Financial and economic crisis getting worse
Tue, Dec 9 2008, 12:23 GMT
by Lloyds TSB Financial Markets Economic Research Team
A few months ago, the financial markets were in turmoil, but since the collapse of Lehman Brothers in mid September the situation has actually turned much worse. As the Bank of England said in the statement accompanying its decision to cut the Bank rate by 1% to 2% on 4 December, ‘Despite the actions taken to raise bank capital, ease funding and improve liquidity, conditions in money and credit markets remain extremely difficult. The Committee noted that it was unlikely that a normal volume of lending would be restored without further measures.’ Equity markets have fallen more sharply, currency market volatility has increased, government bond yields have fallen on a flight to safety and corporate bond spreads have widened significantly further.
The crisis is worsening despite the sharp increases in government spending and lower interest rates...
The economic situation has also worsened everywhere in the last few months, with recession likely in almost all of the advanced countries in 2009, and certainly in all of the major ones, with a weaker outcome for the rest of the world in consequence. And although the emerging economies as a block are likely to avoid recession in 2009, that is down to continued growth in the large economies of China and India. As a result of weaker growth and falling inflation, central banks have been cutting interest rates aggressively in most economies, so pushing down interbank rates, see chart a. But lending spreads have remained wide, see chart b, and credit markets are worse now than at any time since the crisis first broke over a year ago, see chart c. The question is why have all the stimulus measures have not worked so far, even though official interest rates began to be cut about a year or so ago and are at record lows in many cases and government spending has been increased massively. Unfortunately, the answer appears to lie in the nature of the proximate causes of the current downturn. It is a combination of high price inflation, which is now beaten and is no longer the problem, but also excessive leverage (or excessive borrowing) in some developed economies. This was caused by abundant liquidity and too low interest rates along with other contributory factors but leverage is now reversing after large losses on investments made. This is having devastating consequences for the world economy and appears to be intensifying rather than easing even after the broad range of measures taken by governments and central banks to tackle it.
In the last decade, private sector balance sheets in a range of developed countries have expanded aggressively, including the US, UK, Spain and Australia especially but also many other developed economies. This translated into huge leveraged positions for firms that traded the related complex derivative products that lie at the heart of the present financial crisis. This is illustrated by the gap between the value of the underlying stock of global equities and bonds and the derivatives that have been written off the back of them, though the recent crash means that the underlying assets are now down by about 50%, but so at least are the derivatives.
...the reason is that the size of the derivatives market is out of proportion...
Chart d shows that the total global value of equities was $60.1 trillion at end-2007, and global domestic debt securities were put at $42.8 trillion. Hence, the total global amount of equity and debt thus stood then at roughly $103.5 trillion, see chart d. Compare this to the global value of the over the counter (OTC) derivatives market, see chart e. The notional value of contracts written stood at around $800 trillion at end June 2008, though the gross market value at the end of this period was 'only' $23 trillion, see chart f. Just focusing on equity linked, interest rate, and FX derived products and credit default swaps still yields a figure of $15.9 trillion. These are not the net figures - we do not know for sure what those are in these types of markets - but they are a guide to the extent of the pace of growth of exposure and leverage over the last few years in these new markets. In chart g, the extent of the rise is also shown – almost from a standing start in 2001, these have risen sharply in percentage terms.
...so any solution to the current crisis involves restarting the asset backed securities market
This widening mismatch between derivatives and the real economy has led to disastrous consequences. The engineering of ever more complex products to trade in the global financial system in place of the underlying assets has turned even good risks into bad because of the massive leverage that has occurred with those derivatives and the lack of transparency around their structures. The credit crisis effectively started when rising defaults on US sub prime mortgages led to a global fall in the value of all asset backed securities (ABS), and that in turn hit collateralised debt obligations (CDO) that are also bundles of ABS. Confidence is unlikely to return to credit markets until these securities are traded and suspicion is allayed about the solvency of holders of any large quantity of them. So what is to be done? The Paulson plan was initially designed to start a trade in ABS, and in particular mortgage-backed securities, so that they could be properly valued and ultimately traded (i.e. taken off balance sheets for some), so reduce suspicion and return confidence to the credit markets. This plan has now been abandoned as too complex to work and was badly thought through but still needs to be resurrected in a form that will work. A proper trade in mortgage backed CDOs seems required so that confidence about ABS improves. However, that seems unlikely until the new administration takes power in the US on 20 January next year. Until then, and barring a surprise move, this crisis in credit markets seems likely to rumble on, unnecessarily worsening economic prospects in the interim.
