The Credit Crisis Is Not Limited to the US

(Update, Saturday, September 27, 2008.  As a reminder that credit markets and banks are globally interlinked, note that even as WaMu fell in the United States and was taken over by the FDIC, in Europe the Dutch-Belgium Fortis Group (banking and insurance) was under major pressure and might well fall by early next week.  Major pressure means that market investors have serious concerns about its solvency, which has in turn created a crisis of liquidity.  This should sound familiar, of course.  The ECB has said that it stands ready to release any necessary liquidity but, as with US institutions, liquidity is not the underlying issue, but is instead triggered by both questions about solvency -because no one knows the true value of the complex and now illiquid derivative securities – and actual solvency – because there is a broad understanding that many of those complex and now illiquid derivative securities are backed by mortgages which are not being and will not be repaid.  Fortis is moving to do precisely what US financial institutions are finally moving to do (per the article cited below), which is increase liquid shareholder capital and de-leverage (i.e., reduce the ratio of borrowed funds to shareholder capital) through sales of various assets.  Whether this will reassure investors or whether it will be taken over by regulators remains to be seen.  Institutions worldwide hold mortgage derivative securities, some from the US and some from other places; institutions, particularly government central banks, hold vast quantities of US dollar Treasury debt; these markets in credit are truly worldwide.)

One of the questions that arises watching the Wall Street financial disaster unfold in the newspaper headlines each day is the extent to which it extends beyond Wall Street, extends beyond the US.  Of course, as the credit crunch moves from financial markets in the US to Main Street, without a doubt much of the world will be swept up in the effects – if for no other reason than consumer demand drying up in the US.  But a question is the extent to which financial markets worldwide are already caught up in the credit crisis.  News reports over the weekend indicate that Treasury Secretary Paulson was attempting, while pressing his $700 billion plan on Congress, to persuade other central banks worldwide to follow suit; no word, so far as I know now, on what was said in reply.  But it should be borne in mind that the credit markets in New York and, in particular, London are tightly linked, and much of the derivative business involved in repackaging US mortgages took place in and via London.  The LBH bankruptcy obviously has significant repercussions for the City of London.  And, for those following events beyond Wall Street, the UK financial system is squarely in the middle of crisis.  That is all with respect to the financial markets themselves, without looking beyond to the effects on the real economy. This very short article by Desmond Lachman of AEI is helpful in pointing out where things seem currently to be headed with respect to Europe:

At the beginning of the year, many observers believed that this time around the global economic cycle would be different. As evidence mounted that the U.S. economy was experiencing its worst housing-market and credit-market busts since World War II, many cherished hope that the fundamental strength of the European and Asian economies would prevent them from catching the proverbial cold when America sneezed.

Recent economic data suggest that such “decoupling” was never more than a pipe dream. It now appears that the French, German, Italian, UK, and Japanese economies all contracted in the second quarter of 2008. Meanwhile, the massive housing-market bubbles in Ireland, Spain, and the United Kingdom have all collapsed. These housing busts have taken a harsh toll on economic growth; so have high oil prices and the global credit crunch. Europe is also suffering from the combined effects of a relatively strong euro and the European Central Bank’s tight monetary policy.

Since August 2007, European banks have recognized $230 billion in loan losses—nearly as much as the $250 billion in loan losses that U.S. banks have recognized over the same period. In recent months, European credit creation has ground to a halt. More troubling is the likelihood that the losses suffered by European banks will be exacerbated by an economic slowdown and by the ongoing housing busts in Ireland, Spain, and the United Kingdom.

American banks have not responded to their loan losses by raising an equivalent amount of new capital, and neither have their counterparts in Europe. This suggests that European banks, like those in the United States, can be expected to tighten credit conditions further as they try to repair their damaged balance sheets.

While the impact of high commodity prices on the European economy has been softened by the relative strengthening of the euro, one should not minimize the severity of the oil and food shock, which has contributed to a much tighter monetary policy stance in Europe than in the United States. The European Central Bank, remember, has a single mandate: securing low domestic price inflation.