The Sub Prime Crisis: Is it worse than we thought?

(Ref: The Economist, dt. 18 August)

If one were to go by the recent issue of The Economist (18 August 2007), things are much worse than we thought. The mess has gone well beyond rash mortgage lending. Banks no longer seem willing to provide liquidity to each other. As the magazine puts it, “It is alarming when the very outfits that exist to supply the economy with credit start to hoard it from each other. At best, this tightens monetary policy, at worst a shortage of cash will cripple the payments systems and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.”

The Economist has also neatly summed up the basic reasons contributing to the crisis. Lenders have indulged in reckless lending because they could easily securitise the loans and sell off the risk to someone else. Logically, risk should be borne by the party which is best equipped to understand and manage it. But thanks to slicing, repackaging and selling of risk, no one really knows where the risk has finally landed. There is fear all around that risks may have ended up with people who least understand them. Illiquid long term securities have been bought with short term debt, leaving borrowers vulnerable to a change in sentiment every time the debt falls due.

Now the markets seems to be adjusting and retreating to a new level of risk. The market jargon for this process is deleveraging. And going by past history that process may not be smooth. Yet, the Economist argues that central banks must resist the temptation to intervene. If at all they intervene, it must be not to save the financiers but to save the rest of the economy from the folly of the financiers. The Economist concludes on a note of warning: “ …anyone who says the worst is definitely over is either a fool or someone with a position to protect.”