Saturday, August 11, 2007

Paul Krugman on the sub-prime lending crisis

Paul Krugman is pessimistic about what is currently happening in financial markets. The crisis in sub-prime mortgage lending in the US has spread to Europe and Asia – batches of these loans have been sold to French and Dutch banks.

Financial markets have suddenly become illiquid – people wish to hang onto their cash. This could be merely a brief scare or it could generate a chain of defaults that might have an impact in Australia given our record private debt levels. It could also just herald a period of tighter money where constraints on macroeconomic growth emerge.

There is not much policy-makers in Australia or overseas can do about these things although the most recent interest rate hike in Australia was probably ill-advised and further increases are probably unwarranted.

Krugman argues:

‘The origins of the current crunch lie in the financial follies of the last few years, which in retrospect were as irrational as the dot-com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowed people without the usual financial qualifications to buy houses, and the eagerness with which investors bought securities backed by these loans. But investors also snapped up high-yield corporate debt, aka junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit — not all at once, but in a series of blows. First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds: two months ago the yield on corporate bonds rated B was only 2.45% higher than that on government bonds; now the spread is well over 4%.

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns, the investment bank. Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow Jones industrial average — the rule rather than the exception for the past two weeks.

But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” — that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C — and those who do have cash sit on it, because they don’t trust anyone else to repay a loan, which makes things even worse.

And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates — and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100%. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults’.

In a time of economic crisis the advantage goes to experienced economic managers. The current difficulties in Australia are a short-term negative but an election time positive for the Coalition.


James Dudek said...

Paul Krugman pessimistic? That's a huge surprise! This guy is the most miserable person alive - he could find a cloud in any silver lining.

It's been no secret that lending in the US has been out of control for the last 5-10 years. There were many visible signs of this to your average Joe - TV advertising basically begging people to take on loans that were obviously questionable, not to mention the daily tower of junk mail that greets residents.

I'd be interested in your thoughts on why the irresponsible banks doing this obviously crazy lending are being bailed out by the government.

Shouldn't they be severely punished by being forced into bankruptcy? Isn't this what creative destruction is all about? What would happen if the Government didn't step in?

conrad said...

One thing that seems to get almost no mention (and evidently james thinks so too) is that people seem happy to let their central banks lend out vast sums of money to irresponsible banks and investors that make bad decisions. Is this good or bad? It seems like a huge risk subsidy to me, and it isn't done in reverse (in recent times), so when you have huge rises in the same markets, no-one sits their selling. I can't help but think that this sort of strategy is worthless (in fact it probably encourages it) for fixing things like reckless lending (although I can understand it for one-off events) -- it reminds me of the Asian financial crisis, and the outcome of that wasn't very pretty.

hc said...

James & Conrad, I think they want to avoid a panic - not to save a couple of small banks. Its a compromise. There are moral hazard consequences of coming to the rescue of bad lenders but serious consequences of a major collapse in confidence in the banking system.

I agree James with your comments on Krugman. He is a miserable soul with too mmuch leftwing ideological purity.

conrad said...

I realize the justification for it. But it seems to me that the banks are making billions (all over the world). THe fact that the share-market has retreated to what it was in April doesn't sound like any big deal or panic to me -- are shares not allowed to go down anymore or do central banks seem to think irrational exhuberance should last forever too?

More importantly, even if individual banks took a few billion dollars in losses, that is hardly going to make them fall over (like they did in the 80s when I seem to remember Westpac almost going broke), so I don't really see why central banks should be subsidizing their losses. A good example here is HSBC, which was one of the first to write off the bad loans it has -- If I remember correctly it just deleted 3 billion dollars of them, and it hardly even dinted the share price.

Sir Henry said...

"...but an election time positive for the Coalition". Meaning, what, exactly?

hc said...

I agree not that well expressed.

I think on balance signs of economic instability and higher interest rates will be positive for the Coalition. They will not be seen as signs of mismanagement - but will raise fears about the ability of inexperienced politicians to handle difficulties. The reason? The disturbances here are clearly external.

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