Research

Grappling with a global confidence crisis

It's been called a crisis of confidence. It started with bad real estate loans and highly leveraged bets on those loans. Now it has frozen credit markets. Banks aren't lending to each other. Businesses can't get the short-term loans they need to finance day-to-day operations. If it stays this difficult to access credit, the financial crisis threatens to become a real economic one. And it's global. Welcome to what Thomas Friedman calls the "flat" new world.

2008-10-08

What has happened and why

The first financial institutions ran into trouble more than a year ago, but it was in September that the crisis really heated up. In the last month alone, there have been 13 crisis-related failures or takeovers among financial institutions in the U.S. and Europe. Since July, 2007 the failures and takeovers include:

July 2007 — IKB Deutsche Industriebank (Germany) Sept. 2007 — Northern Rock (UK)
Jan. 2008 — Countrywide Financial (U.S.) March 2008 — Bear Stearns (U.S.)
April 2008 — Düsseldorfer Hypothekenbank (Germany) July 2008 — IndyMac Bancorp (U.S.)
July 2008 — Alliance & Leicester (UK) Aug. 2008 — Roskilde Bank (Denmark)
Sept. 7, 2008 — Freddie Mac (U.S.) Sept. 7, 2008 — Fannie Mae (U.S.) Sept. 14, 2008 — Merrill Lynch (U.S.)
Sept. 15, 2008 — Lehman Brothers (U.S.) Sept. 16, 2008 — AIG (U.S.)
Sept. 18, 2008 — HBOS (UK) Sept. 25, 2008 — Washington Mutual (U.S.)
Sept. 29, 2008 — Wachovia (U.S.)
Sept. 29, 2008 — Fortis (Belgium and the Netherlands) Sept. 29, 2008 — Hypo Real Estate (Germany)
Sept. 29, 2008 — Bradford & Bingley (UK)
Sept. 29, 2008 — Glitnir (Iceland) Sept. 30, 2008 — Dexia (France and Belgium)

"The whole world is sick," said Werner Bonadurer, a clinical professor of finance at the W. P. Carey School and former executive for UBS, a Swiss bank. The disease was transmitted from the U.S. housing bubble because more than half of the "toxic assets" — related to subprime mortgages — were held by institutions, banks, and private investors outside of the U.S.

"Crises of this magnitude always spread globally," Bonadurer said, "because we're living in a very interconnected world." But some of Europe's problems were home-grown, too. In April, a report by the International Monetary Fund warned that "any industrialized country with inflated real estate prices is at risk." In the UK, Spain, Ireland, and parts of Eastern Europe that was indeed the case, said finance professor Marie Sushka.

"Those countries overbuilt during housing bubbles and prices subsequently crashed. Until late 2007, everyone was over-investing in housing. Then they woke up and said, ‘Party's over.'" But the root of the current problems, as Rajnish Mehra, professor of economics and finance sees it, was massive overleveraging. Imagine making a $100 investment.

But instead of investing $100 in cash, you invest $1 of your own cash and borrow $99. If the value of your investment goes up just 1 percent your investment is now worth $101. You've made an astounding 100 percent return on your initial $1. With highly leveraged investments, Mehra said, it only takes a small increase in value to generate enormous returns. But the opposite is true, as well. A small decline in value can generate massive losses for the highly leveraged investor.

Imagine, again, that the value of your investment declines just 1 percent. It's now worth $99. You've lost everything — all of the cash that you initially invested. If the value declines a modest 3 percent, you now owe more than the investment is worth. "During the height of the financial boom, institutions (and individuals) were highly leveraged" Mehra said. "And since 5 to 10 percent fluctuations in asset valuations are quite frequent, some of them were forced to liquidate as their net worth became negative."

On a broad scale, when institutional investors (like the banks that are now in trouble) are highly leveraged and they lose value on investments in one market, they have to liquidate assets across all their markets to cover their losses. That has a ripple effect across institutions and across borders. That wave of failures has nearly frozen the credit markets. "Clearly the banks don't trust each other," said Bonadurer.

It's a "crisis of confidence" and, despite the central banks' efforts to promote confidence in financial institutions (by guaranteeing deposits and making extra money available for bank loans) fear still pervades the markets — and the credit markets are still icy. Instead of lending money to each other over the short term, as they usually do, banks are holding tightly to their own cash.

