ANALYSIS:The extent of the threat was outlined yesterday by former chairman of the Fed Dr Alan Greenspan, notes Paul Tansey. The US financial crisis is shaping up to be the worst since the second World War, he said.
THE LIFEBOAT launched by JP Morgan Chase and propelled by Federal Reserve Board funding has saved Bear Stearns, the fifth largest investment bank in the United States. But it has also demonstrated that the US subprime lending crisis has lost none of its toxicity. It continues to pose a substantive threat to the stability of the US financial system.
The extent of that threat was outlined yesterday by former chairman of the Fed Dr Alan Greenspan. The current US financial crisis is shaping up to be the worst since the second World War, Dr Greenspan said.
Moreover, the casualties of this crisis will not be confined to the United States. The US is the world's largest economy, accounting for over one-quarter of world Gross Domestic Product.
A downturn in the US spells economic trouble for the global economy. It poses particular difficulties for Ireland, since the US is Ireland's largest single export market and its principal source of foreign direct investment. Since last August, the Fed - the US central bank - has been struggling to shore up the US financial system from the ravages inflicted by unwise subprime lending. There was nothing sophisticated about sub-prime lending. In a bout of excessive exuberance, an array of US banks gave large loans to poor people to buy houses at low "teaser" mortgage rates. Often, the buyers' credit histories and their ability to repay the loans proffered were not even checked.
Banks dispensed such loans carelessly because they did not intend to keep them on their own books. Instead, they packaged them up and sold them on at a profit to other banks. Such securitisation of loans was a form of financial alchemy; loans that were dodgy in the singular became gilt-edged assets in the plural.
Unsurprisingly, many of the poor people who took out these mortgages have been unable to meet the repayments, especially when their "teaser" mortgage rates expired. Many have defaulted already and many more will do so this year.
Nobel prize winner in economics, Dr Joseph Stiglitz forecast in these columns a fortnight ago that some two million Americans would lose their homes this year, primarily through foreclosures. Further, he anticipated that US house prices would ultimately fall by some 25 per cent.
These toxic loans are now languishing as supposed assets on the balance sheets of banks across the world. For financial globalisation - the increasing integration of international financial markets - has allowed the virus of bad subprime loans, originating in the United States, to be transmitted internationally.
Financial markets operate on trust. Bankers make loans in the expectation that those loans will be repaid with interest. However, the subprime crisis has undermined trust in financial markets, even amongst banks themselves.
The scale of bad subprime loans is unknown - though it is some multiple of what has already been admitted - and their location is uncertain. Banks have become increasingly worried about their lending, not only to customers but to other banks. In this way, the subprime crisis spawned the credit crunch. Even with interest rates cascading downwards in the US, credit has tightened.
The Fed is now fighting a war on two fronts. On the first, it is battling to maintain the stability of US financial institutions, effectively by pouring liquidity into the financial system and by easing access to the credit it provides to financial markets.
On the second front, it is seeking to prevent the US economy from descending into recession by cutting the cost of borrowing. Already, it has reduced its key Federal Funds Rate from 5.25 per cent last summer to a current rate of 3.0 per cent. When the Fed meets today, interest rates will be cut further, by a minimum of three-quarters of a percentage point to 2.25 per cent.
However, the expansionary economic impact of cheap money on borrowing and spending within the US is being offset in significant degree by the unwillingness of the banks to lend. Fear is the key to understanding the US economy in its current phase.