The Credit Crisis: the Mother of all Crises?

It won’t have escaped anyone’s attention that we are in the middle of a credit crisis. But what is the extent of the problem? The figures are not readily available. A search provides us with the results presented below. On the one hand they are encouraging; on the other hand they are alarming. I need an escape clause: no one can derive any rights from the figures listed below, nor can I guarantee that all the estimates are correct.

If you are searching the internet yourself be aware that the Anglo-Saxon use of large numbers is different from the Dutch. The Americans and the English use million (6 zeros), billion (9 zeros) and trillion (12 zeros) where the Dutch use miljoen (6 zeros), miljard (9 zeros) and biljoen (12 zeros)

The US housing market has a value of about $10.5 trillion: an estimated $1.5 trillion in subprime mortgages (or junk home loans), $2.5 trillion in Alt-A mortgages (rated just above subprime) and $6.5 trillion in prime home loans (ordinary). Currently the default rates are estimated at 25-30 per cent, 12-15 per cent and 2-4 per cent respectively. This means that there are no payments for a maximum of $1.1 trillion of mortgages. This doesn’t immediately make them worthless because there is some revenue in foreclosure. The real loss is estimated at $500 billion.

Unfortunately this is not the only debt faced by American households. The combined car loans and credit card debts are substantial at about $2.6 trillion. It is estimated that $50 billion are irrecoverable debts. Depending on the developments in the American economy, this estimate could be on the low side.

On top of this there is also $3.4 trillion in debts for commercial real estate financing. Here, a loss of $180 billion is expected. Depending on economic developments this estimate could also be too low.

All in all the loss is estimated at over $700 billion. It is difficult to judge the exact situation in Europe at the moment. The American financial institutions (banks) have already written off about $500 billion in losses. In Europe this figure is around $200 billion. In addition, banks worldwide (but in America and Europe especially) have received $700 billion in new capital. From this perspective the worst seems to be over, at least from a macro perspective because individual institutions could still be in trouble.

But this is not all. We still have the Collateralized Debt Obligations (CDOs). For a brief explanation of CDOs read my ‘black sheep’ column. This CDO market has an estimated value of $2-4 trillion. During the last few years financial institutions have lodged inferior mortgages, such as subprime and Alt-A mortgages, mainly with pension schemes, hedge funds and investors in these CDO constructions. However, the value of the subprime part of these CDOs is unknown. The darkest scenario for the CDO market is a default rate equivalent to the value of the subprime mortgages, say 30 per cent, and a final loss of 100 per cent. This would imply a loss of $600 – 1,200 billion. We cannot simply add this to the $700 billion loss, though, because then we would be counting an important proportion of this loss twice. The only thing we don’t know is how much will be left over. It is possible that here, too, this loss can be absorbed completely at market level, but for individual parties it could mean that the products they have bought have no value any more.

Lastly, it should be mentioned that substantial losses could be suffered in the Credit Default Swaps (CDS) market. Participants in the CDS market trade in the risk that a debtor is in default. This risk is transferred to a party in return for a premium, the default swap rate. This is usually a small percentage of the principal of the loan for which insurance is wanted. The worldwide value of this market is $58 trillion, of which $15.5 trillion is from the American market. This calculation is a bit strange because in this market the total values of the insured obligations are added together. These CDS are mainly entered into via CDO. If the CDO defaults, the CDS holder can claim compensation for his loss. If the insurer cannot pay the compensation, the insured party will suffer loss. The estimated losses in this market are $250 billion. Altogether the losses are close to $1 trillion.

All things considered, these are substantial amounts. However, the numbers are not as problematic as they may initially seem. Financial institutions have already devalued an important part of these products and supplemented their reserves, also thanks to government support. It appears that in that sense the financial system could do with some more breathing space. One reservation of course is that the real losses will not be very different from the losses estimated above. In addition, there are at least two other factors related to the crisis that could hinder its recovery. The CDO market is part of the much larger Asset Backed Securities (ABS) market. This market operates in a similar way to the CDO market, except that a variety of other financial assets are also used as security. The ABS market could still get into difficulty and because of the size of this market many more billions in losses could be expected. This market might not get into difficulties as easily because it deals mainly with assets other than the subprime mortgages. Secondly, the domino effect could hinder recovery. Financial parties such as hedge funds that hold strongly devalued securities, but that will still have to meet short-term obligations, could be forced to sell these securities. This would create further price pressure on the financial markets, which in turn would hit banks, insurers and pension funds, to name but a few, in their reserves. This would affect the fragile recovery of the financial markets.

Finally, there’s one more instability in the world economy to be pointed out. The prolonged, extremely low interest rate in Japan (0.5 per cent) has led to a huge demand for yen. These are then converted into different currencies and lodged elsewhere at a higher interest rate, or used up (as was the case in Iceland). Once the yen loan matured, the trick could be played all over again. This so-called carry trade boomed, but because of the recent increase in the exchange rate of the yen this attractive form of arbitrage has come to an abrupt end. Now that the yen is higher, much more local currency has to be exchanged to cover the yen debt. If the debtors cannot meet their obligations, there will be more loss for the parties that loaned the yen.

I wouldn’t dare to give a firm answer to the question of whether or not the worst is behind us. On the one hand, the worst seems to be over, but on the other we have to acknowledge certain threats. One thing is for sure, it is the biggest credit crisis we have ever had.

Oscar Couwenberg

Professor of Law and Economics