IT has been nine months since the subprime mortgage crisis began. In the initial round of writedowns for the third quarter of 2007, banks placed their losses at less than $30 billion. Four months later, banks and securities houses increased the amount to more than $150 billion. And the end is not in sight.

Like falling dominoes, credit cards, auto loans, student loans, Alt A mortgages, credit default swaps, debt auction markets, monolines (bonds insurers) and leveraged buyouts are beginning to go sour.

We are still counting the costs of the ongoing crisis. Estimates range from $400 billion to $1 trillion as the crisis spreads to other financial products. At $1 trillion, this represents 8 percent of the US gross domestic product (GDP) or the total capital of US banks, (recognizing that a portion of this loss is borne by non-US banks and investors). By comparison, the US government spent some $200 billion or about 3 percent of GDP to sort out the savings and loans crisis of the late 1980s.

Sovereign funds

Today, US banks are turning to foreign investors like sovereign funds to rebuild their capital. Since the crisis began, sovereign funds like Temasek of Sinagpore, China Investment Corp. and various Middle Eastern countries’ funds have poured billions into the troubled US commercial and investment banks. Many of these investors have suffered book losses as shares of these banks have continued to plummet. For example, since the prince of Saudi Arabia bought the shares of Citibank at $29 per share, they have dropped to $21.

Since August last year, the Federal Reserve, the European Central Bank and other central banks have pumped more than $400 billion of liquidity into the banking system. This has initially calmed the money market system somewhat, but the underlying situation is not pretty and the interbank lending rates after having dropped has climbed up again. For the first time in over 50 years, the net reserves of US banks with the Fed is in negative balance, meaning they are experiencing a liquidity squeeze which constrains their lending capability. Their capital base is so bruised they are averse to take on more risks.

The initial problem of liquidity has deteriorated to a concern about solvency, so that even if some of these institutions have cash, they are reluctant to lend or trade with each other for fear of insolvency. For example, in mid-March, there was talk that banks were reluctant to take on the counterparty risk of Bear Stearns.

Collapse of Bear Stearns

Liquidity is a temporary shortage of cash due to timing mismatch of cash flow, while solvency is the inability of a company to stay in business because its liabilities are more than its assets. In other words, if the company were to sell all its assets, they would be insufficient to pay all its creditors. On March 17, Bear Stearns had to be rescued through a takeover by JP Morgan Chase at a bargain price of $2 per share, one percent of what it was once worth.

To avoid a recession, the Fed has aggressively cut interest rates six times since September 2007 from 5.25 percent to 2.5 percent this month. However, the equity market is not confident about the effectiveness of the rate cuts. For one, the average US household is so inundated with debt, it is unlikely and unable to take on more debt.

Why is recession such a distinct possibility? Seventy percent of the US GDP growth is consumption-driven, built significantly on credit from housing equity loans. The decline of house prices has shut off this avenue of credit. The fall in US housing price has not ended.

In the fourth quarter last year, the average US house prices dropped 10 percent. Every 10-percent drop shaves off $2 trillion in US household wealth. It was estimated by Calculated Risk Research that if there were no mortgage equity withdrawal, the US GDP would have grown only 3.5 percent in 2005.

Stagflation

Worse than a recession is stagflation—a recession or stagnant economy beset with inflation. In October 2007, in a longer article to be published by Levy Economics Institute, I raised the possibility of the US economy sliding into stagflation when most economists were still hopeful it would avoid recession. The sources of inflation come not only from rising commodities and food prices but also from pressure for wage increases in countries like China and India. In other words, the era of disinflation stemming from China and India that the world has enjoyed is coming to an end.

Recent price indices tend to support the stagflation scenario. US producers price index rose 7.4 percent in the last 12 months, the biggest since 1981; its consumer price index increased 4.3 percent and import prices jumped 14 percent since January 2007, aggravated by a weakening US dollar. The initial price hikes in commodities and food prices have spread across the board to include medicines and other necessities. The inflation specter is reflected in long-term interest rates that have been inching up even as short-term interest rates have dropped dramatically.

