The Credit Crunch Will Go On

The events of Black Sunday (the bankruptcy of Lehman Brothers) and Terrible Tuesday (the forced takeover of AIG) are seen by most observers as either cataclysmic or cathartic; an angry sun setting on decades of "credit" capitalism or the final cleansing of the financial system of its excesses, resulting in swift recovery.

Neither image is accurate. The events of this week are a logical progression in the elimination of credit excesses, marking neither Armageddon nor the beginning of renewal. Unfortunately, this is just another stage in the lengthy adaptation of the market system to a less-than brave new world. But it does allow us to get a glimpse of where we are ultimately heading.

Here are the key events: Two investment banks, categorized as non deposit-taking financial institutions (NDFIs), were in difficulty. One fire-sold itself to a bank (Merrill). The other went bust (Lehman). In the case of AIG, another NDFI, the government has imposed a controlled bankruptcy through nationalization.

The collapse of these NDFIs ought to have been expected. Why? They have much less capital than banks to support losses and far riskier assets. They borrow and lend money using securities (often pledged by their clients) as collateral. As financial markets fall their gearing ratios (i.e., the value of their debt relative to their assets) rise. To maintain a constant gearing ratio, the NDFI has to liquidate assets and pay down loans. This causes financial asset-prices to fall and the NDFI gearing ratio to rise again.

So, the outcome will be a long gray, global recession -- not unlike what Japan experienced after the bursting of its "bubble economy" -- in which policy measures (low interest rates, huge liquidity injections and fiscal spending) will attempt to keep it from developing into a deflationary collapse while the credit system adjusts.

Global recession will also mean further losses in the credit system. This time the losses will be smaller as a percentage of higher quality assets, but will affect much bigger pools of debt (e.g., prime mortgage markets are seven times bigger than subprime, and other consumer debt markets are four times as big). This means that, even with lower loss ratios, potential losses could be as big as subprime losses and destroy as much bank capital, causing further credit contraction.

But all is not gloom. There will be an end, as there is to all things. When we emerge from this it will be to a world in which thrift has replaced leverage and scarce capital is invested more productively.