut. Past experience suggests that this stands a very good chance of averting recession in conditions of good economic fundamentals like those that abound currently.

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Published on  Tue, Aug 21 2007, 06:44 GMT