ORIGINS AND POLICY RESPONSE TO THE CREDIT CRUNCH IN NORTH AMERICA

The global financial system has suffered a severe and virtually unprecedented blow, leading to the failure of a number of major institutions and forcing government intervention on a massive scale in a number of countries. This is a shocking development that reflects the fallout from acute economic and financial imbalances that had developed in the first half of this decade.

U.S. housing boom and bust…

Many view the financial calamity as a made-in-America event caused by a U.S. housing bubble created by inappropriate mortgage loans and high risk mortgage products. Through securitization and a variety of complex structured products, these mortgage loans were transferred from the balance sheets of lenders to investors around the globe. As a result, when the value of these financial products plunged, it created a global financial problem. There is a great deal of truth to this summary of events, yet it only tells one part of the story.

The true origin of the financial turmoil was a credit bubble and an under-pricing of risk at a time when rapid financial innovation outpaced regulatory controls and made risk assessment problematic. The trend was global in nature – it was not a U.S. event, although the degree of imbalance was certainly the worst in America.

In order to understand what occurred, one must rewind the dial back to the recovery from the 2001 economic slump when global income growth soared. This dramatic increase in income lifted the available funds for loans and investment. It also led to a dramatic shift in the terms of trade balances between countries, as best illustrated by the growing current account surpluses in Asia and the deficit in the United States. The world became awash in liquidity, with funds chasing any opportunities for good returns.

In many countries, the credit bubble translated into sharply higher real estate prices and abnormally strong returns in equity markets. At the same time, overly accomodative monetary policy in many countries following the tech wreck and the 9/11 in 2001 fuelled spending and investment, while simultaneously creating a quest for yield that pushed investors – institutional and retail – into ever higher risk financial products. This trend was further aggravated by the fact that when investors were not immediately hurt by taking on more risk, they were encouraged to accept even more risk. The result was record low commercial and corporate spreads over government yields. It also fuelled growth in non-traditional financial products, such as financial derivatives and complex structured products, which met the demands of investors by providing higher returns at a time of low traditional yields. Unfortunately, the complexity of these same products made assessing risk more and more difficult. The financial innovation allowed financial firms to increase the leverage of their balance sheets and the rapidly changing times outstripped the ability of regulators to keep pace. Indeed, the traditional regulatory environment was structured to address conventional retail banking, but the problems largely developed in other areas of the financial system, as the new financial products saw the development of a shadow banking system where the ultimate providers of credit to households and businesses were investment banks, hedge funds, pension funds, and other non-retail bank entities.

Many warnings were made about these trends. For example, the IMF Financial Stability Report repeatedly indentified the growing financial imbalances and the pace of financial innovation as matters of grave concern. However, complacency ruled the day.

As with all financial bubbles, it was only a matter of time before a catalyst came along to cause a correction, and that catalyst occurred when a rebalancing of monetary policy led to tighter credit conditions in late 2005 and early 2006.

Credit crunch unfolds

The U.S. housing bubble burst after prices peaked in June 2006, but it was only 15 months ago when the credit crunch erupted that the true financial consequences began to be recognized. Since then, global financial markets have been on a roller coaster ride. The financial losses impaired the balance sheets of many financial institutions, as assets were marked down but liabilities were unchanged. The resulting need to shore up the financial institution balance sheets induced a shift towards cash hoarding. Uncertainty about the financial well-being of other financial institutions also diminished the willingness to lend between financial firms. The combination of these trends caused the cost of funding to financial institutions to jump sharply higher, as evidenced by a dramatic increase in the London Interbank Offer Rate (LIBOR) over government rates. In other words, credit became less available and more costly.

There is a very old analogy that an economy is like a set of interconnected gears or cogs. The financial system is the oil or grease that allows that machine to operate. The credit crunch has been like throwing sand into the machine. The gears are not meshing properly and at times there have been risks that machine could seize up. In order to avoid an economic catastrophe, monetary and fiscal policy authorities have been forced to act. The initial response was principally made by central banks that increased the availability of short-term funding to their domestic financial system and eased monetary policy in an effort to limit the fallout from the financial crisis on the real economy. However, these actions proved inadequate. Eventually, fiscal policy was employed to shore up the financial sector through measures aimed at bolstering the balance sheets of weak institutions.

