The financial crisis that began in the U.S. subprime real estate sector has inspired many investors and financiers to go back to their history books for answers as to how things will finally turn out. One of those people is Alan Greenspan, ex-president of the Federal Reserve. In addition to comparing the current crisis with those of the past, Greenspan told the media that “fear is a much more powerful engine than euphoria.” One reason why many banks have not taken an interest in history is the explosion of innovation in financial markets over the past decade: The rules of the game of finance have been rewritten, and many financial executives have created products that distribute credit risk throughout financial markets, thus altering the way the market works.

Some analysts suspect that a better model for analyzing the current situation would be the events of October 19, 1987, when the Dow Jones suffered its greatest fall in any time of peace. It plunged 22% and the crash spread through stock markets in Europe and Japan. That stock market collapse made clear the interconnection between the world’s various stock exchanges. It took place during a period of widespread fear about an economic recession in the United States.

The country had “an enormous budget deficit in a period when public spending was growing too fast,” notes Jose Ignacio Galan, who heads the department of corporate management and corporate social responsibility at Santander Bank. Galan is also a professor at the University of Salamanca in Spain. “Both [events] took place as a result of an over-indebtedness of the system,” says Manuel Romera, director of the finance department at the Instituto de Empresa business school in Spain. “Now, the same sort of thing has happened, and it is because of an inability to repay high-risk mortgages. Both events took place on a microeconomic level.”

Others compare today’s events with the crisis of 1998, when tempestuous markets in Asia led to the surprising inability of many borrowers to repay the Russian debt. Ultimately, this led to the implosion of the Long-Term Capital Management hedge fund (LTCM). “The 1998 crisis had its origins in the mismanagement of a hedge fund. Now, the crisis involves a product sector, subprime loans. This mortgage market niche represents 13% of the overall real estate market in the United States,” notes Juan Ignacio Sanz, professor of business law on the law faculty of the ESADE business school.

These three crises – 1987, 1998, and today – have something in common. Previously, there were long periods of economic wellbeing that, following human nature, “led investors to feel euphoric and also led to a relaxation in the mechanisms for control,” notes Galan. He adds that these crises are also similar in this respect: Their epicenter was in the United States, from which they spread rapidly through the rest of the world.

Nevertheless, according to both macroeconomic and microeconomic data, unlike the situation in 1998 “the world economy is now very strong. Growth rates in developed and emerging countries are significant. We see how China is raising interest rates in order to restrain growth and subsequent inflation.”

The special nature of the events of August 2007 stems from the existence of financial instruments and techniques, “such as debt derivatives, which did not exist in earlier times,” says Sanz, adding that “you can appreciate how some loans made in Iowa can lead to losses in investment funds throughout the world.” The second big difference from previous crises concerns the behavior of regulators, “who inject liquidity into the system, causing rates to drop, as in the case of the U.S., or to remain at current levels, as in the case of Europe,” notes Sanz.

Indeed, yesterday, the U.S. Federal Reserve cut the overnight lending rate between banks by a half point in an effort to stop declines in both the housing and credit markets. The cut in this benchmark rate — the first cut in four years — was expected, and immediately sent U.S. stocks dramatically higher.

A Crisis of Confidence

Any crisis of liquidity brings with it a crisis of confidence. The current market turbulence has been caused by the fact that banks lack the confidence to loan money to one another. That’s because banks are afraid of being exposed to the problems of the subprime real estate market in the U.S. By extension, this situation threatens to damage other countries beyond the U.S. According to Sanz, “Confidence is something that depends on each of us, which means that you can see how the interventions of regulators have wound up cushioning the fall, while nevertheless not eliminating the fears of investors.”

According to Galan, the European Central Bank should have “acted with more diligence and bluntness so that a limited and relatively insignificant problem did not create a snowball effect that has spread throughout the European economy.” The United States has done a “relatively good” job of dealing with the problem, but in Europe, he says, “markets have not responded. It’s worth noting that European stock indexes are suffering larger declines than U.S. indexes themselves, and have been out of sync with events.” Romera believes that the European Central Bank must “act and behave reliably.”

For his part, Galan suggests that governments “should provide a lot more information — the more information and transparency, the better. They must reveal real data that show that the economy is healthy and it is growing.” Galan advises companies to focus their attention elsewhere. “They must focus on their customers, on their workers, on their suppliers and on their organization; on surviving in the markets and obtaining a sustainable comparative advantage. Ultimately, a company that creates benefits for shareholders and behaves in a way that is socially responsible and ethical will be the sort of company that survives and prevails in the marketplace.”

According to Romera, when investors are fearful and lose confidence, this often leads to “a stoppage in the system, since people are not ready to loan their money because there is growing fear that people will have a hard time repaying those loans.” One essential characteristic of that fear is “it is not controllable.” Its direct consequence, he notes, is “a wave of selling financial assets because of fear that these assets will suffer losses. That leads to an overall drop in stock market prices. For his part, Galan believes that this loss of confidence in financial markets can last “one, two or three months. But what is ultimately going to dictate who is who in the business world is a capacity for innovation, efficiency, organization and competitiveness in real markets.” On the other hand, Romera advises banks and companies to “control their risks very well; to know whom to loan money to, and how far they should go in that process. They have to keep in mind that liquidity crises are something that can occur.”

