When There's Nowhere Left to Spread the Risk

It will be months or years before the definitive history is written of the mix of factors that led to the great credit market and economic retreat of 2008-09. What's clear already, however, is that the world is in the midst of an event that will change the way everyone who borrows, lends, or invests looks at finance—and risk.

Among other things, the traumas of the past two years are leading academics, market participants, and regulators to reexamine:

the role of structured finance;

financial industry regulation;

the implications of a world financial system that is interconnected to an unprecedented degree;

the proper role of corporate governance in limiting ultra-risky management behavior;

the speed with which burst speculative bubbles can lead to the deterioration of markets and financial institutions; and

the most effective methods of emergency action when unforeseen events threaten to damage severely the entire financial system.

Seismic Shift

Collectively, the lessons gleaned from the investigation of these issues may lead to the most sweeping rethinking of financial practices since the 1930s—and, in our opinion, almost certainly will have a major impact on the way the world's credit markets function.

Much is hanging on the ability of everyone involved to reevaluate risk and reframe the financial system to move swiftly—but more importantly, effectively—to establish a new and sounder order. This will mean successfully tackling a challenge whose complexity is unprecedented.

For example, the number of ways in which a sudden shock—such as a bursting of the housing bubble—can adversely affect the global economy has multiplied, because financial markets are more interconnected than ever before. This increases the likelihood that problems in one country will echo around the world. The current tightening in financial markets and the recent commodity price boom and bust are good illustrations. And we believe that other potential dangers lurk ahead.

Risk Contagion

Indeed, it appears to us that financial market bubbles have become more frequent and arguably more damaging to the world economy. At the same time, the growing globalization of financial markets has allowed imbalances in trade and financial flows to become bigger and persist longer than ever before—which in certain circumstances can elevate risks to the worldwide economy. This means that major economic events may in the future be capable of triggering geopolitical risks.

We believe this simple realization could prompt reassessments of how to deal with—or ideally, avoid—the lockup in credit markets that grew progressively worse starting in 2007. In the past, central banks have said they were not in the business of popping bubbles. They felt that instead, they should manage the economy and overall inflation rate and avoid interfering with financial markets. But the wisdom of the financial markets has come into question, given their apparent disregard for risk in the years leading up to the 2007 liquidity crunch. With dismaying speed, credit markets swung from risk obliviousness to risk obsession, with lenders refusing to loan money to any financial institution that wasn't directly or by inference government insured. This has quickly led to more government support, initially for banks and insurers, such as AIG, which in our view will create a new set of risks as the government controls more of the financial market.

As Bubbles Have Grown, So Has the Global Impact

The need for better strategies to avoid or control financial crises is highlighted by our sense that bubbles are occurring more often than in the past—and are bigger. Often, they seem to occur when interest rates are low and investors are looking for better yields. Perniciously, in fact, periods of stability may lead to bubbles, as Washington University economist Hyman Minsky has argued, because they lead to an underestimation of risk (see John Maynard Keynes by Hyman Minsky, Columbia University Press). The fact that the U.S. economy survived several bubbles without major damage over the past two decades likely made it easier, in our estimation, for the most recent bubble to inflate without arousing what in retrospect should have been more concern on the part of the markets and regulators.

For a bubble to materialize, investors and the markets have to persuade themselves that it isn't really a bubble; if the bubble were obvious, it wouldn't inflate because of concerns over the excesses that create it. But imagine a situation in which the common perception becomes that Internet stocks are underpriced because they can continue to rise at 30% annually. Or that home prices in the U.S. will be permanently higher relative to homebuyer incomes because the country is running out of desirable land or Americans are moving toward a European pattern of higher home-price-to-income ratios. The difficulty is that although a bubble may seem obvious in retrospect, it is often hard to distinguish from a sustainable trend until too late.

Examples of this abound. A commercial real estate bubble in the late 1980s led to the 1991 U.S. recession—which turned out to be moderate by historical standards. At the same time, similar bubbles that occurred throughout the world also proved to be relatively benign or short-lived. But the exception was Japan, whose commercial real estate bubble popped with the Japanese stock market bubble, which at its peak had sent price/earnings ratios soaring toward 50. The problems the dual bubbles created for Japan's financial sector led to that country's "lost decade" of the 1990s, with growth averaging less than 1% per year and prices declining steadily.

Now You See It, Now You Don't

Subsequent bubbles had a mixed effect. The bursting of the global dot-com bubble in 2000 had a minor impact on the real economy; the 2001 recession was the mildest in history (many economists still think it shouldn't have been called a recession). By contrast, the Asian currency crisis in 1997-98 resulted in a regional recession. The difference was that the Asian bubble occurred in exchange rates and thus affected businesses directly as well as through financial markets.

At other times, however, currencies have dropped sharply, with little impact on the global economy; examples include the decline of the dollar in 2002-2003 and the yen in the late 1990s. One major differentiator when it comes to inflicting financial harm is the nature of foreign debt: When a country owes debts in its own currency, the impact of a currency decline is modest or even beneficial. If, however, it owes debt in another currency, the cost of servicing that debt can become a major problem.

The recent housing bubble has been so damaging, in our view, in part because it's a worldwide phenomenon. Home prices rose more slowly this decade in the U.S. than in many other industrial countries. But the way America financed home sales—with very low down payment mortgages and extensive use of securitization—led to a somewhat greater impact on U.S. financial markets than other countries suffered. Nonetheless, the resulting recession is worldwide, with all industrial countries likely to see major GDP declines this year.

