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The roots of the crisis

For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in the value of housing would generate a paper loss of $5.75 trillion. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion reduction in total consumption - a modest amount compared to US GDP of $15 trillion. We should have seen a serious impact on consumption, but, there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but did not by itself turn a housing downturn into a global financial crisis. There is no basis on which to say banks were too leveraged in one year but were safe the year before; how leveraged a bank can be depends on many factors, most notably the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, today's crisis was not a foregone conclusion.

There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years. The second path is more dangerous. If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading

to major, abrupt changes in liquidity and asset prices. These credit panics can be selffulfilling; fears that assets will fall in value can lead directly to falls in their value.

A crisis of confidence

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998. For countries then, read banks (or markets) today. In both cases, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession. Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves. Their currencies fell sharply and their creditors suffered major losses.