Cracks in the foundations
The decision of the US Federal Reserve to cut interest rates by 0.75 per cent is as clear a sign of panic on the part of the monetary authorities as we’ve seen since the 1987 stock market crash. It’s not entirely coincidental that it followed a dreadful week on Wall Street, and a couple of awful days on world stock markets while the US was closed for the long weekend.
Still, stock markets have fluctuated quite a bit in the last 20 years without producing this kind of reaction. The really alarming events have been happening in bond markets and, in retrospect, the most alarming happened just over a month ago.*
That’s when Standard and Poors cut the credit rating of ACA Financial Guaranty Corp from A (strong investment grade) to CCC (just about the worst kind of junk) in one move. This event showed the weakness of two of the most important defences against the kind of credit derivative meltdown that market bears have been worrying about for years.
First up, it’s yet more evidence that, when it comes to systemic risk, credit rating agencies like S&P are either asleep on the job or, worse, incapable of performing it. They are fine at the day-to-day job of comparing different assets of the same kind, for example, estimating which companies are more or less likely than others to default on their corporate bonds. But when it comes to assessing the risks of whole asset classes, particularly new and ‘innovative’ asset classes, they’ve proved themselves to be hopeless.
They were caught napping by the Asian financial crisis. In the dotcom boom, they failed to detect the bogus financial structures of firms like Enron and many of the big telecoms. And they have been centrally implicated in the crisis that began with the repacking of subprime loans into bundles of securities, many of which were given AAA ratings on the basis of dubious projections of default rates.
But the failure to detect problems with bond insurers like ACA is far more serious. As I said in the 2002 post I linked above,
The starting point [for a possible financial meltdown] is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) … refuse to pay up.
To protect themselves against such a risk, parties to these deals have insured themselves against the possibility of default with bond insurers like ACA. But what happens if the insurers themselves go broke? This looks very likely to happen. ACA is relatively small, and has just staved off liquidation for a month or so. But the bigger insurers like MBIA and Ambac are also in trouble – Fitch just downgraded Ambac to AA and if the other agencies follow suit, the company will be largely unable to write new policies. It’s hard to believe they can make it through the coming year without being rescued either by the big banks (themselves looking pretty sick now) or the US government.
Suddenly, there are a couple of trillions of dollars of bonds that are less secure, maybe much less secure, than their holders thought they were. If, as seems entirely possible, derivative contracts have been written with these bonds as part of the underlying assets, the amounts at stake could be much larger.
The subprime mortgage crisis, in isolation, seems likely to produce losses of a couple of hundred billion, possibly enough to generate a mild recession in the USA. But the possibility of large-scale failure in bond and credit derivative markets, now all too real, could bring an end to the long period of global economic expansion that began with the end of the last big global recession in the early 1990s.
Note:I’ve made various updates in response to helpful comments
* Just when I began my Christmas break, as it happens.