"Anything That Can't Go On Forever Will Stop"

That's because international trade imbalances heightened the current downturn. The "glut of world liquidity" that Ben Bernanke, who was then chairman of the Council of Economic Advisers, talked about beginning in February 2005 was very real. The massive surpluses China and Japan and, later, OPEC countries generated had to be invested in something—by money managers who apparently felt a strong incentive to maximize gains at the cost of taking on higher risk, by investing in private rather than government bonds and structured finance instruments.

U.S. investors joined in the chase, not wanting to believe that the 19% annual gains they realized through most of the 1980s and 1990s were a thing of the past. Low interest rates encouraged taking on more risk, both because the safest investments generated such poor returns and because the cost of borrowing was so low. The growth of the "yen carry trade" was the most egregious example, as investors borrowed yen at extremely low interest rates to lend in other countries at much higher rates. This trade was highly profitable for most of the past two decades.

As we have now learned, international imbalances are dangerous because they are not sustainable. As the late Herb Stein, former chairman of President Ronald Reagan's Council of Economic Advisers, said in the 1980s: "Anything that can't go on forever will stop." Heavy net borrowing from abroad financed the huge U.S. trade deficit, with net inflows into the U.S. reaching $1.2 trillion in 2006. At the same time, U.S. external debt rose sharply as a percentage of GDP. With interest rates low, servicing that debt was fairly inexpensive. But interest rates weren't going to stay low forever. And even if they were, there was a practical limit on how much world portfolio managers could invest in the U.S.

Reality Intrudes

In a perfect world, such imbalances can correct themselves without major losses. But the real world is invariably flawed, so this seldom happens. By 2008, the inflows from abroad had slowed to half their 2006 level, which lead to the sharp decline in the dollar in 2007-08. The U.S. wasn't the only one to suffer losses from such rebalancing. We believe that once the smoke has cleared, the imbalances will turn out to have been even more damaging to overseas creditors of the U.S., who will get back far less than they invested as the dollar drops as a result of the unwinding.

Of course, the U.S. isn't the only country with significant long-term trade deficits. Britain, Australia, New Zealand, and India, among others, also have them. On the other side of the ledger, some countries have had long-term surpluses, notably China and Japan. But these are just as unsustainable as the deficits they offset. China's current slowdown has occurred in part because it has used exports as an engine of growth, and that engine is now sputtering because of the recession in the West. Japan, in part because of its inability to generate domestic demand, also has pushed its surplus to unsustainable levels, which makes a recession almost inevitable when external demand drops, as is happening at present.

Trade isn't the only imbalance that can't last forever. Rising use of limited natural resources, including both fossil fuels and water, is another habit most countries won't be able to sustain. Growing populations will exacerbate the problem because they will increase demand for limited resources. While most countries now have birth rates consistent with zero population growth, Africa and the Middle East remain notable exceptions.

Another demographic challenge is the rising proportion of retirees in most industrial countries. Baby boomer retirements will substantially increase the number of retirees relative to active workers. The budget pressures that aging will generate, such as increased pension and medical costs, will require either major reductions in entitlement programs or major increases in tax rates. Although Western countries will feel the effects initially, China will be close behind as its population ages.

Regulation is a Double-Edged Sword

The current financial turmoil likely will exacerbate these trends, creating pressures that will end 30 years of financial and other market deregulation in America and most other industrial countries. But new regulation can create new risks for businesses.

Although we believe the recession shows that deregulation went too far, we worry that reregulation could do so, as well. While some politicians are concerned about excessive regulation, voters are likely to keep demanding measures that will prevent another crisis. The easy answer is to regulate behavior explicitly, including bank lending and private borrowing, which usually means excessive regulation of markets. The degree to which the pendulum swings back will determine how significant the potential damage to the world economy will be, in our view.

One important regulatory issue will be standardization of rules across countries. As financial markets have become more global, the impossibility of regulating them on a national basis has become clear. Individual central banks no longer have as much control over their own financial systems as they once had. Although an international regulatory authority is probably not politically feasible, we think there at least needs to be closer international cooperation between regulatory authorities. For the U.S., this points to a need to streamline the regulatory system: One lesson of the current crisis is that a multiplicity of regulatory agencies makes it all but impossible to coordinate rules within the U.S., let alone globally.

The problems world financial markets face have the potential to become a vicious cycle. Uncertainty about regulation, combined with uncertainty about taxes because of aging populations and mounting deficits, make it hard for businesses to plan. The inability to plan reduces the willingness to invest and may lead to slower long-term growth. And slower long-term growth will worsen fiscal problems.

The Big Chill

That, of course, will increase the risk to taxpayers. One reason for increased regulation is that governments and central banks are taking on more lending risk. As credit markets have reached new heights of risk aversion, central banks and governments have increasingly become the lenders of last resort. Although this has probably reduced immediate damage to the economy, individual citizens could end up paying a large chunk of the tab.

Because the current freeze in credit markets is unprecedented, the full range of new risks that may materialize is still unclear—as is the question of who will bear them. Most previous panics in financial history have ended in a few months. This one has persisted for a year and a half. And the resulting degree of risk aversion is beyond anything we have seen since the Great Depression. This in itself creates risk, because it dries up a ready supply of liquidity that many businesses have relied on to fund their activities. Banks and other financial institutions have been hit hardest by frozen liquidity because many of them depended on wholesale funding, large deposits obtained from other financial corporations rather than direct deposits from retail customers, to support their loan and security portfolios. Once money became scarce, they had to sell off securities at fire-sale prices, worsening the downward spiral.

A sustained failure of credit markets to thaw will create even more risk. As loans and notes mature, borrowers may not be able to renew them at reasonable rates. That alone could lead to business failures, particularly within such highly leveraged sectors as finance and real estate. Some signs of a thaw are appearing, but the ice is still thick enough to cause major problems. And in this era of increasingly interconnected global economies, cracks in the ice could be cause for concern as well as for relief.

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