Lessons from the Credit Crunch
Mervyn King, Governor of the Bank of England
We are seeing that all the major financial institutions are going to go a lot further than might have been expected initially. In the first few months there was a feeling of a liquidity problem — "As long as we can acquire sufficient liquid assets, we will be all right."
I do not think liquidity is the source of concerns now, although problems may show up in terms of liquidity down the road. It is much more now that people are taking a structural look. They are realising that a number of the markets in complex financial situations are unlikely to reopen, a simple example being the mortgage-backed security market.
The form in which those instruments were sold — they would need to be modified at least in order to provide the right incentives, and in many other instruments it is very unlikely that they will reappear. This extraordinary expansion of balance sheets in the last five years is unwinding, and banks will have to make up their own minds as to how far they want to go. I think it was Stephen Green of HSBC who pointed to the need to rebalance the focus of banking away perhaps from trading activity and more towards the provision of services with customers at the other end.
Certainly we have given thought to the ability of the banking system to finance investment in general. That will affect not only the expenditure on investment but also, as a result, the growth of productive capacity of the economy, which would otherwise have been enhanced by more investment.
That is one of the consequences of the credit crunch. It is extremely difficult to make quantitative judgements as to how big that impact will be.
George Magnus, Senior Economic Adviser, UBS; spotted the "Minsky moment" earlier than most
The credit crunch represents the bursting of the most powerful financial bubble since the end of the Second World War. I think it was irresponsible to allow leverage to grow in the way it did. It was, as I wrote in March last year, a "Minsky Moment" — named after the economist Hyman Minsky, basically about the highest stage of leverage and its relationship with and to the price of money and asset prices. It's less of a moment, as such, and more about a sequence of events in credit markets, triggered by anything that causes asset prices to falter and risk premiums to rise sharply. In this case it was faltering house prices in the US.
Two things are easy to predict. First, that it takes a long time for the consequences to work through; we will see torridly weak growth until 2010. Second, the influence and role of government is bound to grow in areas previously thought unthinkable, such as public ownership of parts of the mortgage market.
There is also a case for a large, durable fiscal stimulus, along the lines proposed by Barack Obama, rather than the tax cuts being enacted by President Bush, which tend to boost savings rather than spending. We should not allow an inflationary spike caused by commodity prices to distract us from the deflation still beavering its way through the economy. All those rocket scientists at the Fed, the Bank of England and the European Central Bank have a valid point about not moving into an inflationary world, but they are fighting the last war.
Nouriel Roubini, professor of economics and international business, New York University, and founder of RGE Monitor
If it walks, quacks and ducks like a recession duck it is a recession duck. We are in a recession now. The US economy entered a recession in the first quarter of 2008 and the second quarter growth recovery is totally artificial. It was totally driven by the massive tax rebates that artificially propped up consumption.
The headwinds hitting consumption are stronger than the tax rebates whose temporary effect will fizzle out at the latest by August. The headwinds include falling home prices, falling stock prices, falling home equity withdrawal, high debt ratios. Then, reset interest rates on mortgages, credit cards, auto loans and student loans are squeezing disposable income. Rising inflation is eroding real incomes. There is sluggish wage and income growth, collapsing consumer confidence, high oil prices and gasoline above $4 (£2) dollars a gallon, falling employment and rising unemployment claims, and a sense of general economic and financial malaise and insecurity.
This recession will be long, ugly, painful and deep. And the credit losses associated with it will be closer to $2 trillion — leading to the most severe systemic financial and banking crisis since the Great Depression.
It would be more honest for the financial firms to write down to zero the value of these assets (with possible positive revaluation if they turn out being worth more than zero) and keep them on balance sheet rather than pretending to "sell" them as Merrill Lynch did last week. The credibility and viability of the most sophisticated financial system is at stake now, as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy.
Joseph Stiglitz, professor at Columbia University and 2001 recipient of the Nobel Prize for economics
In both the UK and the US, about 40 per cent of corporate profits go to the finance industry. What is the social function of the industry that justifies that generous money? The industry exists formanaging risk and allocatingcapital. Well, it clearly didn't doeither very well.
A year ago I was confident it would be as bad as it has turned out to be, so I have not been disappointed.
The bail-outs of Bear Stearns and of Fannie Mae and Freddie Mac are unconscionable. You needed to do something about liquidity, but it didn't have to be done in a way that maximised moral hazard. These bail-outs rewarded those people who caused the problems in the first place. Bear Stearns shareholders walked away with $1bn; for Fannie and Freddie, taxpayers have been asked to give a blank cheque with no sense of how much their shareholders or bondholders are going to have to pay.
