Global credit crisis

The catalyst of the current financial turmoil has been the losses on the subprime mortgage market. However, the low quality of these partly collateralised housing loans was known for a while and the default on subprime mortgages was largely expected.

Banks have transferred risks to other Financial Institutions. Such a practice gave the false impression that credit risk was transferred from banks outside the financial system. This was indeed not the case. The funding needs associated in particular with backup lines of credit for off-balance sheet vehicles generated pressures on the interbank markets and led central banks to massively intervene.

In the subprime crisis, major central banks have intervened aggressively to provide liquidity to contain disruptions and contagion in financial markets. At the same time, the US Federal Reserve has cut interest rates substantially to ease monetary conditions, and the US Congress has approved a fiscal stimulus package. In the Asian crisis, monetary and fiscal policies were initially tightened to support exchange rates because of massive capital outflows and a run on foreign reserves, which contributed to a downward spiral in the real economy. Only after exchange rates had stabilized at a lower level did governments adopt more expansionary fiscal policies of support the real economies.

Also, in the current crisis, the main recapitalization of banks has come through direct placements or through capital injections by sovereign wealth funds.

Background

Two notable exceptions were Northern Rock, which was nationalized by the UK government, and the Bear Stearns rescue, which exposed the US Federal Reserve to potential losses from Bear Stearns’ impaired assets. However, if the subprime crisis worsens, governments will likely be forced to take a greater and more direct role in stabilizing the economy and the banking system.

Credit crises are not new threats to the global economy. Many countries have defaulted, nearly defaulted, or repudiated large amount of sovereign debt over the past century. But the credit crisis that is currently sweeping through global financial markets is fundamentally different in at least five critical ways, qualifying it as one of the most significant threats to the global economy in the post-Depression era:

* The crisis originated not in small or underdeveloped economies fraught with political risk but in large, well established and sophisticated financial markets, primarily the United States;

* The crisis was created and exacerbated by some of the largest, most sophisticated financial institutions in the world, suggesting a collapse of basic risk management with catastrophic financial consequences;

* The crisis was triggered, transmitted and fuelled not only by widespread default on debt instruments as in past credit crises but through excessive leverage (borrowing) and widespread securitization of complex structured financial products by some financial institutions.

The leverage amplified even small changes in real (or perceived) risk associated with the underlying debt instruments which were then transmitted globally via securitization, resulting in a rapidly spreading and, at times, largely uncontained risk;

* Regulatory and accounting mechanisms for identifying, monitoring, quantifying and controlling excessive exposure to credit risk were at best ineffective and at worst outright failures, raising fundamental questions regarding the current nature and form of regulation, its adequacy as well as necessary proscriptive changes to prevent such collapses in the future. Liquidity concerns also loomed large.

* Traditional economic policy tools (such as central bank interest rate reductions and fiscal stimulus initiatives) were not designed to manage credit and liquidity crises and are therefore are of limited effectiveness.

Credit crisis origin

Viewed simplistically, the current crisis in global financial markets is merely the manifestation of the collapse of two intertwined bubbles - credit and housing.

To be continued