Not even experts can guess how long the loss of confidence will continue. “Confidence is not something that you lose or gain from one day to the next,” says Galan, adding that he doesn’t believe “in the forecasts of those people who expect a catastrophe. That’s because we don’t have any economic evidence that would lead us to think that we are in a recession. All the data, reports and forecasts point to the contrary. It’s logical to think that there will be a slight slowdown, especially in the United States….Surely, the markets will be behaving in a completely normal way in two or three months.” In addition, he says, “Financial institutions in the U.S. will be reporting their earnings in October, and we will see the impact of these losses on their balance sheets. If it is not too serious, things will recover right away.” For his part, Romera believes that this is a “structural problem, involving confidence.”

Wall Street is being strong, and has taken the view that recent “movements in prices are something that the market needed,” notes Galan. The Fed has interpreted events correctly and has responded “steadfastly and successfully.” On the contrary, the ECB “has lacked diligence, and should have done a better job of interpreting the signals in the markets,” he continues. Injections of liquidity have been “correct” but markets “have asked for – and continue to ask for – interest rates to drop unmistakably.” The facts prove that markets “have reacted well to the comments of the Fed, while they have responded indifferently to the ECB, only to continue to drop in response to its messages.” Romera says that the Fed “must be vigilant about managing the economy well, and it is the Fed that can lower interest rates in order to control the economy.”

The Latin American Position

Which countries are most frightened by the current crisis? Analysts don’t think is the Latin Americans. According to Romera, “these countries are used to dealing with more periods of tension. They are more than used to dealing with periods of crisis.” Galan agrees, and warns that, in coming decades, Latin American markets will experience high rates of economic growth and development. “If they are able to provide themselves with solid organizational models that simultaneously stimulate innovation and efficiency, we will see that the Latin American economies will experience some unprecedented levels of development.” Galan notes that Latin American economies are rich in natural resources and raw materials, which is “something that is increasingly valued in a world of scarcity and in today’s economic conditions.  Like they said in classic works about the Latin American economy, the only thing missing is the other major factor in economic growth – organization.”

The best way that banks can get their customers to stop worrying, Galan adds, would be “to continue with a high-risk model, without letting themselves get carried away by a panic, which could strangle the economy.” Romera adds that banks should project “an image of trustworthiness and the liquidity of its clients.” Nevertheless, Sanz notes that many banks don’t know how to calm down their customers.

It is hard to say who is responsible for this crisis. Probably, notes Galan, “it is the same thing that happened in the case of Enron, where several people were responsible. Each category of player has a responsibility for the ultimate result: analysts, regulators, business executives, risk assessment agencies, the mass media, investors…. In my opinion, the European regulators could have done a little more. Likewise, risk assessment agencies could have played a more relevant role in the initial phases so that a crisis would not have taken place. Nevertheless, the responsibility is widespread and shared.” Romera agrees with Galan, holding responsible “the world in which we live, the regulatory agencies and those who supervise the market. Those who were responsible for assessing risks did not realize that their models were inefficient.” Sanz stresses that some reports of credit risk agencies “might not have been sufficiently transparent when it comes to the riskiness of financial assets guaranteed by subprime loans.

Global Political Moves Keep an Eye on the Economy

Global political behavior plays a clear role in two different ways, according to Galan. “In the first place, it is because such political activities as regulation are factors responsible for this situation recurring sporadically. Second, it is because global political activity clearly shows that the impact of the mortgage crisis is practically non-existent in Europe.” Romera suggests that political players around the world must take care that “the economy grows in a sustained way.” For Sanz, the role of politics is “to transparently regulate financial markets and responsibilities in case risks become harder to perceive.”

Authorities believe that the most viable situation is for each bank to divulge its real situation and let people know what measures it will take to straighten out its accounts. For their part, governments know that, day by day, there are no instruments that they can use in order to discover such financial conditions [on their own].

In order to have a clear and reliable view of the financial systems, authorities try to work within the framework of the International Monetary Fund. This involves four different activities: Evaluating necessary liquidity, managing risks, exchanging information about cross-border operations and supervising assessment agencies.

When confidence returns to the markets, the bubble will go away. In any case, says Galan, “periods of readjustment are good for the economy. Each bubble eventually becomes inactive. Bubbles are more dangerous in real markets and they involve more risks.” When systems recover their ability to pay off loans, adds Romera, “that’s when the bubble stops.” Nevertheless, he predicts that the impact of the current crisis will diminish. “All the forecasts point to growth rates either maintaining their current levels of slowing down only slightly,” says Galan. Although Sanz also believes that the impact will be slight, he recalls that “the number of financial institutions that go bankrupt is an important indicator.” Romera encourages banks to “re-think their risk policies.”

Galan draws several conclusions from the August 2007 crisis. On the one hand, long periods of economic health feed the euphoria and speculation that lead to bubbles and market failures. Second, the economy does not move according to economic models that are easily predictable, and interest rates are a double-edged sword. “If you focus exclusively on containing inflation when there is a credit problem, that approach can produce an undesirable effect, and lead to growing distrust in markets.” Finally, in the absence of indicators and information about these conditions, “regulators must act with due diligence and decisiveness, with the sole goal that there is no loss of confidence in the market, and that confidence will be reestablished.” Romera adds that “You have to find out if the people you loan to have the capacity to re-pay you, and you need to do a good job of distinguishing between fixed interest rates and variable interest rates.” Concludes Sanz: “Financial markets operate at great speed but at times, they are not aware of the risks that are incurred.”