In the laconic words of a senior IMF official yesterday, “The world economy is tilting to the downside” and a global recession is in the offing. Separately, the G-7 richest countries called on banks to come clean on their exposure to US subprime debt. The hope is that such an analysis will restore the banks’ mutual confidence and get them back to lending to each other. It seems highly probable that such a housekeeping exercise will have been overtaken by other more threatening events in the next three months.
One thing is always certain whenever markets go into sustained retreat. Fools are found out. And such fools can take different forms. They may be banks or businesses that bet the farm in the expectation of great profit, when a more thoughtful manager would have settled for a smaller return for a smaller risk. Recession can also make fools of regulators and politicians, the latter always ready to claim credit for a boom time while blaming any bust on international circumstances entirely beyond their control. Thus UK premier, and for 10 years finance minister, Gordon Brown ignores massive state spending on his watch and parlous banking regulations and insists British financial problems, such as they are, have been imported from the US.
Yet even when everyone is admitting how dangerous markets have become, people still go on taking dangerous risks. JP Morgan’s rescue of fellow US investment bank and subprime victim Bear Stearns looks like a bargain for Morgan. However, both banks are leading sellers of complex loan guarantee products. Combining the two books propels JP Morgan past the top player and gives it fully 25 percent of a multitrillion dollar market. Even in good times such an exposure by one institution would seem risky. Given market turbulence and the probability some of these guaranteed loans will go bad, it might be madness. The chances of Morgan’s being able to sell off part of its exposure, even at knock down prices, seems remote. The real problem facing world markets is that no one could quite bring themselves to admit that the long boom would end. Intellectually, the reality was acceptable but there was always time for one more risky but lucrative deal. It is greed and foolishness that have brought the world economy to this pass. It will be wisdom and common sense that allow it to recover. One challenge is that there are not many senior bankers and businessmen who have experience of the last crash in 1987. Twenty-one years is a long time in business. Many old and painful lessons are going to have to be learned again.
But the basic lesson is this. The globalized financial system developed some highly useful new products — asset securitization is not of itself a bad thing. But those who manufacture such products must guarantee their quality and those who rate them must do a far better job. When securities with some of the highest ratings collapse, the system has failed, through a combination of wishful thinking and avarice.
