Credit Crisis: Just how bad can it get?
Have we reached a turning point in the credit crisis with the bankruptcy of Lehman or is this just the start of worst times to come? Sean Farrell, Sean O'Grady and Stephen Foley ask the experts
Wednesday 17 September 2008
Richard Lambert, CBI director-general
I'm not nearly so gloomy as some observers, and I think it is possible to exaggerate the problems and to talk ourselves into making the position worse.
One thing I have learnt is that capitalism is extremely resilient, and it is about destruction as well as creation. If you look at previous financial crises they worked themselves out within a year or two: the Russian debt default; the collapse of Long Term Capital Management; the end of the dot com bubble. All were dramatic, but all of these had little profound long-term effect.
That said, it is true that this is the worst financial crisis since the Second World War, and it will have a definite effect. We've seen a substantial loss of wealth as a result of the decline in the value of property and bank shares. Clearly, the banks' balance sheets are going to have to contract.
That means that there will be less credit available to the real economy, and it will be dramatically harder to borrow than before. If you talk to companies, though, you see that 70 or 80 per cent of their financial needs are met though retained earnings, and they have been through a period of substantial growth.
The period after 1929 and the Great Depression is being compared to the current crisis, but I would say that the problem then was also big policy errors being made by the central banks, allowing the supply of money to shrink. Today we see the Fed, the European Central Bank and the Bank of England taking prompt and aggressive action to pump liquidity into the system.
Nouriel Roubini, Professor of economics
This will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades.
This is not just a sub-prime mortgage crisis, this is the crisis of an entire sub-prime financial system, and at the end of the day it will imply credit losses of at least $1trn (£561bn) and more likely $2trn.
As I predicted months ago, no independent broker-dealer will survive. In the credit default swaps market, $62trn of nominal protection sits on top an outstanding stock of only $6trn of bonds, and counter-party risk – and the collapse of many counterparties – will lead to a systemic collapse of this market.
Hundreds of small banks with massive exposure to real estate will go bust, and the Federal Deposit Insurance Corp will for sure run out of money. Hundreds of US municipalities will go bust. Equity prices in the US and abroad will go much deeper in to bear territory.
In a typical US recession, equity prices fall by an average 28 per cent relative to the peak, but this is not a typical US recession. Equity prices will fall 40 per cent relative to their peak, so we are only barely mid-way in the meltdown of US and global stock markets.
The rest of the world will not de-couple from the US recession. Already 12 major economies are on the way to a recessionary hard landing. All of the G7 economies are now entering recession, while the rest of the world will experience a severe growth slowdown. This financial crisis signals the beginning of the decline of the American empire.
Diana Choyleva, Lombard Street Research
Fears of a financial meltdown are overdone – we have had good news over the past day or so. The fact that Lehman Brothers was allowed to fail has finally spurred Wall Street into action in terms of getting their house in order.
The US suffers from excess debt – it needs to deleverage and it needs to see a shrinking financial sector so banking consolidation is needed. It is a lot better that the market does this rather than the government intervening and distorting and creating further moral hazard.
Banks have acted irresponsibly but the main culprit to blame is central banks because the Bank of England, the ECB and the Fed kept policy rates far too low for far too long. It is not a surprise that this encouraged excessive behaviour by everyone. Central banks did not do their jobs properly. Banks had this huge influx of liquidity and they would have been stupid not to expand their balance sheets. They made a mistake becoming too reckless, but the problem began with central banks.
For government, it is a mistake to intervene in a slumping housing market and to imply there is anything a government could do to stop tumbling house prices.
Such measures won't work and that's the good news – the sooner the UK's overpriced housing market falls, the faster an economic recovery can occur. This is a necessary correction and it would be a mistake to bail out irresponsible banks and buyers who created the mess.
Robert Reich, former US Treasury Secretary
This is the end of the middle of the beginning of the credit crisis. The problem is that no one knows exactly where we are and no one knows because no one knows what the underlying value of some of these securities really is. What we saw beginning last year in the mortgage-backed securities market, when we had a lot of sub-prime securities, was that a lot of bankers thought they were worth much more than they turned out to be. There was a lot of speculation, a lot of indebtedness and not enough regulation and not enough oversight. The outcome of all that is very clear but no one yet knows where the bottom is.
