The causes of the US subprime crisis have been explored in the article by Marc Bautista in this website. Since the crisis first came to light in August last year, the general public, not only in the USA but the rest of the world that has strong economic ties with the USA, has been wondering how much the crisis will impact the US economy in general.
A report by Bloomberg http://www.bloomberg.com/apps/news?pid=20601109&sid=a9YwntHR.pFQ&refer=home provides us with clear explanation as to how the losses at the US commercial banks are being transmitted to other parts of the economy. Essentially, when a bank's net asset is reduced, its ability to lend is also reduced. Since net asset equals to total assets minus debts, if the value of debt increases, then net asset value will decrease. In the eyes of US banking regulators, it is not just the quantity of debt that counts, but also its quality. When the quality of a bank's debt holding drops, its risk-based value will increase. Hence, when the rating of the debt held by a bank is downgraded, then its net asset is reduced in the calculation of what US banking regulators called risk-based capital ratio.
Warren Buffet said, when the tide goes out, we will know who has been swimming naked. Other people use slightly different wording to say the same thing, i.e. when the times are good, everyone looks fine. When bad times come, your true form will show.
The report says that in 2007, the number of ``problem'' banks rose to 76 from 50 a year earlier. In 1990, the total reached 1,500. Three FDIC-insured banks failed in 2007, the first since June 2004. I am not sure how one should interpret these numbers. It may mean that the problem today does not look as bad as that in 1990. Or, it could mean that we will see more banks failing later this year. Hmm.
My interest in this report is more on what the authorities should do at times like this. The downgrading of debts when the time is bad seems to worsen the situation, and will result in a slower recovery. It has also been said that when banks lose money, they are inclined to tighten lending standard, and the authorities would impose laws and enforce existing ones to make sure that banks take less risk than during the good time. In effect, in good times, rules are relaxed and credit is allowed to balloon; in bad times, rules are tightened and lending is reduced. Which can explain why market volatility occurs.
If someone is to suggest that banks should tighten lending standards when times are good, then I imagine not many people will object, especially now when the bad times are known. However, if the suggestion is to relax lending standards during bad times like now, I doubt many people will support it, because it is emotionally unacceptable. How could we do something that led us to the problem in the first place? we should repent! But logically, to avoid worsening of the financial crisis, the authorities should kick-start lending. One may not do it so blatantly, like reducing the required capital ratios, but fiddle with the calculation of risk-based capital, for example. Unfortunately, one may sometimes have to do something that one would not do in normal times in order to correct a mistake - two wrongs to make one right. After the crisis is over, when we get to start afresh, we can do everything right, but when we are in big trouble, we have to think outside the boundaries.
Some people may argue that, even if you reflate the capital ratios of banks, the bankers may still be reluctant to lend, because of the memory of the recent problem. In behavorial finance, this is a cognitive bias, like a trader who is so emotionally burned by a recent error that he/she refuses to take risks even though times have changed. In good times, bad credits get ignored. In bad times, good credits get rejected. This may be true, but is it not better to remove one obstacle at a time? With the return of a more normal level of risk premium, which was too low before the crisis, banks should be able to overcome the cognitive bias eventually. Taking temporary measures to speed up the reflation of capital ratios will help the healing process.
For banks to regain their composure fast, and not to continue to behave like deers caught by a headlight, leadership from their central bank would be very important. However, the central bank cannot exert leadership unless it can show that, first, it knows what is going on, and second, it knows what the best way to get out of the mess is, implying that it has weighed different options and understood the consequences of each option. For example, by rescuing Bear Stearns, the US Fed should explain adequately how worse the situation would be had it not done what it did; it should also explain why it was necessary to grant access to investment banks the low lending rate that was normally only available to much more tightly supervised commercial banks.
So far, the US Fed seems to have done a reasonable job in explaining the former, but not the latter : if the problem with investment banks is one of liquidity, then they can be given access to liquidity, but at an interest rate higher than the lowest rate. Now, the market suspects that the problem with the investment banks are more a solvency issue than a liquidity issue. If so, there would be a higher chance that the US Fed's lending to the investment banks will go bad. To re-establish credibility, the US Fed should first acknowledge the mistakes made which allowed investment banks to have such a high impact on the health of the whole financial market, yet they were not subject to the same degree of scrutiny as commercial banks, in order to justify the apparently inordinate actions taken to save investment banks that may lead to losses to the US Fed. Such explanation will assure the public that the authorities know what went wrong. Without this, it would be hard to convince people that they know the cure.
There are of course other consequences of the subprime crisis, such as the loss of homes by some home owners, the loss of investment by those who speculated in the real estate market, the making of profit by the minority who betted against the mortgage default rates implied in the securities backed by subprime mortgages, and so on. This article has focused on the one consequence that I think is of the greatest concern to people watching the broad US economy.
(Chiu Ying Wong, CFA)