As background to the “flight from risk” which underpins the growing financial crisis in the US and Europe, see the latest annual report from the Bank for International Settlements published in June, especially the chapter on financial markets in the advanced industrial countries. The BIS is a kind of central bank for central banks.
While cautiously stated, it’s not difficult to detect a lot of concern in this report regarding the increased “appetite for risk” which emerged over the past few years as hedge funds and other financial investors piled into very risky US sub prime mortage backed securities and the junk bunds used to fund the recent wave of private equity buy-outs in North America and Europe. It now seems certain that big banks, pension funds and institutional investors will take a hit from the meltdown of the market for these very risky securities, especially since there will be few buyers except at very sharply discounted prices. Banks providing interim financing to stalled private equity buy outs (like TD in the case of the buy out of BCE) may be especially vulnerable. In the final analysis, nobody seems to know just who has been left holding the most risky and illiquid securities – and it seems the US Securities and Exchange Commission is busy trying to find out much is held by the giant US investment banks which were so recently doling out huge end of 2006 bonuses to their senior executives and traders.
The BIS, the Economist and others seem to think that the financial system as a whole will weather the shock since overall bank profitability is high, and the credit risk of most outstanding debt held by corporations and households is low – but one does increasingly wonder. One also wonders why evidently worried central bankers did not call on governments to increase prudential regulation of the financial sector before the crisis hit, rather than extolling the dubious virtues of “financial innovation.”. The unsustainability of a late stage US housing boom based on extremely cheap credit – including “ninja” loans to those without jobs, income or assets, cannot be seen as a surprise. And the same can be said of the wave of private equity buyouts at large premiums over share values.
What may be in the cards next is some kind of orchestrated rescue of hedge funds and banks in the form of establishing a buyer of last resort for high risk mortgage securities and low grade corporate junk bonds. Perhaps that is what the injection of liquidity by central banks yesterday was all about. As in the US Savings and Loan Crisis and the Asian financial crisis, means will be found to socialize the losses to some degree to preserve the stability of a financial system which has, to put it midly, been hugely irresponsible in terms of piling up high risk, low quality assets.
A lot of wealthy investors in the hedge funds will take a well-deserved hit, but we shouldn’t forget the real victims of recent financial excesses – millions of low income US households who have taken on mountains of mortgage debt on houses which are falling in value; and workers who lost their jobs and experienced squeezed wages as a result of buy-outs at absurd values, fuelled by junk bonds.
The financial meltdown may not lead to a crisis in the real economy – but the US is increasingly at risk of recession as the housing crisis deepens, and we can be sure that the flood of cheap money which has underpinned the growing wealth and incomes of the financial elite is coming to a halt.