The day after tomorrow?

Since the dawn of the credit crisis last summer, fear has replaced greed as the motivating instinct in the financial markets. The crisis has been more persistent than anyone expected and the mood has darkened steadily.

At this point, it is widely accepted that the fallout could be protracted, painful and damaging for many corners of the financial markets, rather than an isolated mortgage securitisation problem.

The central view among analysts still points to an unpleasant, but tolerable, outcome. Federal Reserve chairman Ben Bernanke has been careful to avoid using the word ‘recession’, but central bank forecasts, including that of the Fed, emanate fear.

Many analysts now acknowledge that the acute pessimism signalled initially by a minority cannot be dismissed as a wild exaggeration. Since the pessimists may just be right, Bernanke, and the rest of us, must now examine carefully those extreme outcome theories and consider how we might cope with them.

The US sub-prime mortgage problem was ­initially seen as the result of reckless lending which, though large, could be managed. But the credit crunch has escalated into a major crisis because of the sheer size of losses and the internationally interdependent nature of the financial sector.

As is now known, in modern banking practice, many loans are not kept on the balance sheet of the bank that originates the deal. Instead, they are packaged into securities that are then either sold to other investors in the market or placed in off-balance sheet ‘vehicles’, thus ­making room for new business. These vehicles are separate legal entities, but, importantly, are closely linked morally to the originating bank.

When times were good, this ‘originate-and-distribute’ banking model had many virtues, boosting efficiency, raising profits and spreading risks more widely. But once the sub-prime crisis erupted and multi-­billion dollar losses came to light – forcing some financial institutions to secure emergency funding from central banks, sovereign funds or enact emergency rights issues to avoid a collapse – the model failed and made the crisis worse: since no one knew where the poor quality loans being sold were actually held, fears and rumour mounted and banks became reluctant to lend to each other.

Off-balance sheet vehicles backed by ­mortgages were suddenly unable to obtain funds in the markets. The banks that originated the mortgages were faced with unpalatable choices: either allow their off-balance sheet vehicles to fail, with huge damage to their reputation, or take the vehicles back onto their own balance sheets, just when the inter-bank market dried up and the first talk of a credit crunch started filtering through the markets.

Cash injection
The abrupt re-pricing of risk has created a huge global liquidity problem. In response, the major central banks have injected huge amounts of cash into their respective banking systems. But as events have evolved, it has become ­evident that the central banks’ arsenal may not be ­nearly enough to handle what could be a major ­solvency crisis, in addition to severe ­liquidity shortages.

The management style of the central banks are in sharp contrast with each other. From the ­outset, the Fed, under huge pressure to show it was in control, plumped for big liquidity ­injections and aggressive interest rate cuts. The European Central Bank, on the other hand, has restricted itself to providing cash, but has so far kept official interest rates at a pre-crisis 4%. The crisis rolls on despite these approaches. This ­striking policy gap reflects greater US concern over threats to growth and a more determined US effort to counter those threats. In the eurozone, inflation remains a bigger worry. But America’s pro-active policies have failed to end the crisis. Mortgage interest rates have risen, in spite of big cuts in official Fed rates. The realisation now is that a deeper US downturn – the word of choice over there – may be unavoidable even if the Fed slashes rates to 1% or lower. If these fears are valid, the consequences could be chilling.

Determining the scale of bad mortgage debts is a challenge and estimates of the losses have escalated in a frightening manner, from a measly $100bn as indicated last summer by Bernanke, to more than $1 trillion as suggested by authoritative analysts today. More extreme figures, as high as $3 trillion, have also been bandied around. But big falls in house prices accentuate losses from mortgages. The decline in US house prices from recent peaks is estimated at 12.5%. Since house prices will continue falling, the overall size of mortgage losses will be revised further upwards. If US house prices were to fall 25% to 30% from their peak, almost 10% of US household wealth could be wiped out. This is before counting collateral damage in other areas, such as commercial property and share prices.

In terms of spending, the most serious impact of collapsing wealth values would be on personal consumption and further reduced investment in residential property. More massive losses on mortgages would severely weaken the balance sheets of banks and other financial institutions and further impair their ability to lend.

In turn, this would further damage US ­personal spending, which depends critically on credit.

The ultimate disaster would be a vicious spiral of plummeting property prices and falling expenditure on consumption and investment. Mounting bank losses would spread from ­mortgages to consumer debt such as credit cards and car loans and eventually to business loans, resulting in widespread bank failures.

The result could be a calamitous economic downturn. Swelling losses and falling expenditure would feed upon themselves. All this, the most doom-loving nay-sayers predict, could mean a 1930s-type slump, with high unemployment and falling output.

