The global economic storm clouds continue to gather. To the credit crunch caused by banks not wanting to lend to each other, is now added the concern that highly specialized US insurers are in danger. The “monoline” insurers who cover bond investors against the danger an issuer will default are facing billions of dollars of claims, because they have guaranteed securities structured around subprime property loans.
Some of the monoline insurers, while apparently having adequate capital from a regulatory point of view, may not be able to meet these commitments. As a consequence, credit agencies have cut their ratings for monoline insurers. This, in turn, has undermined the perception of the bonds — many of them straightforward municipal bonds — by investors. Prices have fallen and the cost of issuing new bonds risen. It is interesting that these monoline insurers should find themselves in this position. For much of the last 30 years, these specialist firms have been making a steady, if unspectacular, living from the bread-and-butter business of local government finance. Then they were attracted by the securities created from “sliced and diced” subprime debt.
But, as with so many other players in the financial crises that underpin the present economic difficulties, it was the abandonment of prudential controls, proper credit assessment and rigorous risk management that have done the damage. Because financial institutions were under pressure to boost revenues dramatically, year on year, the frenzy to find profitable investments overruled plain common sense, let alone internal risk controls. Because every institution was chasing the same sort of high-yield products, they each helped sustain the market. When confidence wavered, they all rushed for the exit at the same time, actually precipitating the crash. In every financial crisis throughout history, the troubles have begun when people convinced themselves that markets were subject to neither gravity nor reason and would continue to rise inexorably.
The contagion of fear that drives recession has not been confined to a single country. Though the Chinese and Indian economies appear to be driving on strongly at present, they will also be, in time, hit by the downturn, because this is now a truly global market. It, however, throws up an important question. The financial scandals of the last decade have prompted a wide-ranging series of new regulations embracing accounting, corporate governance and capital adequacy. But the greatest part of these has been national. When economists analyze what went wrong this time, they may well find that too many different jurisdictions and differently enforced rules allowed financial lunacy to go unchecked. They will also discover that the reason the markets ran scared from securities built on subprime mortgages was that these instruments were so complex, very few people actually understood them in detail — hence the panic to get rid of them at any price.
