International Financial Crisis — Swimming in Quicksand

15 November 2008


Note: A number of the reference links have become stale and no longer reference existing pages.

Watching pension savings deteriorate and home equity evaporate while hearing we can expect layoffs, decreased output and lower incomes in the months ahead, is leaving many feeling bewildered and confused. Being told this bleak future is a result of defaults in the U.S. sub-prime mortgage market—a market very few of us even knew about, much less participated in—only adds to the confusion. How bad and how long it lasts depends upon whether governments accurately identify the magnitude of the problem and how quickly they adopt appropriate policy measures to solve it.

On Wednesday, October 29, the Federal Reserve Board in the United States released a statement explaining its rationale for cutting the Fed funds rate to 1%. “Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures and official steps to strengthen financial systems should help over time to improve credit conditions and promote a return to moderate economic growth.”

Reassuring words, but unfortunately they belie the fact that the world’s most powerful central bank does not have a grasp on the problem we face. All policy measures focus on getting the free flow of credit moving. The Board believes that if they make money cheap enough, bankers will see the wisdom in lending to consumers and businesses, returning us to economic growth and price stability. After all, it worked to get us out of the tech bubble in 2001 didn’t it?

There is no possibility that monetary policy will work. The circumstances surrounding the current crisis are fundamentally different than ever before. It is not a flow of funds problem but a stock of funds problem. Until this is acknowledged the polite debate regarding the merits of monetary policy versus fiscal policy will drag on as the timeliness for implementing effective policy solutions becomes stale-dated.

Paul Krugman’s column on Friday, October 31 in the New York Times, identified the crux of the issue. Monetary policy could work “unless for some reason the Fed can’t offset the fall in consumer spending.” The reason the Fed can’t offset the fall in consumer spending is because the economy is drowning in a liquidity trap. “Fed policy has lost most of its traction…the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year. The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem.”

What is desperately required is an expansionist fiscal policy by government which would protect people from foreclosures. Large scale foreclosures don’t just hurt individuals, they hurt entire neighborhoods. Current estimates suggest that as high as one in five U. S. homeowners hold mortgages that are greater than the resale value of their home. Policy makers should also significantly increase spending on health care, education, public housing, roads, bridges, rapid transit, and other forms of productive physical assets. This will create meaningful employment and generate income that is sorely needed.

There’s no doubt consumer spending has decreased and access to credit has fallen off. What doesn’t make sense is how quickly the trend changed and by how much. When sub-prime mortgage market failures hit the news it seemed shocking that so many defaults could occur so quickly. Usually the effects of a downturn take much longer to feed into the economy and there are warning signs. When people have difficulty paying their mortgages, banks try to avoid triggering the lengthy and expensive process of repossession. Not this time.

The circumstances of this credit crisis are fundamentally different because of underlying agreements embedded in the clauses of derivative contracts called credit default swaps. These contracts transform the incentive to renegotiate loans for a troubled debtor into incentives to trigger their write-off and collect on insurance. Why bother renegotiating at a lower interest rate and longer term to maturity when you can get a higher return by collecting insurance on the entire amount outstanding? Renegotiating loans, behind closed doors and in good faith, becomes outdated.

The incentive to renegotiate loans has always provided a type of holding-tank protection for market adjustments. It keeps things in a flow of funds environment. Renegotiated loans may be akin to swimming in dirty water: not very comfortable but you can still do it. Write-offs are akin to swimming in quicksand.

In and of itself the disincentive to restructure, although significant, would not cause a full scale collapse of the financial services sector. Coupled with the unique features of the derivatives market which allowed too many swaps to be written on the same pool of assets without corresponding reserves to back them up has multiplied the problem. When one entity triggers a default it sets in motion a string of calls, each with the incentive to trigger other calls. Multiple parties held rights to what historically would have been a single string of payments. Reserves are eaten up very quickly and institutions fail. These multiple claims help explain why the U.S. Treasury bailout to financial companies is already close to $3 trillion while the amount needed to forestall foreclosures directly would have been much less.

Until the nature and magnitude of the problem is acknowledged, U.S. federal policy makers are going to think and act like monetarists while banks and other financial institutions continue to think and act like liquidators. Accordingly, calls for meaningful solutions for homeowners are going to go unheeded with their problems translating into problems for us all.

The need to acknowledge this disconnect between financial institutions and consumers becomes even more critical in light of the impending problems in credit card and auto loan receivables. The market for credit receivables, packaged as asset-backed securities, is structured much the same way as the sub-prime mortgage market. It’s very likely this will be the next shock to hit the market. It’s hard to imagine how an already weakened system will absorb the hit if the policy response copies that of the sub-prime mortgage crisis.

1. Board of Governors of the Federal Reserve, The Federal Open Market Committee decided to lower its target for the federal funds rate 50 basis points to 1 percent, Press Release, October 29, 2008.

2. Krugman, Paul, When Consumers Capitulate, New York Times, October 31, 2008.

3. For a broader discussion of the implications of the derivatives market see Scott-Quinn, Brian and Walmsley, Julian K., The Impact of Credit Derivatives on Securities Markets, International Securities Market Association, Zurich, Switzerland, 1998. and Arthur D. Little, Demystifying the Credit Crunch, July 2008.

4. As of November 10, 2008 the bailout package is estimated at $3 trillion including a $700 billion fund to buy equity and assets of troubled financial companies and $1.5 trillion in a term auction facility. A fund of $300 billion has been set aside for direct assistance to homeowners at risk on future mortgages, but lenders have been reluctant to access these funds. See Where AIG’s New Bailout Ranks,, November 10, 2008.