Reluctant to lend

This means house owners and firms may not see any decline in their borrowing rates. Banks are reluctant to lend and to reduce interest rates even as their cost of funds decline because they are short on liquidity, are more risk averse, demand higher risk premium, and need to increase profits to rebuild their balance sheet.

For all these reasons, banks, rather than borrowers, may be the major beneficiaries of the interest rate cuts as they begin to enjoy higher interest margins when the yield curve steepens (i.e. the interest rate differential between the long-term and short-term interest rates widen).

Structural imbalance

There are structural imbalances—wealth and income, current account, and financial versus real economy—that cause the crisis.

Over the last three decades, we have witnessed explosive economic growth in many countries but this has been accompanied by an ever-widening wealth and income disparity. In the United States, between 1970 and 2006, the share of GDP accruing to labor dropped from 60 percent to 56 percent while the share of GDP accruing to capital rose from 27 percent to 43 percent.

The same story is found in China, India, United Kingdom, etc. This inequality results in underconsumption for the vast majority of the population and excess savings for a tiny portion of the rich and super rich. For example, the top 25 hedge fund managers in 2006 took home $14 billion in compensation (equivalent to the GDP of Jordan, ranked 95th in the world).

The excess savings of the super-rich individuals and institutions, including sovereign funds, are manifested in excess liquidity that flow into the financial system seeking for investment opportunities, spawning all types of innovations and derivatives to meet these demands. Ironically, the excess liquidity in search of higher yields leads to increased risk taking, reduction of risks premium and asset inflation—all building up to the next bubble.

The second imbalance is the current account imbalance between exporting countries and the United States. In 2006, the US current account deficit reached $800 billion or 6.5 percent of its GDP. This is financed by the current account surpluses of countries like China, Japan, India and Germany. China and Japan together hold 45 percent of the world’s foreign reserves, the vast majority of which is used to finance the US government deficit and the consumption binge in the private sector.

Trade surplus

The US household has negative savings rate. Just as the petro dollars in the 1970s created excess liquidity that found their way to finance the Latin American debt debacle, today the trade surplus from developing countries is used to finance the housing bubble in the United States.

Finally, the financial sector has come to overshadow the real economy. Thirty years ago, financial wealth equaled the world GDP. Today, it is three times the world GDP. Foreign exchange transactions that originally facilitated real economy transactions like trade, services and investments have grown many times over the real economy, taking on a life of their own.

Explosion of derivatives

For example, the total volume of world trade in 2006 was $13 trillion, but the volume of traditional and derivatives foreign-exchange transactions amounted to $5 trillion a day. This explosion of financial derivatives and transactions has contributed to volatility and instability not only in the financial markets but also in the real economy. Given the size of the financial sector and its multiplier effects, what happens there has profound implications for the real economy as we witness today.

George Soros, a master at these games, calls it the worst crisis in 60 years and suggests that “market fundamentalism” has failed and some kind of correction and reforms are needed. Unfortunately, Soros did not follow his incisive analysis of market fundamentalism with suggestions for fundamental reforms. These could include recent calls for reforms in the incentive system that rewards financiers upfront for the risks they take.

More fundamentally, reforms should take into account the risks that these individuals and institutions externalize. Moral hazards exist because governments have been cleaning up financial excesses caused by the financial industry, resulting in privatization of gains and socialization of costs. High taxes should be levied on speculative incomes and capital gains like the proposed Tobin tax on speculative capital flows.

Other fundamental reforms should address loopholes in off-balance sheet activities and penalize nontransparent financial activities in the tax havens of the world. It is morally indefensible when the super rich such as partners of private equity funds set up in tax havens pay less tax as a proportion of their income than their cleaning ladies.

(Michael Lim Mah-Hui wrote in the Nov. 18, 2007 issue of Talk of the Town about the roots of the subprime crisis. He worked for more than 20 years in various international investment, commercial and development banks like Credit Suisse First Boston, Deutsche Bank and Chemical Bank (now JP Morgan) and Asian Development Bank. He is now a senior fellow at the Asian Public Intellectuals Program of the Nippon Foundation. He can be reached at limmahhui@gmail.com)