April 2008 | By Francisco Lopez Lubian, Professor of Finance at IE Business School

The subprime crisis, which began with problems of liquidity, is now a confidence and profit crisis with a marked impact on the real economy. The virtuous circle could be turning vicious.

The financial crisis unleashed last summer was previously announced and summarised by reports from international organisations such as the IMF and the BIS. Essentially, the message at the time was: the real economy, fine; but be careful with the excesses of the financial economy.

At present, can we confirm that the crisis is essentially financial or are we in a situation where the elements necessary for a perfect storm have been blown together?

One summary of the facts could be the following:

1) Recent years of expansive monetary policy with negative interest rates in real terms, which has allowed intense growth in consumerism and investment (homes, corporate takeovers) based on significant family and corporate leverage.
2) A widespread development of financial products, especially credit risk transfer (CDS, CLO/CDO), on both a national and international scale.
3) An increase in the securitisation of credits, which has enabled an apparent alienation of risk and profits obtained simply from the structure.
4) The purchase of this securitised debt by investors who were looking for a higher level of profitability than that offered by the traditional markets on a scenario of very low interest rates.

So far, the sequence of events is logical and reveals an intelligent mechanism for generating wealth, used wisely. So, what has gone wrong in the process? The very wisdom aimed at finding a balance between the apparent profitability (not adjusted by the risk) and the real profitability (adjusted by the risk).

Indeed, rating agencies responsible for classifying these structured debt issues awarded the highest scores to securitised assets that included mortgage loans (the sadly famous subprimes) with high risk, since they were only profitable if there was an indefinite and permanent increase in the price of real assets (the homes) which, in many cases, were already overvalued. Furthermore, the said “additional” profitability could only apply if there were no defaults by the debtors (families, occasionally with low resources). It seemed that the said families would always be immune to factors such as increases in interest rates or unemployment. Finally, as on so many occasions, inflation reappeared, the interest rates increased, the growth slowed down, the defaults appeared and… the price of the credit risk was adjusted and caused significant losses among investors, who had invested in securities with a theoretical minimum risk. Furthermore, a certain lack of transparency brought about the odd crisis of trust among the economic brokers, which has simply worsened the situation. The theoretical virtuous circle of the generation of value began to turn into a vicious circle of reluctance and paralysis.

What began as a liquidity crisis became a crisis of trust, in some cases a crisis of profitability, with obvious effects on the real economy. The elements of what could be referred to as a perfect storm have been blown together: a sudden halt to the demand for homes (the usual reversion to the average of any excess demand has become an average blow), unemployment, a fall in consumerism, economic deceleration…

What can be done? The formulas are few and far between, well known and quite difficult: for the shortage of liquidity, massive injections of liquidity from the monetary authorities (how much? Until when?); for the slowing down of the economy, a reduction in interest rates (how much of a reduction?) and budgetary and fiscal ease (with the consequent secondary effects). Perhaps the most complicated part will be to implement the necessary legislative changes to improve transparency in the portfolios of financial investors and the models for valuing the price of the risk and its covers, based on the financial institutions´ need for capital. It would appear that Basle II has a long road ahead.

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