Shock to the System

Shock to the System
Financial markets still reeling from credit crunch

By Wesley Phoa, vice-president, Capital Strategy Research Inc.

The financial system is undergoing a severe crisis. The International Monetary Fund has estimated that aggregate credit related losses might approach $1 trillion. The global system is capable of absorbing that loss, but there will be a significant impact on economic activity in the medium term and on the structure of credit markets over the long term.
There are three stages in the development of a financial crisis. The first is the creation of fragile entities that can be highly leveraged without adequate scrutiny from regulators. This occurred in the 1980s with the development of off-balance-sheet financing techniques, culminating in the launch of the first structured investment vehicle in 1989. The second stage is the creation of bad assets to be held in these entities. This occurred beginning in mid-2005, when aggressive mortgage products and poor loan underwriting started to become widespread in the U.S. The third stage is a shock, or sequence of shocks, causing losses to crystallize and triggering the crisis itself. The recent sequence of shocks unfolded as follows:

  1. June 2006: The cessation of speculative activity in the housing market, ending home price appreciation and leading to the first subprime early payment defaults.
  2. March/April 2007: The demise of virtually all the non-bank subprime lenders, following subprime mortgage losses and the withdrawal of financing channels.
  3. August 2007: The crisis in the interbank and commercial paper markets, caused by balance sheet pressures arising from leveraged buy-out hung bridges, hedge fund failures and structured investment vehicle failures.
  4. October/November 2007: The first solvency crisis, caused by unexpectedly large writedowns, and leading to broad concerns about capital adequacy.
  5. January 2008: Emergence of recession fears in the U.S., as a sharp deceleration in real activity first became apparent.
  6. March 2008: A bout of financial instability, culminating in the near-failure of Bear Stearns; Fed intervention was followed by widespread capital raising.

There has been no widespread credit crunch, but some markets have closed. While private sector mortgage- and asset-backed securities can still be issued, spreads are too wide to make ongoing loan origination viable. The secondary high yield and leveraged loan markets are active, but primary issuance is difficult. And markets for the highest quality credits have recovered substantially: debt can be placed, and while spreads are very wide, absolute yield levels are reasonable.

Understanding losses

Negative headlines will continue. First, while subprime losses are well understood, and alternative asset losses to some extent, ultimate losses on option adjustable rate mortgages and home equity loans remain uncertain. Second, losses on structured credit securities are unknown. Third, a number of non-viable leveraged entities have not yet unwound, but will do so. Fourth, losses related to commercial real estate have not yet been fully recognized. Fifth, economic slowdown will affect companies that recently underwent a leveraged buy-out, and may lead to defaults.
A moderate recession is likely, followed by a disappointingly slow recovery. On the downside, uncertainties remain regarding potential housing and stock market wealth effects. On the upside, the falling US dollar continues to drive both exports and import substitution, providing a helpful boost to GDP growth.

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