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2. Wave 1: The U.S. sub-prime mortgage market;
Wave 2: The collapse of Lehman Brothers and the unraveling of credit default swaps (CDSs);
Wave 3: Recognition of a serious recession for most developed countries;
Wave 4: (If it happens) A spreading of recession to emerging market economies, particularly China.
3. Real estate prices in the U.S. soared from 2002 through 2007 largely in response to the widespread availability of low interest, zero-down mortgages, referred to as sub-prime mortgages.
These mortgages were aggregated and resold as collateralized debt obligations (CDOs) and in most cases were highly rated by Moody’s and other bond rating agencies.
The downturn in housing prices and rise in floating interest rates in most sub-prime mortgages precipitated a wave of defaults.
The drop in the asset value of CDOs and lack of transparency caused the capital base of a large number of banks to erode, leading to the collapse of Bear Sterns, Washington Mutual, and others.
Fear about the solvency of large international bank led to a sharp increase in inter-bank lending rates, a decrease in lending, and a contraction of credit to commercial customers.
Reduced bank lending sparked growing concern about a U.S. recession.
4. Almost all banks are interwoven with credit default swaps( CDS). If default should occur the institution issuing the CDS will have to make good on the difference. It is like insurance, but may not have the pool of capital assets necessary to back up a systemic wave of defaults.
Lehman Brothers was a key player in the CDS market and its demise on 9/15 triggered a whole set of obligated payments leading to the bailout of AGI, the world’s largest insurance company.
The Lehman bankruptcy also triggered a series of national crises in countries whose bank had overextended during the boom times.
On 10/1 Ireland, with a euro-based currency, guaranteed its banks to a total of €400 billion, a level twice its gross national product. This created a potential run on all eurozone banks, necessitating a wholesale bailout of all major banking institutions in Europe.
Within a few days all major national governments had moved to guarantee the solvency of their banking systems by extending deposit insurance programs and investing directly in the banks.
Government nationalization of banks across the globe effectively ended the second wave of the crisis, but led to another, the fear of recession.
6. The rise in LIBOR rates and drop in commercial lending associated with waves 1 and 2 of the crisis precipitated increasing pessimism about the rate of economic growth in 2009.
Stock markets around the globe plunged as investors reassessed the likely depth and length of the recession.
The increasing pessimism has led to falling retail sales and postponed investments, a prescription for a serious recession.
7. There is a better than fifty-fifty chance that the worst of the financial crisis is behind us. Bank solvency is now no longer an overwhelming issue.
However, the full range of the impact of reduced bank lending and dislocations caused by the financial turmoil have yet to be measured.
The impact on emerging economies, particularly the BRIC – Brazil, Russia, Indian, and China – has been uneven. Russia is likely to have the most difficulty due to its dependence on oil and gas revenue.
It is thought that China will shore up faltering export demand with domestic infrastructure projects, as they did following the Asian financial crisis.
China’s official forecast is for 8% GDP growth in 2009. However, emerging anecdotal evidence suggests that economic growth may be substantially lower.
8.
The Enron collapse raised a number of issues that demonstrated the potential systemic problem associated with Wall Street’s handling of sub-prime loans and the risk of credit defaults.
Derivative techniques were used to shift debt off Enron’s balance sheet;
Enron booked a portion of the estimated present value of futures profits as current profits. It also paid managers bonuses based on expected futures profits. Such profits were not supported by cash flow, requiring excessive borrowing.
At its peak Enron’s one-to-one exchange, Enron-on-line (EOL) handled as much as two-thirds of over-the-counter (OTC) energy contracts. Enron’s traders were successful in unwinding these contracts mainly because the spot market was relatively stable at that time. Had there been pricing turmoil, the unwinding could have been far more convulsive.
9. First and foremost, the financial turmoil has had a substantive impact on expected economic growth which, in turn, has been the primary cause of the drop in energy prices.
Second, although the drop in energy prices has an immediate benefit to consumers it will also impact investment and possibly set up another price rise in the face of economic recovery.
Third, concern about the credit worthiness of counter parties is rapidly increasing the use of third party clearing houses to monitor and settle OTC derivative contracts. This secures the process, but it also raises trading costs and reduces liquidity.
Fourth, the financial turmoil may spawn an international response to monitor and regulate trading, which in turn could inhibit economic development.
Fifth, modern communications has greatly increased the speed at which markets accommodate information – both going down and going up.
Overall, the crisis is likely to enhance the role of national oil companies and government sponsored enterprises with an attendant drop in economic efficiency.
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