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Ripple Effect of U.S. Economic Woes

3/20/2008 --

Written by Linda Lim, professor of strategy at the Ross School, for the Straits Times in Singapore.

What is happening in global financial markets? How could U.S. financial markets—the world's largest, richest, deepest, most sophisticated and supposedly best-regulated—get into such bad shape? Why has this affected global markets? What is the likely impact on the 'real economy' in Asia?

The problems we see now have been brewing for many years. Foreign money flowing into the United States following the late 1990s Asian financial crisis—famously called a 'global savings glut' by current U.S. Federal Reserve Bank Chairman Ben Bernanke—and the Fed's own cheap-money policy following the tech boom-and-bust of the early 2000s, led to very low interest rates.

Together with financial market deregulations, cheap money led to a wave of financial market innovations, such as the now infamous 'subprime' mortgages. Traditional financial institutions such as banks sought to realise higher-return investments in a low-rate world, including by creating and spinning off hedge funds which could take higher risks.

Subprime mortgages are simply mortgages extended to high-risk borrowers with weak credit histories who otherwise would not be able to borrow to buy housing. They are usually offered easy payment terms initially, which can then escalate as a result of 'adjustable interest rates' linked to external market events having nothing to do with the individual borrower's repayment performance.

To limit the risks to themselves of extending these sub-prime loans, U.S. lenders packaged them together with lower-risk 'normal' mortgages. They then 'sliced and diced' the packages into mortgage-backed securities or collateralised debt obligations (CDOs) which they sold to other financial institutions.

The theory behind this was the well-established financial principle of 'risk diversification.' By mixing high-risk subprime loans with lower-risk debt, and then widely distributing the ownership of the new assets through many institutional owners, the risk inherent in any individual asset for any single investor would be minimized.

Even better, the risk of default on these asset-backed securities was insured by insurance companies, including specialized bond insurers—so-called 'monoline insurers' like Ambac and MBIA. Credit rating agencies like Moody's and Fitch usually gave these loan securities the same triple-A (very safe) rating enjoyed by blue-chip banks like UBS, HSBC, Citigroup and Merrill Lynch that issued or purchased them. Such securities—now 'safe', liquid and tradable—became highly desirable in investment portfolios, and were accepted as collateral for other loans.

So, if only 1 percent of a loan security is at risk of turning bad, the market belief was that the safety of the other 99 percent would prevent the whole security from suffering a loss in value if that 1 percent did turn bad—that is, become uncollectible.

Unfortunately, given the way these securities were structured, there was no way of isolating the potentially defective 1 percent to assess its risk in the pricing of the entire security.

This uncertainty has led to a loss of confidence in the value of the entire security. The 99 percent of low- or average-risk loans in the security has now been 'contaminated' by the high-risk 1 percent, instead of diluting it.

A plunge in the value of the loan security (because the 1 percent does, or is feared might, default) then cascades through other financial instruments, such as derivatives based on the security (traded by hedge funds). Financial institutions which hold or insure the security are also affected. In addition, fund managers may be required by their own rules and government regulations to rebalance their portfolios to hold less of such 'contaminated' securities.

This adds further to their price declines and the capital and income losses of their investors.

The potential ripple effect of monoline insurers defaulting is particularly great, since they insure all bonds, not just subprimes, leading to the current attempt by some of their largest bank customers to bail them out.

Bonds that lose their insurance are automatically downgraded, forcing some funds to sell them for their rules do not allow them to hold securities with low ratings.

Effect on U.S. economy

A similar situation in the U.K. has already led to the collapse and nationalization of one bank (Northern Rock) and the closure of many investment funds. This is ironic, given that the 'Anglo-American' financial system had hitherto been lauded as representing the 'best practices' that others should strive to emulate.

If the only problem was U.S. subprime mortgages, the damage would be limited and very small. Subprimes account for only about 5 percent of U.S. mortgages, and the vast majority of them are being properly serviced, with mortgage holders making their mortgage payments on time.

Home mortgages as a whole are only a minor part of the U.S. financial sector, which in turn is only 12 percent of GDP, about the same as manufacturing. (Manufacturing has been sluggish for years without dragging down the rest of the economy). The U.S. accounts for only 25 percent of global financial markets and 20 percent of the world economy, while U.S. residential housing contributes only 5 percent to total U.S. GDP and less than 25 percent to private fixed investment.

Unfortunately, the problem in the U.S. residential housing market goes beyond subprime mortgages. Years of record-low interest rates led to excess demand and overbuilding in this sector. American consumers stopped saving out of current income, believing that the market values of their homes—the single largest capital asset owned by most households—would continue to rise forever, and 'build equity' for them without the need to reduce consumption.

Worse, many became addicted to home equity loans, which allowed them to borrow against the (rising) value of their homes, eroding any potential savings! Ballooning credit card debt—undertaken because of the 'wealth effect,' that is, people 'felt rich' because of the growing value of their homes, so were more willing to borrow—added to record indebtedness. With the cheap credit extended to them by foreign savers as well as the U.S. Federal Reserve, Americans rushed out to buy goods and services to fill their large new homes, the economy sucked in imports as it grew, and the U.S. current account deficit (the excess of imports over exports) expanded to record levels.