The US is a nation that is consuming too much, and the Bush administration response has been to tell people to consume more. Rather, we need investment in public infrastructure, in transportation, in green technologies. We should be adapting to the new realities we have to face.
The idea that banks should self-regulate, relying on their own risk management systems and rating agencies, is absurd. We lost sight of why regulation is needed. The trouble is that regulators are too close to the people they are regulating. There was a party going on and nobody wanted to be a party pooper.
Sir Howard Davies, former chairman of the Financial Services Authority
A very large amount of credit was being created outside the banking system. All of the central banks and the other authorities probably did underestimate that and the market itself has been surprised to discover how much these instruments were being used to generate credit outside the banking system. Credit conditions were much looser than the authorities had believed. The contraction in risk spreads that occurred from about 2003-4 was quite dramatic. People used to talk about the search for yield. Interest rates were generally low and there was a lot of money sloshing round the system. The effect was to bid down yields on a lot of more risky assets so that risk was being mispriced.
While losses on the more exotic assets have mostly been washed through the system, the problem now is that the consequences are producing plain vanilla losses on banks' normal mortgage books and consumer credit books while business defaults are starting to rise. We have been reminded that clearing banking in this country is surprisingly volatile.
Banks seem to make good returns in nine years out of 10 and in the 10th year they lose their shirts. I think the banks themselves and investors had forgotten that when things turn down and a bank has lots of mortgages, loans to businesses and consumer debt you can lose a lot of money.
I don't share the view that it is all over. Clearing the Augean stables of rubbish may have occurred but there are new bad debts every day. I have been at the bearish end of this right from the start and I don't see any reason to change my mind. I'm pretty gloomy for the next 12 months and it probably won't feel better for some time after that.
Stephen Green, chairman of HSBC
The financial markets are going to be difficult into 2009. The real economy, which is weakening, will of course recover. It may need a number of quarters to recover. Financial markets will not be the same because I don't think either the regulators or the directors on behalf of shareholders will tolerate high and increasing leverage and complex structures being parked in off-balance-sheet instruments. The parts of the market involved in that will have to find a new business model.
It will take a while for all this to settle down and there will be certain sectors of the financial markets that will employ fewer people. But we can't go back completely on securitisation. We are not going back to the old days of banks simply being intermediaries of credit.
This is not the end of civilisation as we know it. This is pain that has to be worked through. The authorities have loosened credit to the financial markets extensively. In many ways it has had a limited effect so far. They are on the horns of a dilemma between the need to keep liquidity in the system and the need to rein in inflation. There are lessons to be learnt by banks, regulators and investors. The banks clearly didn't have risk management as strongly enforced as they should have and there are issues about the way compensation arrangements work to encourage risk-taking on the part of individuals.
The FSA has been candid about the lessons to be learnt. It will pay a lot of attention to banks' liquidity and capital bases. Investors also need to make up their own minds instead of relying on credit ratings.
Charles Goodhart, Professor Emeritus, London School of Economics; former chief adviser to the Bank of England
We have come to the end of the first stage, which was about the internal funding problems of the banks. The second stage is an attempt by the banks to cut their leverage and reduce their lending, so helping to drive the economy into recession. That will then feedback via bad debts in non-sub prime lending and impact the capital strength of the banks. So we will see an adverse vicious circle of weak banks creating a weak economy which creates more weak banks. The developed world will decline until oil and commodity prices fall, and then the central banks can start easing interest rates, but that will not be for six or seven months, by which time recession will have taken a grip on the economy. If I were the Prime Minister I wouldn't spend so much time talking about how I would deal with the problem because there isn't much he can do. I'm not terribly optimistic.
Central banks did nothing during the asset price and leveraged credit bubble prior to 2007, because there was almost nothing that they could do. So, what needs to be done to give our central bank some balls?
Capital and liquidity requirements have, somehow, to be made counter-cyclical, and I would add maximum, time-varying, loan-to-value ratios reintroduced. Should anyone, ever, be able to borrow more than, say, 97 per cent of the current value of a property? If not 97 per cent, what would be your preferred figure? 125 per cent as Northern Rock did? And should appraisers of housing values be made legally responsible, or at the very least independent of mortgage lenders and other interested parties in the deal?
Bill Gross, chief investment officer of Pimco, world's biggest bond fund
We are all to blame. For the most part, you can throw in central bankers, Wall Street investment bankers and you can throw invest-ors into the pot as well as mortgage bankers and regulators who looked the other way. All those in the club share part of the blame for creating the bubble and looking the other way in terms of allowing for the most part home mortgages to be sold and packaged under false pretences.
This is a bubble that is different from the stock market bubble and the dotcom bubble, which were inflated unrealistically but not on the basis of excessive leverage or debt. This asset bubble has been accompanied by a debt bubble and as asset prices come down, we have housing prices and now prices for used automobiles coming down.
