Milan (AsiaNews) – Events appear to be confirming Alan Greenspan’s warning of last 16 December when for the first time the former chairman of the US Federal Reserve mentioned the real possibility that the world economy might experience stagflation, something that in theory is a contradiction in terms since economic stagnation and inflation were thought unlikely to occur together. But the past is there to tell us that this is nothing new; in the 1970s structural factors had already led the world down that dangerous path. With Greenspan’s warning in mind, some of the best analysts have picked the notion and run with it, applying it not only to the United States but also to other economies, including those of Asia.
Why stagflation? Why now? The current problem is rooted in the rise of bad debts in the US subprime lending housing market, which has led to an insolvency crisis that is affecting the collateralised debt obligations (CDO) and collateralised mortgage obligations (CMO). In practice the term refers to securitised debt in which assets are classified into pools, and offered as collateral for third-party investment that well-known investment banks (like Goldman Sachs, Morgan Stanley, JP Morgan, etc.) and hedge funds had placed with commercial banks to the tune of hundreds of billions of dollars.
The world’s major credit rating agencies (like Standard & Poors and Moody’s and Fitch) had given top ratings (AAA) to these obligations not only because of the prestige of those who issued the bonds but also because the pools were insured so as to shift the risk of insolvency on third parties. The bonds are in fact insured via credit default swap (CDS) by monoline bonds insurers (like Ambac, MBIA, FGIC, CIFG, SCA), who claimed they had developed complex statistical algorithms that allowed them to carefully evaluate the insolvency risk of mortgage-backed securities. With the appropriate financial provisions they claimed they could cope with any problem, i.e. eventual loan defaults. Since the monolines were also rated AAA, CDOs and CMOs had the same good rating. Commercial banks could thus boast that they had invested their assets in top credit securities, which was like having ready cash, even though what they really had was a smorgasbord of mortgage-backed securities, good and bad.
With the first subprime victims falling by the wayside the banks realised that small real estate credit agencies had loaned money without properly checking borrowers’ credit worthiness since they made they made their money on commissions and were not responsible for any loan default. Hence these agencies were more interested in subscribing as many mortgages irrespective of the borrowers’ possibility of repayment. Contrary to more mainstream loan, these bank securities were built on a mountain of dubious debt.
When problems began mounting, people began realising that the problem was structural, involving the whole edifice built around CDOs and CMSs. Mathematical and stochastic models used by monoline insurers proved themselves inadequate and commercial banks came to realise that they had no clue about the algorithms the former used. In the end what became clear was that the insurers, which had insured the collateralised obligations, could not honour the risks they had taken on and were thus technically insolvent.
No one however, least of all the banks, had an interest in forcing the monoline insurers to assume their responsibilities and meet the day of reckoning. To ask them to honour CDSs meant certifying their insolvency and forcing them to go under; in which case all collateralised obligations in bank portfolios would legally lose their status as credit with a right to insurance coverage. This would have meant insolvency and being downgraded to C or junk bond status. Under current rules for the banks’ balance sheet such rating would have meant putting in the bad debt reserve a considerable fraction of the nominal values of the securities. In that case bank losses would have been much greater than has actually occurred, thus forcing bank executives to ask stock holders not only to forgo dividends but also subscribe to greater capital outlay to avoid bankruptcy. So far Banks have opted not to call in the chips from the monoline insurers and credit rating agencies (Standard & Poors, Moody’s and Fitch, etc.) have just marginally reduced their credit rating from AAA to AA.
The other option was to act directly on the underlying loans and take over the properties but that was easier said than done. In fact it became clear that the banks did not have a clue about what was behind the underlying loans. In many cases it was not even possible to trace the original mortgage-backed securities or the necessary registration transfer because some of the small real estate credit agencies had shut down; others had gone belly up. In more cases still, in the whirling trading in overlying collateralised obligations underlying mortgage-backed securities had not been individually transcribed.
So far the financial and banking system was able to avoid disaster despite the dark shadow cast on the affected financial markets. At the end of the third quarter of 2007 the overall nominal value of these instruments, which are generally not quoted in the stock market, have reached US$ 6,810 billion. Hence the Union des Banques Suisses (UBS) estimated that final bill for the crisis might reach US$ 600 billion. Initially, this might seem too much, but at a closer look it is based on the assumption that losses would remain at 10 per cent of the operations in US$ dollars.
If we accept the UBS’s estimate, it is reasonable to think that notwithstanding the bad moment the financial and banking systems can still recover on the medium term, especially if no other sector is touched. For instance the underlying value expressed by the CDS combined, including those that do not concern CDOs and CMOs guaranteed by the monoline insurers, stands at around US$ 45 trillions (1 trillion = 1000 billion). The value of all the over the counter contracts (OTC), including derivatives and other new instruments, has reached mind boggling levels: US$ 516.4 trillions as of 30 June 2007 according to data released by the Bank for International Settlements (BIS). By comparison the US GNP in 2006 stood at US$ 13.021 trillions, i.e. the OTC total value is 40 times the value of US GNP. Hence, a leak caused by a significant number of defaults in one compartment could have Titanic-size consequences elsewhere.
Such an analysis has to go further which we shall do in another article. For now, let us stick to a summary of the main consequences of security insolvency, which is the possibility of a generalised crisis spreading to commercial banks. Capital movements between banks are at the heart of the system which means that until it is not clear how far the rot has gone it won’t be possible to evaluate the their financial reliability.
Banks with portfolios that hold securities whose value has drastically dropped because of insolvency must raise capital to stay within the already weak parameters that are designed to show if they are strong enough to meet the commitments they have undertaken. For the banks the collapse in value of paper securities wipes out wealth and reduces their liquidity. It especially affects their reliability and their image of reliability, and makes the system appear fragile from the outside.
The crisis in interbank markets is the most obvious sign of the banks’ current volatility. With banks losing trust in each other, not only does the banking lose outside trust but banks lose their liquidity and capacity to perform their “natural function” which is to lend money to companies, consumers and governments.
What had began as a financial crisis and turned into a crisis of the banking system is now affecting the whole economy, producing economic stagnation not only because consumers are cutting back on expenditures but also because firms are offering fewer goods and services and generating less wealth. This could mean that stagnation might turn into a recession first than even a depression like the one of 1929.
In a later article we shall look at the effects of what the United States Federal Reserve has tried to do to cope with inflation.