The subprime mortgage crisis was only the first prick in the U.S. housing and debt bubble. The bubble was bound to burst.

Before the crisis that began last July, economists had already expected foreigners to become reluctant to lend more to the United States. The interest return they were getting on dollar assets was falling and the value of these assets was declining in foreign currency terms as the dollar fell. Furthermore, the risk for foreign countries concentrating their foreign exchange reserves in U.S. Treasury bonds—issued by the U.S. government to fund its record budget deficits—was increasing.

As foreign capital inflow slows, the dollar will fall and inflation will pick up, fueled by the falling dollar, which raises import prices. In these circumstances, U.S. interest rates should rise, making borrowing more expensive and 'cooling off' the economy. A slower-growing economy would then deflate the housing and other asset bubbles, reduce inflation, and shrink the current account deficit, helped by a weaker dollar making exports cheaper and imports more expensive.

This process is already under way, but it has been complicated by problems in the financial markets. The inability to assess risk and correctly price mortgage-based and other 'innovative' securities has led to a serious 'credit crunch.' Lenders are demanding much higher risk premia (interest rates) for their loans—or worse, becoming reluctant to lend at almost any price.

Unchecked, this could restrain new investment and consumption, and push even otherwise healthy borrowers into default, worsening the downward spiral of debt writedowns and falling asset prices.

In parts of the United States, housing prices have already fallen below the value of homeowners' mortgages. Meanwhile, the adjustable rates on these mortgages have shot up. As a result, many people are simply walking away from their properties. This has led to record foreclosures and further housing gluts and price falls—not to mention, hits to the balance sheets of banks which issued the mortgages.

The credit crunch and associated loss of consumer and investor confidence also hurts the stock market. Falls in the value of individuals' and households' stock portfolios, as well as of their homes, create a 'negative wealth effect.' Feeling poorer, people reduce their spending, further slowing down the economy and threatening a deeper and longer recession than would result from a pure 'business cycle' downturn.

Ostensibly to forestall a recession, the U.S. Federal Reserve and some other central banks have pumped credit into the system by providing commercial banks with access to more loan funds, and by lowering interest rates—aggressively and repeatedly in the case of the United States.

These policies have been criticized for several reasons:

They delay the necessary deflation of asset bubbles by prolonging the easy-money conditions which led to the bubbles in the first place;

They worsen price inflation, which is already being pushed up by the falling dollar and rising commodity prices;

And they create 'moral hazard' by bailing out financial market actors from the consequences of their own risky behavior, which they are then more likely to repeat in the future.

Such loose monetary policy—and the associated fiscal stimulus that has been enacted by the U.S. government—can be justified only if a severe and prolonged recession is otherwise likely.

Until recently, such a severe recession—as opposed to a mild and short-lived one, such as was experienced in 2001—was considered unlikely unless conditions in the financial markets get much worse.

This possibility cannot yet be determined with any certainty. But the U.S. Fed is sufficiently worried that it has taken the unprecedented step of bailing out one financial institution—Bear Stearns—and offering to buy up to US$400 billion (S$550 billion) of the mortgage-backed securities that none in the private sector want to hold right now.

If one looked at the broad numbers, the U.S. economy is not doing too badly. Though it has slowed down and housing is in a serious slump, unemployment remains relatively low and the weak dollar has led to an export boom, reviving the previously moribund manufacturing sector. Moreover, U.S. corporate profits are likely to be at least partially sustained by continued rapid growth in emerging markets, led by China and Asia. Europe outside of the U.K. is also not doing badly.

Effect on Asia

A U.S. recession—two quarters of negative GDP growth—is probably inevitable now, but it would not be all bad, including for Asia. A reduction in American consumer spending, while it would hurt growth, would have salutary effects in reducing inflation and debt burdens, and the current account deficit. A fall in U.S. imports from Asia would encourage Asian governments and businesses to move more quickly away from their hitherto neo-mercantilist (export-promoting) policies toward serving domestic Asian markets.

Asia's banks and other financial institutions are relatively insulated from the problems of the U.S. and U.K. financial markets, since their 'less sophisticated' banks were not allowed by regulators to buy offshore CDOs.

Asian economies also have ample supplies of capital from their high domestic savings; hefty foreign exchange reserves; continued, if shrinking, current account surpluses from commodity and manufactured exports (which go increasingly to each other rather than to the United States); and flows of portfolio capital leaving the credit-risky and slow-growth United States for Asia. A credit crunch is not likely here.

The bigger economic risk for Asia is probably not imported recession from the United States, but rather accelerating homegrown inflation and asset bubbles. These are fed in part by domestic monetary authorities continuing to favour low exchange rates, in their attempts to preserve export competitiveness by trying to keep pace with the sinking U.S. dollar. This policy aggravates imported inflation, whereas more rapidly strengthening currencies would reduce it.

Allowing currency appreciation would also ease the necessary and inevitable transition away from export dependence towards production structures more focused on the expansion of Asian domestic consumption and investment. That would help fulfil the much-vaunted 'de-coupling' of Asia from the troubled U.S. economy.

We are not there yet.

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,