The problem here is a lack of what we might call transparency. Most people because of deregulation over the past 15 years, including by the Clinton administration of which I was proud to be a part, created a kind of casino atmosphere in which almost anybody and any bank could make a lot of money by going deeper into debt, by buying up all sorts of debt instruments, by selling securities to people who didn't even know what was in the securities. In this sort of atmosphere we were begging for some kind of crisis.
The most important thing now is for governments to require financial institutions to be much clearer about what they actually have on their books and what they are selling. Transparency is the name of the game. You cannot have trust if borrowers and lenders simply do not know the value of pieces of paper that have promises on them. Either government is going to bail out and subsidise and insure, or government is going to regulate and make the system honest.
James Montier, global strategist, SocGen
People had misunderstood the nature of what was going on. This was the bursting of a credit bubble. The last time we saw the bursting of a credit bubble in the West was in the 1920s and there was the Great Depression. Japan experienced something in the late 1980s.
That dynamic is very different from the view that this is a market slowdown as expressed by the vast majority of people. We also think this has a very real economic impact and creates potentially a very deep recession. I don't think there is a big enough margin of safety to start buying financial stocks at the moment because no one knows what they are worth. We have to see continued deleveraging, not just in the financial sector. We haven't seen the consumer start to deleverage and that is when things get bad.
There is definitely worse to come. It tends to take years rather than months or days. I don't think we can expect the size of the imbalances that have built up to be corrected in any short period. The big issue is not necessarily the hugely leveraged US consumer but the symptoms of that problem over the natural recourse of that bubble bursting.
Over the past 20-odd years there has been a view that central banks were omniscient. This time it will be a lot harder because if people are suffering from debt revulsion it is not that they can't get access to credit but that they don't want credit. I'm sure the central banks will cut rates and do whatever they can but I'm not sure it will have any lasting effect.
Derek Scott, former adviser to Tony Blair
It is as dangerous as the 1930s. We have had a period of abnormally low interest rates, not just in the US but in Europe as well and you get all kinds of excesses in those kind of conditions. The textbook solution is wholesale liquidations – that is what happened in the 1920s and the 1930s. I think policymakers are going to avoid that but the response is going to be more government support and intervention because the alternative is even worse. You saw that with Northern Rock just as you saw it with the New Deal and to that extent I think some financial institutions over the next five years are going to become the new utilities.
It is going to get very rocky, but there is no way that major institutions holding large numbers of savers' money are going to be allowed to go bust.
In a sense, financial markets have always been seen as casinos, there has always been greed out there and the problem has been that since 1998, if you were trying to put the blame on anyone, one would be Alan Greenspan and secondly would be the single currency which has enabled interest rates to remain too low for too long. In that period, you do get these excesses and lenders and borrowers have both behaved irresponsibly – the basic disciplines of liberal capitalism get undermined.
The problem about this environment, just as we saw in the Twenties and Thirties, is that this period we have had since the 1980s of genuine international capitalism is going to be eroded. People who have been working under these circumstances since the mid-1990s think this has been a normal period and it's been an abnormal period. I think we are going to go back to a period of more government intervention.
Kenneth Rogoff, Harvard University
I hesitate to say where the bottom of this abyss is. I imagine that, absent huge further intervention by governments, the problems are going to radiate out into the economy and the corporate credit markets.
It is not going to end any time soon. On the other hand, governments are going to step in at some point and try to put an end to it but global credit markets are so huge that governments can't guarantee everything.
The worst-case scenario is not very likely. That would be a recession where growth became -5 per cent or -6 per cent across the developed world but governments are not going to let that happen.
Taxpayers are going to get soaked to prevent that from happening. It took a lot of guts to refuse to bail out Lehman Brothers but it was the right thing because it would have meant bailing out AIG [American International Group], Merrill Lynch, etc. The bill would have been staggering and until the credit markets shrink no plan will succeed.