Hedge funds, SIVS and conduits all operated in what we call the shadow banking system. It wasn't regulated and it went to excess in terms of the leverage. We have a sense that this can't be happening to us but this has happened for hundreds of years. History has proved that when you combine leverage with excessive price appreciation, there is an inevitable conclusion.
I think this process unwinds until we have a balance sheet or a provider of liquidity that [supplies] more than $5-10bn increments. like we have seen with Merrill Lynch. There are only two balance sheets that can make a difference: the US government or foreign [sovereign] balance sheets. We continue to deflate from the standpoint of assets. The only solution is to get one or both of those balance sheets into the process.
Paola Subacchi, Research Director, International Economics, Chatham House
I am not too concerned about the banking system. The main problems there have clearly emerged over the last year, but there are still regulatory issues that need to be addressed for the future. The main one is who is going to take the risks. Is the central bank always going to have to do this? We need to clarify the role of the central banks. There is certainly a question of moral hazard here facing all the central banks. We have to ask questions about a system where the central banks play the role of rescuer; maybe there should be more spreading of risk. At the moment we have a non-rule based system of financial surveillance, so another area that has to be looked at is whether we should move to a more rules-based system of regulation. We could have more binding rules in the international financial system, encouraging better surveillance and transparency and more focus on who is the risk taker. We need to focus on better prevention mechanisms. The novelty in this financial crisis is the new Sovereign Wealth Funds and the role they have played in helping to rescue banks — but that doesn't mean we will have them forever playing that role.
A year on from the start of the credit crunch we are now seeing the impact on the real economy, with the slowdown in consumption, investment and growth, and this is what we will see over the next six to 12 months.
On monetary policy I would keep interest rate policy focussed on how to manage demand. The big question is whether we should focus solely on inflation or take into account growth. This is really a turning point in how we use the tools of economic and regulatory policy.
George Soros, global financier and philanthropist
In my opinion, in addition to the housing bubble that was the trigger that set off the financial crisis, there is a super bubble that has been going on for 25 years or so that started in 1980 when Margaret Thatcher became prime minister and Ronald Reagan became president. That is when the belief that markets are best left to their own devices became the dominant belief. Based on that, we had a new phase of globalisation of financial markets and liberalisation of financial markets. The idea is false. Markets do not [correct] towards equilibrium.
If [as a regulator] you only use your powers to bail out the failing institutions you introduce, this will encourage the phenomenon of moral hazard. That is what has been going on for the last 25 years. As a result, credit creation has been encouraged and these periodic crises managed to be dealt with without any serious fallout in the real world. That reinforced credit creation and the misconception that markets correct themselves.
That is how we arrived not only at the housing bubble but also the creation of this alphabet soup of synthetic instruments so that when the sub-prime crisis happened, the authorities were totally unprepared that the whole system would fall apart. Markets that I didn't even know existed ceased to function. That revealed that the whole construct, this really powerful financial structure, has been built on false grounds. For the first time, the entire system has been engaged in this crisis and the authorities have considerable difficulty even in providing enough liquidity.
Bank bail-outs and other warnings
8 February 2007: HSBC issues its first ever profit warning alerting the market to rising bad debts from sub-prime lending
20 June: Two Bear Stearns hedge funds announce losses after investing in securities backed by sub-prime loans
5 July: Peter Wuffli, UBS's chief executive, is ousted following $124m of sub-prime losses at its Dillon Read hedge fund
9 August: BNP Paribas freezes $2.2bn of funds because of sub-prime losses. Inter-bank lending dries up and overnight borrowing rates soar. The European Central Bank injects €95bn of one-day funds into money markets; US Fed and Bank of Canada also add liquidity. German authorities organise rescues for two regional banks
13 September: Bank of England support for Northern Rock causes a run on the bank that stops four days later when the Chancellor guarantees deposits
30 October: Stan O'Neal, chief executive of Merrill Lynch, is ousted after revealing $8.4bn of quarterly writedowns
4 November: Citigroup's chief, Chuck Prince, leaves after the bank takes a $8bn-$11bn hit from sub-prime writedowns
12 December: Bank of England, ECB, Fed and other central banks take unprecedented co-ordinated action to boost liquidity
22 January 2008: Governor of Bank of England calls on UK banks to raise more capital
16 March: Bear Stearns is sold to JPMorgan to stop it failing
19 March: Bank of England and FSA reassure market after rumours about HBOS send its shares down 17 per cent
22 April: RBS announces £12bn rights issue. HBOS, Barclays and Bradford & Bingley follow, announcing £8.9bn of capital raisings
14 July: Alliance & Leicester sells out to Santander, saying market turmoil makes future too risky