And financial institutions, already weak from write-downs on bad debt, are having trouble attracting new investors. "People are scared about putting their money anywhere but Treasury bills — despite yields close to zero," he said. "That includes putting money into the commercial paper markets, into bonds, and into stock markets," he said.

While the root of the financial crisis was overleveraged investments, the trigger for the current crisis of confidence, many say, was the U.S. government's decision to let Lehman Brothers fail. Lehman's bankruptcy hurt European investors (including investment banks) with exposure to Lehman bonds and other debt holdings.

But perhaps even more significantly, the failure of Lehman Brothers created a level of fear in the market about where the government would step in and where it wouldn't. "After Lehman Brothers failed, the market was thinking 'If the government will let Lehman fail, what's next?' Investors began pulling their money out of the market, and certainly stopped putting it in. And that's led to our current cash crunch," said Sushka.

What's being done to help?

Recognizing the need to restore confidence to the financial markets, the U.S. government, governments in Europe, the U.S. Federal Reserve and the European Central Bank have all been taking action, aimed in some cases at reassuring savers and investors that their money is secure and in other cases at getting credit flowing again. Some highlights:

Across Europe, governments have increased protection for bank deposits. Ireland, for example, offered a two-year blanket guarantee that makes the government responsible for $400 billion in deposits, twice the country's annual economic output.
In the U.S., the government increased the FDIC bank deposit guarantee limit from $100,000 to $250,000.
The U.S. Federal Reserve, the European Central Bank and other central banks have lowered their direct-lending rates (the interest rates they charge on loans to financial institutions) and have aggressively lent money to those financial institutions.
Both the U.S. Federal Reserve and the European Central Bank have aggressively lent money to banks and are considering potential interest rate cuts, all in order to revive interbank loan markets.
The UK partly nationalized Bradford & Bingley after the mortgage lender struggled to get private financing.
The UK also brokered a takeover of HBOS by Lloyds TSB after HBOS shares lost most of their value.
For a reported $68 billion, Germany rescued Hypo Real Estate, a key lender for construction and mortgages there, in the biggest rescue in German financial history.
France and Belgium together extended $9 billion to Dexia, a Belgian-French lender.
France's BNP Paribas bought assets in Belgium and Luxembourg of banking and insurance group Fortis for $20.1 billion.
The U.S. government's $700 billion financial rescue plan allows the government to buy bad mortgage-related and other assets from banks, wiping the debts from their books and freeing them to start lending again.
The central banks of the UK, Canada, Sweden, Switzerland and the U.S., as well as the European Central Bank cut their key interest rate targets by half a point on October 8. The central banks of China, Hong Kong and Australia also made separate interest rate cuts.

In Europe and the U.S., governments are trying to stabilize the biggest banks, Sushka said. Europeans are more comfortable with the idea of taxpayers taking ownership of companies — as the U.S. government did with AIG — than Americans generally are. In the U.S. the government has favored a role of sale broker, helping to arrange sales of Bear Stearns and Washington Mutual, for example.

"Certainly there's a cultural difference between the way Europeans look at government takeovers and the way Americans do. But government takeovers shouldn't be confused with socialism. When the government rescues a company in exchange for equity in that company, it's an investment with taxpayer dollars," she said.

While admitting that now's not the time to "spread the good news about the free market economy," Bonadurer warns that regulators will likely go too far — toward overregulation — in attempts to mitigate the financial crisis. "There is a tendency for cycles of overregulation and then under-regulation," Bonadurer said.

It's a pattern that plays out around the world, he said, though overregulation will likely be worse in Europe, where people are more accustomed to heavier regulation to begin with. "There's no doubt that we need regulation now. But in two years we will look back and say, 'What did we do?'"

Is there more to do?

The experts agree that doing something — even if it's not exactly right — is far and away better than doing nothing. The U.S. $700 billion financial rescue plan, for example, "is good news because it means the government's doing something," Sushka said. "During the Great Depression, the feds sat on their hands until FDR was elected."

Increasing government guarantees of bank deposits is clearly a necessary step to try and shore up individuals' confidence that their bank deposits are secure, said Bonadurer. "The worst thing we could have is a panic and a run on banks. Then this crisis would start to look like the Depression," he said. Recapitalization — the restructuring of a company's debt and equity mixture to make the company more stable — is also key to making credit flow again.

Mehra says that we should look to Sweden to find a good model of how to do just that. "In the 1990s, the Swedish government took over the banks, recapitalized them in 6-8 months and sold them off." That's what Mehra says needs to happen now. "The governments must provide for an orderly liquidation process," Mehra said.

