The Financial Crisis: An End in Sight?

While the U.S. Congress was desperately scrambling to salvage its bailout plan, a panic-inducing chill went through the spine of the financial markets this past Monday, September 29 – as specialists and laymen alike are still struggling to come to terms with the finer points of this ongoing crisis.

How exactly did the massive issuance of mortgages to financially vulnerable U.S. households send the worldwide financial system into a tailspin? Some $1.8 trillion in so-called “subprime” mortgages were granted between 2004 and 2006. Based on the assumption that an unprecedented 25% of these loans will fall into foreclosure and the properties put up for resale for a mere 50% of the original value of the mortgage, total losses would amount to $225 billion.

But as of August 27, 2008, banks, insurance companies and other financial players had already reported losses of US$436 billion. (Canadian financial institutions accounted for only $11.6 billion of this total, half of which is attributable to CIBC).

And European banks, which never ventured into the subprime market in the first place, have reported greater losses than their U.S. counterparts ($181 billion versus $140 billion).

Clearly, subprime mortgages are not the cause of the financial crisis but one of the triggers and are, quite possibly, only the tip of the financial iceberg. For modern finance has transformed debt into a convoluted collection of complex, esoteric instruments that are traded on virtual markets and whose values fluctuate constantly, depending on supply and demand.

Automobile loans, credit card balances and other consumer debts ($3.5 trillion), commercial mortgages ($1.7 trillion) and corporate bonds and debts ($17 trillion), like subprime mortgages, are often grouped together into tranches according to projected returns, level of risk and maturity dates. These tranches are then sold to investors, banks, investment funds, pension funds, hedge funds and other players around the word, in accordance with their investment strategies and tactics.

In addition, these credit tranches can be backed by credit derivatives to protect them against borrower default. This is where things get particularly complicated.

Since the value of these “products,” i.e., loan tranches, credit derivatives, etc., is contingent on supply and demand, those who hold these instruments must account for them on a mark-to-market basis. Regardless of the value of the underlying assets or the fact that the product will achieve its full value upon maturity, these products must be reported in quarterly or other financial statements as a loss if the corresponding market, as of the reporting date, is down. As a result of these mark-to-market accounting rules, the losses that appear in financial statements are unrealized losses, since it is possible that at a later date (3 months, 6 months, 12 months, 3 years, 5 years, etc.) these “losses” will have to be reversed, in whole or in part, if the market takes an upswing.

When the outlook for these markets turns negative and extremely prudent buyers are seeking high returns, banks and other investors must immediately claim enormous accounting losses due to the rapid drop in the value of the assets they hold. These losses trigger margin calls (i.e., the need to add warranties or pay additional amounts to guarantee the solvency of a derivative product that has suffered a dramatic drop in value) and a decline in the capitalization of the corresponding institutions. This makes them more vulnerable, exposes them to the risk of violating their regulatory obligations and forces them to seek out additional capital in a challenging market. Thus begins a downward spiral.

Because all markets for these new products (not just the subprime sector) are vulnerable to uncertainty, their value falls dramatically. But the total amount of these instruments held by investors and funds of every type is astronomical, exceeding $20 trillion.

One of the technical causes of the financial crisis – over and above greed, the lure of financial gain, the indefensible lack of regulation of credit derivatives and the arrogance of so-called “financial geniuses” – is the widespread use of mark-to-market accounting principles. Although this approach is appropriate in some circumstances, its impacts on the market that financial “engineers” have constructed for us have been unexpected and detrimental.

The bailout bill defeated by the U.S. Congress on this Black Monday, September 29, 2008, contained two interesting provisions in this regard. It granted the head of the U.S. Securities and Exchange Commission the authority to suspend mark-to-market accounting for any category of transaction, where warranted by the public interest. The bill also required the impact of this accounting rule on financial institutions to be studied and accounting measures better adapted to current financial markets to be proposed. It is highly probable that the final version of the bill will contain similar provisions.

Why the need to act immediately?

U.S. authorities are under a great deal of pressure to act swiftly and more boldly than ever for several reasons:

• Widespread pessimism has resulted in significant drops in market value across the board, not only in the subprime sector, but even in markets that are still solid and are showing no increase in payment defaults, no significant rise in bankruptcies and no other signs of imminent danger.
• These virtual losses have led to bankruptcies, mergers and the nationalization of financial institutions around the world. They have eroded the capital base of financial institutions, which in turn hampers their ability to issue corporate and consumer credit.
• A credit crunch of this nature would have tremendous repercussions on the state of the economy and, consequently, the financial situation of corporations and consumers.
• All of these financial instruments (other than subprime mortgages) that are falling in value because of widespread pessimism would see their market value drop even further should there be a sudden plunge in the quality of their underlying assets.
• The markets for these other products are enormous. The additional losses that would be incurred by financial institutions of all types would have a disastrous effect on the global economy.

The challenge facing authorities in the U.S. and around the world is to prevent this scenario from occurring. They need to control the contagion and brace for the approaching tsunami by vigorously fighting against the credit crunch at the corporate and consumer levels and finding ways of minimizing accounting losses. Here’s hoping that they are successful in their efforts.

After that, however, is when the real work will begin. We need to overhaul the financial system – which has become little more than a black market, accurately identify the causes and culprits of the current crisis and put the financial markets back in their place – as a tool serving industry and society as a whole.