In reality, the circumstances that could produce this sort of disastrous scenario are unlikely to materialise in their totality. Another Great Depression is unimaginable. But many warning signals that we are in for a deep period of ­contraction persist. Other extreme, but plausible, scenarios include (a) a US version of Japan’s 1990s stagnation, (b) an inflationary upsurge ­triggering serious political instability, or (c) a collapse of the US dollar, default and loss of US creditworthiness.
• A Japanese-style slump would see huge property losses causing massive damage to the banks’ ­balance sheets. Even if the authorities manage to avoid a major slump in the real economy, the financial damage would still be severe in the long-term, as financial sector balance sheets would remain burdened with huge bad debts for years. With the banks paralysed and unable to provide finance to sound businesses, the US economy could relapse into a long period of stagnation, just as happened in Japan. The result would be low productivity and gradual economic decline. This scenario may be less dramatic when compared with a major depression, but is nevertheless an unmitigated disaster for the US, long able to claim rare business dynamism and economic dominance.
• An alternative scenario is almost at the other end of the scale: determined efforts to avoid slump and stagnation could lead US authorities to abandon, initially at least, any serious concern over inflation. The Fed would cut interest rates to near 0%, it would buy a large volume of sub-prime mortgages and accept them as collateral when providing cash, a measure sometimes described as ‘the nuclear option’. The US Administration could introduce very aggressive fiscal measures, both tax cuts and spending increases. All these steps would inevitably worsen inflationary pressures, bond yields would shoot up in spite of lower ­official rates and the dollar would fall. Then, when inflation became intolerable, the Fed would reverse course and push up interest rates to halt the upsurge in prices. The result could be a cycle of instability as the authorities lose control over events and lurch into frequent policy changes to cope with worsening conflicting ­pressures. In this scenario, economic performance would worsen sharply and the risks of stagflation would increase.
• But what if the dollar collapsed and the US lost its credit worthiness? The early stages of this third scenario are similar to the previous one: aggressive policy-easing leads to a surge in ­inflation. But instead of reversing course, the authorities are prepared to tolerate higher ­inflation for much longer in the hope of avoiding recession and stagnation. If such policies are ­pursued, the US dollar could collapse, not simply weaken. A massive devaluation of the currency, as well as boosting exports, would enable the US to, in effect, wipe out its huge external debt. While politically tempting, such a ‘default’ would entail huge costs: an irreversible loss in credit worthiness and a disastrous decline in its global status as a superpower. In the longer term, the policies associated with this scenario would fail and would have to be reversed.
Growth would eventually shrink, since high inflation fosters inefficiencies. Anti-inflation policies would prove inevitable, since the US cannot allow higher inflation to continue indefinitely.

What does this mean for the UK? The housing market is not in freefall at present and there is no severe housing collapse in the way things have deteriorated in the US. But UK house prices have long been significantly overvalued and are now beginning to fall. The thing most people thought would never really happen is happening.

More fundamentally, the economy is facing problems and imbalances that are similar to, and possibly worse than, those the US is facing. The personal debt ratio in the UK is very high, while the economy is vulnerable to the downturn in the financial sector. The current account deficit is very high and sterling could face sharp speculative attacks. Worst of all, given Britain’s exposed public finances, the Chancellor’s fiscal rules prevent him from using budgetary expansion to sustain growth. The UK could still avoid a major recession, but a severe slowdown is unavoidable – the International Monetary Fund says UK growth will slow to just 1.6% – and it is complacent to assume we are somehow better placed to cope than the US.

No immunity
Overvalued house prices, high personal debt and growing threats to financial sector balance sheets are equally critical risks for economies outside the US. Many European banks’ balance sheets hold ­securities backed by US sub-prime mortgages. Countries such as Spain, Ireland and the UK, where overvalued domestic house prices are expected to fall, or are already falling, are most vulnerable to housing downturns and hard landings.

The US situation will have adverse global effects. Japan and China would suffer from shrinking net exports to the US and it is clear Europe and Asia would be harmed, too. The more extreme outcomes would also accentuate threats of destructive trade wars.

The world has entered a period where, as in the 1930s, monetary policy may become ­ineffective even at very low interest rates. But it is inconceivable that the American political ­system would tolerate another 1930s-style slump. A ‘Japanese’ scenario is also very unlikely.

The US would go to extreme lengths and use the most radical methods to avoid a slump or ­prolonged stagnation.

But some potential triggers of a slump or ­stagnation will remain present for some time. This heightens the danger that some aspects of the extreme scenarios put forward here will remain plausible. Recession or stagnation are the bigger near-term threats, but are least likely to be accepted in the medium term.

In contrast, outcomes involving elements of high inflation, sharp dollar falls and US debt default could have political attractions and are more plausible in the medium term. A collapsing dollar would force China, Europe and Japan to accept more of the initial pain of any downturn. But a default scenario would cause devastating damage to the US’s global position – something the country cannot afford to let happen.

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