U.S. efforts to address the financial crisis

A time line of the policy actions in North America to the credit crunch is provided on the final two pages of the report, but it is worth quickly reviewing the key developments.

Due to the deep imbalances in the U.S. economy, extreme measures have been required. Our current tally has the U.S. government, through the U.S. Treasury, providing slightly less than US$1 trillion dollars to address the structural weakness in the U.S. financial system. This has been done through three measures: US$225 billion to nationalize Fannie Mae and Freddie Mac (two government sponsored entities that held more than 50 per cent of the mortgages in the United States), US$50 billion to guarantee U.S. money market mutual funds, and the US$700 billion Troubled Asset Relief Program (TARP) bill that passed through Congress. The latter measure is broadly defined and is aimed at addressing the root of the financial problem – bad assets on the balance sheets of financial institutions that are reducing the ability and/or willingness to make loans. The TARP will accomplish this task by providing capital to financial institutions. For example, it is the source of US$250 billion in funds that will be used to buy preferred equity stocks in nine major financial institutions and a variety of regional banks. There is also an expectation that some of the TARP funds will be directed to buying up some of the dubious-quality assets held by some firms. This policy action is not about bailing out banks from the mistakes of the past. It is about creating the necessary conditions to get financial institutions lending to homeowners and businesses again.

Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has increased the deposit insurance limit on interest-bearing accounts to US$250,000 and fully ensured all non-interest bearing bank deposits until Dec 31, 2009. It also guaranteed new senior unsecured debt (the primary type of debt financing) that U.S. banks issue by June 30, 2009 with a maturity up to three years. The former is aimed at bolstering household confidence that their money is safe, while the latter is to help financial institutions to raise new capital.

On the monetary policy front, the Federal Reserve has responded aggressively. The Fed has slashed the overnight rate to a mere 1.50% and we expect that it will soon return to the 1.00% low that prevailed after 9/11. It has provided enormous liquidity to financial markets through a variety of initiatives that amount to US$2.13 trillion dollars.

The Term Auction Facility (TAF) allows the Federal Reserve to conduct an auction through which depository institutions can obtain funds by putting up a variety of different financial collateral. The TAF has extended US$1.367 trillion in liquidity. Primary securities dealers have been able to access US$218.3 billion in funds through a newly created Term Securities Lending Facility (TSLF) and Primary Discount Credit Facility (PDCF), both of which allow cash to be obtained by putting up collateral. The Fed has also issued $30 billion in loans to help fund the Bear Stearn’s debt buyout by JP Morgan Chase and US$122.8 billion in loans to AIG. Unlimited currency swap arrangements have also been put in place with major central banks abroad, which are designed to be drawn upon if financial institutions in the foreign countries find they cannot obtain needed U.S. dollars during the credit crisis.

Finally, the Fed recently announced a commercial paper facility through which it will provide funding to U.S. issuers of commercial paper through the purchase of three-month unsecured and asset-backed commercial paper directly from eligible issuers. While the rate cuts are aimed at creating a steeper yield curve that should ultimately help boost profitability in the financial system and provide stimulus to the economy, the various other actions are all about providing needed short-term money to financial institutions.

Putting all of these efforts together, the total value of U.S. monetary and fiscal policy liquidity actions amounts to more than US$3 trillion dollars – a staggering amount that does not include assorted other non-Fed or Treasury items like the US$9 billion acquisition of IndyMac by the Federal Deposit Insurance Corporation (FDIC). Financing these commitments will put additional strain on U.S. government finances in the near term, which points to higher U.S. government bond yields and a weaker U.S. dollar.

However, it should be stressed that the ultimate fiscal cost will be dramatically less than US$3 trillion. The Fed’s actions are not spent from the public purse – as they are largely temporary liquidity provisions, with the loans tending to be made and then repaid over short periods between 1-day and 3-months time. The U.S. Treasury’s policies could carry a larger taxpayer burden, but the policy response represents the U.S. government taking an investment position in the financial sector. The fiscal price tag will ultimately depend upon how the financial institutions perform in the future and what happens to the value of the assets transferred to the government.