I think the US is going to have a recession similar to what it had in 1983 which was pretty bad, a lot worse than the last two recessions. We are going to see more consolidation. We are in the thick of it here and I hesitate to say where it is going to stop. I think we will see some emerging market sovereign defaults before this is over. It is going to radiate out to the whole system before they [governments] rein it in. They have tried and it has failed.
Sir Howard Davies, former FSA chairman
The landscape has changed radically. There will be a completely different shape to the financial system as a result of this. All the small brokers have now gone. Goldman and Morgan Stanley are not in the same position as Lehman but there are big strategic questions about what investment banking will look like in the future.
Leverage will not be the same because the extension of the Fed's discount window to investment banks will mean a different regulatory environment for those firms.
I have been a bear throughout all this and I have not changed my mind. We are in very unfavourable economic conditions and some of the things that are happening now are just that. It is not complicated, exotic stuff going wrong but banks and insurers are having to write down assets. What we are seeing at the moment is people digesting the fact that we are moving into a recession and financial services businesses will have losses. People thought a recession was a City, Wall Street, Canary Wharf thing and now we are seeing it spread through large swathes of the economy and it is feeding back into financial firms.
It has taken some time because, after 15 or 16 years of growth, a lot of people had assumed it was going to carry on. I don't think it will be a recession where you have massive social problems in the North-east but I think it will be quite long-lived because the effect on financial institutions and the need for them to rebuild their balance sheets will take some time to work through. My assumption would be a longer, shallower recession than we had in the past.
Angela Knight, CEO, British Bankers' Association
I'm fairly optimistic, though that's quite difficult with an event such as this; a situation that hasn't been seen before. This is a time when a certain steeliness and common sense needs to be reasserted.A year from now I believe we will be looking at a much improved position. Some of the traders who have just come back from their holidays will never have seen an economic downturn, if you joined a bank at age 24 in 1992, say, and are 40 now, you would not have witnessed a recession in your professional life.
The UK banks are well capitalised and well run. What we are seeing is a disturbance to the financial system as a result of an investment bank getting into difficulties in the US. What we have is a bubble bursting, and whenever a bubble bursts it is extremely uncomfortable. We saw that when the dot coms collapsed.
We have now banks lending responsibly against sensible criteria, and quite a few of them are taking on mortgages from Northern Rock's loan book as it is run down.
There are lots of observers making assumptions that they shouldn't. Do we really think the banks aren't taking steps to strengthen their capital position? A rumour is still a rumour. Full stop.
As for the bankers being greedy, that's like saying that all reporters write rubbish or that all the media are scaremongers.
My view is that bankers are running large, complex organisations and it is wrong to tar a whole industry with the failings of one institution.
Meredith Whitney, analyst, Oppenheimer
One thing the dissolution of Lehman and takeover of Merrill Lynch will result in, in our opinion, is meaningfully less liquidity within the credit market. With Bank of America fully committed to managing through acquisitions of Countrywide and Merrill Lynch, we can only imagine Bank of America will be more focused on managing its balance sheet than growing it. Other banks are in similar capital management situations.
The impact of such lower liquidity will surely be lower home prices. Since housing price appreciation is the most important variable assumption in mortgage asset valuation, the fact that all banks under our coverage have unrealistic home price appreciation assumptions will in our opinion lead to a protracted writedown and capital pressure scenario for banks well into 2009.
With no hope for the return of the mortgage securitisation and overall liquidity continuing to dry up, we believe that, with fewer mortgages available, few people will qualify for mortgages and homeownership will head materially lower. All this creates a recipe for meaningfully lower US house prices.
The futures market is pricing in peak-to-trough home prices of 33 per cent. The mistaken math is that a 33 per cent peak-to-trough decline would only return home prices to 2002-03 levels when home-ownership was lower. We believe peak-to-trough levels will be far worse than 33 per cent.Similar to how the securitisation market volumes have plummeted since the credit crisis hit, housing prices will likely go through a severe correction. We believe that the magnitude of this housing correction will be beyond that of market expectations.
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