World braces for subprime fallout

Where might Goldman Sachs Group CEO Lloyd Blankfein bump into actress Emma Thompson on his way to hear U.S. Secretary of State Condoleezza Rice talk about climate change and terrorism? Can you imagine  George Soros and Merrill Lynch Chief Executive John Thain hitting up musicians Peter Gabriel and Yo-Yo Ma for autographs as they line up to see Al Gore and Bono discuss ways to simultaneously fight poverty and global warming? All theoretical possibilities at this week's annual meeting of the World Economic Forum in Davos, Switzerland.

Former U.K. Prime Minister Tony Blair, (now working part time for JP Morgan Chase) and Henry Kissinger and are among seven meeting co-chairs. According to MarketWatch's William Watts, the topic that's expected to dominate discussion is if strong growth in emerging economies will help the rest of the world to "decouple" from the U.S. mortgage meltdown and resulting economic slowdown.*

We shouldn't expect any new detailed proposals for getting us out of this mess, Watts says, but rather a discussion of what went wrong. The big question: is the "originate and distribute" model of packaging mortgage loans up as collateral for complex investments sustainable? U.S. Treasury Secretary Henry Paulson and European Central Bank president Jean Claude Trichet are on a panel discussion Thursday, "Systemic Financial Risk," where they will discuss what we've learned from the subprime crisis. 

Can't make it to Switzerland? You can get "key Davos snippets" on Twitter, watch debates on YouTube, or join the Davos forum group on Facebook.

*Click "continue reading" for a quick summary of the systemic financial risk the U.S. mortgage meltdown poses and its potential impacts on the world economy.

Excerpts from: "Global Risks 2008: A Global Risk Network Report"

Systemic financial risk is the most immediate and, from the point of view of economic cost, the most severe. The financial conditions of the past decade have allowed for an exceptional period of economic growth and stability. But, with so many potential consequences of the 2007 liquidity crunch unresolved, the outlook for the future is more uncertain at the beginning of 2008 than it was a year ago.

A recession in the United States cannot be excluded in the year ahead, and economists are divided on whether domestic-led growth in Asian markets can drive the global economy. In Europe, the impact of economic uncertainty may be highly divergent. The role of the financial sector in the United Kingdom leaves it particularly vulnerable to financial turmoil, while large current account deficits in some central and eastern European economies may prove increasingly unsustainable in 2008. The resilience of the export-led growth of other major European economies may also be brought into question if disruption in the financial markets spreads more widely. Over the much longer term, the dollar may find itself under increasing pressure as the global reserve currency, undermining the geopolitical position of the US and foreshadowing the end of a hegemonic period in global economic history.

...

The increasing complexity of financial markets, and the rate at which financial markets are evolving, make the task of avoiding and managing systemic financial risk extremely difficult. Increasing global interconnectedness has multiplied the possible pathways for the
contagion of financial risk. Layers of leverage may have increased the possibility for magnification of risk. Financial innovation, in the form of complex financial instruments, may ultimately contribute to the opacity of systemic risk. At the same time, however, the increasing importance of the financial sector in the real economy has made the question of
systemic financial risk more important than ever.

....

First, the US housing recession, which began in late 2006, has accelerated, with new housing construction at its lowest level since the early 1990s and house prices down nationally. Second, the world has experienced a crunch in global liquidity, affecting even essentially solvent financial institutions, and raising the prospect of tightening credit as banks are forced to readjust their capital ratios. Finally, the dollar price of oil rose to an all-time high, close to the inflation-adjusted peak of the early 1980s.

But if an eventual global re-appreciation of risk was foreseeable in early 2007, the timing and precise nature of the trigger event was not. In early 2007 many expected that any systemic
crisis would be the consequence of an unwinding of global economic imbalances – notably the US current account deficit. The actual trigger for the current systemic crisis was the collapse of a critical segment of the US mortgage business – the subprime mortgage market. It was widely thought in early 2007 that the main threats to financial stability would come from leveraged hedge funds. But it turned out to be problems related to complex security structures and off-balance-sheet vehicles created by the banking sector that have generated the systemic elements to the current crisis. Predicting what will happen is easier than predicting when and how events will unfold.

The meltdown of the US sub-prime mortgage market and the growing prospect of a global credit crunch dominated financial markets in the second half of 2007. An abrupt evaporation of liquidity and dramatic repricing of risk led to widespread financial instability, ultimately threatening the viability of smaller financial institutions even in well-regulated markets such as Germany and the United Kingdom.

The US Federal Reserve has projected direct losses related to sub-prime of US$ 150 billion; non-subprime financial losses may be considerably greater. As in past systemic financial crises, complacency in credit standards – driven by perverse incentives and moral hazard – lowered risk premiums to unsustainable levels. The periodic underpricing of risk in financial markets may be structural and to some extent unavoidable. But few systemic financial crises are entirely dissimilar to earlier episodes. This suggests room for improvement in the management of crisis including better early warning systems and more coordinated and forceful action by market supervisors and central banks.

Financial crises may never be avoided. But their frequency and severity may be significantly reduced. Is the financial system now more stable and resilient? Some recent experiences – such as the relatively benign Y2K rollover, the very short-lived market disruption following the events of 9/11, and the relatively muted effects of more recent spikes in the dollar price of oil – have led experts to conclude that markets are now more resilient to exogenous shocks. But many would argue that the overall resilience of the global financial system will only become fully evident under conditions of severe stress over the next year.

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