What began as an aberration in U.S. commercial paper markets six months ago has become much more, affecting financial institutions and individuals world-wide. What will the fallout be?
Consider the origins of the credit crunch. The U.S. housing boom of 2002-06 was creatively facilitated by financial institutions, which made low- or no-equity mortgage loans to individuals of increasingly dubious creditworthiness.
These sub-prime loans were bundled into pools that, by force of numbers, looked diversified. The pools were parked in specially created subsidiaries, off the banks' balance sheets, which financed the holdings of those assets by issuing asset-backed commercial paper. Investors in that paper knew that the underlying assets were above-normal risk, and the return was higher as a result, but they also believed that the pool was diversified.
The problem came when U.S. housing conditions deteriorated and default rates began to rise. The diversification of the pools did not help because so many borrowers began to default at the same time. As questions emerged about the viability of the associated asset-backed commercial paper, investors refused to roll it over, the market froze, and a credit crunch was born.
Even so, it would have been reasonable to expect the disturbance to be temporary, as central banks injected liquidity to keep the system moving. The problem is that the underlying default wave keeps getting bigger.
What may have looked like a temporary liquidity problem in the beginning has become something much more like a solvency problem, and one that - through the desirable property of diversification and globalization of markets - is spreading everywhere.
Consider that, globally, financial institutions have already written off something on the order of $150 billion in assets as a result. This puts the magnitude of this event on the same footing as the U.S. savings and loan crisis back in the early 1990s, which stretched out the period of slow U.S. growth in the aftermath of the recession of 1990-91. But this one could grow much larger still.
Meanwhile, investor risk aversion has clearly increased.
The commercial paper freeze-up has spread to other paper unrelated to U.S. housing, and insurers that have guaranteed these loan pools are under pressure. BBB credits have a spread against U.S. Treasury bonds of 2.25 per cent, up from 1.5 per cent back in August. Junk bond spreads have risen by two per cent during the same period. It will cost companies much more to finance investment spending in the next 12 months as a result.
The same is true for emerging market sovereign bond spreads, which have risen from two per cent to over three per cent since August. This has been led by the likes of Argentina, the Dominican Republic, Pakistan, Poland and South Africa, which are about as far away from a home mortgage default in Florida or Michigan as you can get. It will clearly cost more to finance growth in emerging markets this year.
The bottom line? The credit crunch looked innocent at first, but has become insidious. As economies slow, risk aversion will grow.
The outcome is difficult to forecast - it will depend on a complex combination of economic fundamentals, investor psychology and policymaking.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
