Back on the true origins of the crisis

More than 4 years after the official start, now where everyone wonders how we will emerge from this ongoing crisis, let’s come back for a moment on the true origins.

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First major cause of this crisis that helps going back to the end of the last century, long rates kept to abnormally low levels in an environment of abundant liquidity poorly allocated. Three reasons for this crisis that actually goes back to the early 2000s with the development of Chinese economy in big part, carrying serious imbalances.

- 1/ First of all, we live in a world of excess savings over investment worldwide, mechanically leading to a sustained downward pressure on long rates

- 2/ Then the second strong reason (translation of the above reason) that maintains long-term rates at low levels is that Western government deficits continue to be funded (we say "monetized" in Europe) by the central banks of emerging countries and oil exporters for the reasons we know: we must prevent the currency of some emerging countries from appreciating against the dollar in particular, to remain competitive

- 3/ Finally, long rates could not look back for a third reason: the monetary policies of major central banks will remain permanently too expansionary and that naturally leads investors around the world to build profitable conversion positions (government bonds purchases refinance with short term borrowing at low rate)

Second major cause of this crisis-and of course a consequence of the first too low long-term rates led to the establishment of an uncontrolled financial engineering. The crisis was fueled by an environment of low interest rates and thus attractive financing costs to open investment positions (accommodating monetary policy, low government bonds rate with global liquidity, credit spreads paying very little corporate risk).
Traditional investment products paying less and less and profitability requirements remaining unchanged, it was necessary to use financial innovation to make sophisticated and complex structured products with Enhanced Return easily refinanced. It has been a generalization of the debt (the leverage) to meet the constraints of profitability.

While the crisis started officially in July 2007 with the finding of excess mortgage debt of insolvent American households and transformation of toxic debt of these households into packaged structured products (toxic securitizations with varying degrees of leverage ) by investment banks and sold to investors worldwide.
Then the crisis will take many faces through or because of a series of risk transfer

  • First, a securitization crisis that transforms into a banking crisis. Indeed, assets impairment generated by holding these positions threaten some financial institutions from bankruptcy.
  • States already indebted badly, will recapitalize number of banks and, in extreme cases, nationalize. Therefore, the banking crisis will quickly turn into a sovereign debt crisis. It will become even less taboo to consider the default of a country from the Euro zone.
  • The sovereign debt crisis that we are now facing, recreates the conditions of a banking crisis in view of the accumulation of government papers in bank balance sheets and the beginnings of so-called orderly depreciation for some of them . And we are now at the point where there is no more solution, at least in conventional solution.
Interbank exchanges are paralyzed because, as banks do not lend liquidity anymore to each other under normal conditions. After all, who is the more wary of a bank? Inevitably another bank
Mory Doré

We must therefore rely on the lender of last resort, in this great economic and financial system, the central bank to replace the interbank market since it does not function normally. Interbank exchanges are paralyzed because, as banks do not lend liquidity anymore to each other under normal conditions. After all, who is the more wary of a bank? Inevitably another bank.

We must also rely on a buyer of last resort, still the central bank to refinance outstanding debt of some important states in the euro zone (the size of outstanding Spanish and Italian debts cannot be funded by the EFSF whose resources are borrowed and therefore limited; while the refinancing through money creation by the central bank is technically easier because by definition limitless. Even today, in Europe, one comes up against a strong political constraints, German opposition to this type of monetization.

We will see in a future article that this opposition will quickly change into a principled opposition under the pressure of events and that central banks in general and the ECB in particular will become the trashcan of the international financial system, real bad banks in some way since one will benefit from their dual specificity:

- 1/ they are the only financial players with some of their liabilities (debts) not payable, by creating money, the central bank issued debt on its own that is non-refundable in any case as the currency issued is accepted as a means of exchange, payment, transaction and reserve. We cannot for a moment imagine that it is any other way because the economic agents that we are all, have no other choice.

- 2/ In addition, they are also the only players indifferent to the mark-to-market (valuations) of the assets they hold in the case of market value loss, there is no need to recapitalize them as normal banks; we just have to write a provision for liabilities in the balance sheet as we know so well how to do it in finance.

So, as long as there will, we will be saved and can sleep peacefully.. And central banks, it as long as there will be central banks, it will always be tempting for political and business leaders to ask them to pay their mismanagement, their inconsistency or incompetence. We will see however that in Economy, albeit often less complicated than some would have make us believe, things are still not that simple. And the financial system cannot rely forever on the buyer and / or the lender of last resort.

Mory Doré , November 2011

Article also available in : English EN | français FR

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Mory Doré’s column About the author

Financial market professional active on various fields for more than 20 years, Mory Doré is a key advisor of his company on portfolio and risk management for various financial institutions. In addition, he is also a trainer, teacher and (...)

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