That way, banks don't have to sell their assets at such low "fire sale" prices but still get the benefit of fresh infusion of capital in exchange for those assets. "We can learn three lessons from Sweden's actions in the 1990s," he said. "First, don't panic. Second, don't have any knee-jerk reactions. Third, quickly recapitalize bank assets." Just as Sweden offers an example of what governments today should do, Japan can teach us about what not to do.

In 1989, the Japanese stock market plunged 50 percent almost overnight, Sushka said. The culprit? Bad real estate loans. But, unlike the U.S. and European governments, the Japanese government didn't let the banks write down their bad debt. Instead, the government hid the problem. And spent the next decade paying for it. "The attitude now in the U.S. and Europe is, 'Let's get all the bad stuff out as fast as we can,'" Sushka said.

That's scaring everyone, she said, but probably bodes a healthier future than hiding in the sand. But so far government actions to deal openly with the crisis have largely been confined within political borders. Yet leaders are beginning to voice a desire to join together in coordinated action, a move that Bonadurer said is critical.

"What is needed now is a meaningful, comprehensive, systemic response," he said. "If there were a global coordinated action, it could go a long way toward calming the markets." Investors are looking to just such a meeting — of the Group of Seven finance chiefs — scheduled for October 10. They're set to discuss potential coordinated actions such as liquidity injections or interest rate cuts.

What are the longer-term effects of the financial crisis?

Mehra says that the financial crisis has not yet spilled over significantly into the real economy. "But we must act rapidly to ensure that it doesn't," he said. The danger, he said, is that businesses rely on bank loans to finance new productive investments, and when they can't get these loans because the credit markets are frozen, they can't grow — and that has a negative effect on real economic performance.

Bonadurer is less optimistic that the financial crisis has not already — or won't soon — spill over into the real economy. He says that the outlook, in terms of a global recession, is bad no matter what actions governments take. "Global growth is slowing significantly and likely to move below 3 percent, and the IMF suggests that 2.5 percent demarcates a recession," he said. "We are not there yet."

"During the Great Depression, unemployment was 25 percent; it's now at 6 percent. Mortgage delinquencies were at 40 percent; they're now between 4 and 5 percent. The political, economic and monetary arsenal is much broader and more effective than ever before."

But could a prolonged financial crisis in the U.S. lead to a loss of confidence in U.S. investments among foreigners — who currently own 50 percent of America's public debt and finance more than 70 percent of new debt?Sushka says no. "Everyone still wants to put their money in the U.S.," she said. "The U.S. as an institution is strong. The dollar is still important. No one thinks the U.S. government will fail."

So while foreign investors may not be buying up U.S. corporate bonds right now, they're certainly buying Treasury securities, and will continue to, Sushka said. Mehra agreed. "Foreign investors buy U.S. assets because the U.S. economy is more productive than Europe and Japan," he said. "Plus, investors have trust in the U.S. political and economic system." Despite the recent turmoil.

Bottom Line:

The U.S. financial "disease" was transmitted from the U.S. housing bubble to the global financial markets because more than half of the "toxic assets" — related to subprime mortgages — were held by institutions, banks, and private investors outside of the U.S.
A wave of failures and takeovers among financial institutions — 13 in September alone — has nearly frozen the credit markets. It's a "crisis of confidence" and, despite governments' efforts to promote confidence in financial institutions, fear still pervades the markets — and the credit markets are still icy.
While the root of the financial crisis was overleveraged investments, the trigger for the current crisis of confidence, many say, was the U.S. government's decision to let Lehman Brothers fail.
Recognizing the need to restore confidence to the financial markets, the U.S. government, governments in Europe, the U.S. Federal Reserve and the European Central Bank have all been taking action, aimed in some cases at reassuring savers and investors that their money is secure and in other cases at getting credit flowing again.
Increasing government guarantees of bank deposits is clearly a necessary step to try and shore up individuals' confidence that their bank deposits are secure. Recapitalization — the restructuring of a company's debt and equity mixture to make the company more stable — is also key to making credit flow again.
A global coordinated action could go a long way toward calming the markets.
The danger to the "real economy" is that some businesses rely on loans to grow, and when they can't get loans because the credit market is frozen, they can't grow — and that has a negative effect on real economic performance.

Finance Faculty