Over the past 20 years major financial disruptions have taken place roughly every three years, starting with the 1987 stock market crash; the Savings & Loans collapse and credit crunch of the early 1990s; the 1994 Mexican crisis; the Asian financial crises of 1997 with the Russian and Long-Term Capital Management events of 1998; the bursting of the technology bubble in 2000; the potential disruptions of the payments system after the events of September 11 2001 and the deflationary scare in the credit markets in 2002 after the collapse of Enron.
This record suggests that by 2007 the world had been overdue a major disruption. Sure enough the problems of subprime mortgages – initially seen as a confined issue – went systemic as the market began to doubt the creditworthiness of even the strongest institutions and rushed to buy US Treasury debt. Financial crises differ in detail but, just as there are plot cycles common to literary tragedies, they follow a common arc.
First there is a period of overconfidence, rising asset values and growing leverage as investors increase their faith in strategies that have enjoyed a long run of success. Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies. Third, as investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy. Eventually – sometimes in a few months as in the US in 1987 and 1998; sometimes over a decade, as in Japan during the 1990s – there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.
Only time will tell where we are in this cycle. There have been some signs of returning normalcy over the past week, but we cannot judge whether they represent a false spring or the end of a crisis phase. There may be further shoes to drop in the financial sector. The impact on consumer confidence and spending that has driven US expansion over the past several years remains unknown.
While it is too soon to draw policy lessons, we can highlight questions the crisis points up. Three stand out.
First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default. There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that – as in previous financial crises involving Mexico, Asia and Enron – the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? What is the alternative? Sarbanes-Oxley was a possibly flawed response to the problems Enron highlighted in corporate accounting. What, if any, legislative response is appropriate to address the ratings concerns?
Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve’s payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments. Central banks that seek to instil confidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?
Third, what is the role for public authorities in supporting the flow of credit to the housing sector? The lesson learnt during the S&L debacle was that it was catastrophic to finance home ownership through insured banking institutions that borrowed short term and then offered long-term fixed-rate home mortgages. Now a system reliant on securitisation, adjustable rate mortgages and non-insured financial institutions has broken down.
I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae, the Federal National Mortgage Association, and Freddie Mac, the Federal Home Loan Mortgage Corp , as they have operated in the mortgage market. But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.
This crisis could have a silver lining if it leads to the careful reflection on these vital questions.
The writer is the Charles W. Eliot professor at Harvard University