Canadian policy response

The Canadian policy response to the credit crunch has been much more subdued. The Bank of Canada lowered the overnight rate to 2.50% and we believe that another half point reduction to 2.00% is in store. The Bank also provided additional liquidity to financial institutions through Purchase and Resale Agreements (PRAs) as needed. The PRAs are similar in nature to the U.S. liquidity initiatives in that they give out loans temporarily in exchange for financial collateral. The value of PRAs as of November 6th will be $30 billion.

The Government of Canada has also recently taken action with the announcement that it would buy up to $25 billion in pooled mortgage loans from Canadian financial institutions through reverse auctions conducted by the Canadian Mortgage and Housing Corporation (CMHC). This action provides Canadian lenders with the ability to remove loans from their balance sheets in return for cash at a time that liquidity is problematic. It should be stressed, however, that the risks to the Government are negligible because the pooled mortgage loans are restricted to those that were insured by the CMHC, all of which are prime quality loans. Due to the auction process and the lower borrowing cost of the Government, there is an expectation that the public sector will run a profit on the program.

The policy action is a win-win for both government and Canadian banks. The first $5 billion tranche of the mortgage pool auctions was held on October 16 and the average rate paid by bank participants was 132 basis points above the cost of funding for the Government of Canada, whereas the rate at which banks would have had to borrow from markets was 230 basis points. This illustrates that the government made a positive return on the transaction and the financial institutions received financing at a lower cost than would have been faced through normal channels.

The more limited policy response in Canada is a testimony to the fact that the Canadian financial system has remained on a sound footing throughout the credit crunch. Although financial losses have been incurred due to exposures to U.S. mortgage backed securities and other structured products that have fallen in value during the credit crisis, the impact has been limited and the blow to balance sheets has been limited to a few selected institutions that have since raised capital. The greater challenge to Canadian financial institutions has come from the higher costs of raising capital in global markets and the resulting lower profit margins on many products. This is why the greatest policy efforts have been targeted at increasing access to short-term financing and, with the expanded Canada Mortgage Bond program, medium-term financing as well.

Will the policies work?

The critical issue is whether the policy response will alleviate the credit crunch. These are uncertain times and it is difficult to give a definitive answer. The U.S. measures do appear to be targeted at the root of the problem – weak balance sheets in the financial system. As the government funds are dispersed in the coming months one would expect the financial position of firms to eventually improve. If so, credit should start to flow again and interbank lending rates would decline.

However, it should be stressed that the policies are not a magic wand that will make the problems go away overnight. There is also likely to be significant additional demands for financing from many firms in the coming months, as past credit programs reach their maturity, which could limit the scope for borrowing costs to recede. Moreover, further financial shocks cannot be ruled out. For example, U.S. home prices are still well above their 2002 levels – when the housing boom started – and inventories of unsold homes are running at excessively high levels, both of which point to a further decline in real estate prices in the months ahead. The global economy is headed for a recession, and while this is increasingly being priced into financial markets, there is still a risk that the full extent of the weakness is not anticipated. Financial problems overseas also pose a risk of filtering back to the North American financial sector.

The conclusion is that a close eye should be kept on changes in the cost of funding. In the U.S., the benchmark is the difference between LIBOR and 3-month T-Bills referred to as the TED spread. This captures the difference between what financial institutions charge each other to borrow and the risk free rate of interest. In Canada, the comparable metric is LIBOR less the Overnight Index Swap (OIS) rate. An increase in these spreads indicates greater financial strain.

An alternate Canadian measure that directly relates to banking is the Prime lending rate less the 1-month Bankers Acceptance (BA) rate – as this captures the difference between the benchmark for bank loans compared to the cost to banks to raise short-term funding. A decrease in this measure signals declining profitability.

The evidence that the policy actions are easing the financial distress would be if the above mentioned spreads improve. If this does not occur in the coming months, there would be greater downside risks to the economy and further policy actions would be required.

For those wishes to keep abreast of developments on this front, TD Economics will post a daily tracking of the interbank lending rates on our website at www.td.com/economics starting mid-next week. We will also be updating and posting the North American credit crunch timeline on the web site.

Craig Alexander, VP & Deputy Chief Economist
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