The financial crisis erupted this summer because of difficult conditions in the American subprime real estate market, which provides loans for people who have only a low level of buying power. The problem, which extends beyond the subprime sector, has its origins in the high level of non-payments registered in recent months. More specifically, the percentage of payments in arrears shot up to 13.77% at the end of the first quarter of this year. This situation has led to the bankruptcy of some institutions that made subprime loans, such as New Century [Mortgage]. In addition, the subprime crisis is sending shock waves through the market for derivative products related to the value of real estate, an area which many banks around the world have exposure in. The situation has endangered some financial institutions in the United States and Europe.


On June 23, Wall Street investors trembled after it became known that Bear Stearns hedge funds could be in trouble because of their investments in real estate based bonds. That was the first shock, but it was only the beginning of a crisis that has already affected more than 100 companies, including banking giants such as BNP Paribas, UBS and Goldman Sachs. It has even affected non-financial companies such as retail chains Wal-Mart and Home Depot.

The crisis has the potential to affect the growth rate of the U.S. economy, as the U.S. Federal Reserve has recognized. It will also have an influence on activity outside the borders of the U.S. The International Monetary Fund has acknowledged that it could “slightly” lower its forecasts for global economic growth in 2007 because of the recent crisis in global markets. “We are aware that risks have grown. It would not be surprising if there were an impact on growth, a reappraisal of risk. Markets are adjusting and they are going through a correction,” noted Rodrigo Rato, the Spanish-born director general of the IMF.

“We are in the process of a global re-evaluation as a result of the rise in credit risks,” said José Ramón Díez Guijarro, professor of economics at Spain’s Instituto de Empresa business school. “This is a process that people have been warning about in recent months (and years); it was necessary and positive from the medium-term viewpoint, but in the short term, could come at a cost for those who have misbehaved.”

Reactions to the Crisis  


Between August 9 and 10, the European Central Bank (ECB) became the first institution to come to the aid of markets. The ECB made a large injection of liquidity, valued at more than 150 billion euros. The ECB was responding to the serious drought in the credit market that had led fund manager BNP [Paribas] to shut down three investment funds. From then on, ECB has loaned more than 350 billion euros in additional cash in order to avoid a liquidity crisis in the inter-bank market. Although the ECB has managed to calm short-term interest rates in the market, longer-term rates such as those of one to three months, remain at extraordinarily high levels.


For its part, the U.S. Federal Reserve made an important and surprising move on August 17. The Fed lowered its discount rate to 5.75%, a drop of a half of a percent. This is the rate at which the Fed makes loans to banks. With that move, the Fed injected an additional $6 billion into the system to cover the credit needs of banks. As of August 9, the Fed had provided $94 billion in inter-bank loans.

Altina Sebastián González, professor of finance at the Complutense University in Madrid, explains that the liquidity injections made last month by the ECB and the Fed “had the goal of avoiding the collapse of stock markets and reducing the volatility caused by problems in the U.S. subprime market, as well minimizing any possible negative impact on the real economy. Sebastián González believes that the injection of liquidity was “indispensable” and that central banks “have acted in an appropriate way.” Nevertheless, she believes that “the Fed’s management of the crisis has its own share of positives and negatives.”


The public statements of Fed president Ben Bernanke in August “did not help to quiet markets,” Sebastián notes. “When the last monetary policy meeting was concluded on August 7, Bernanke said that his main concern continued to be inflation. Ten days later, however, he had to submit to market pressure by lowering the discount rate by a half-percentage point. He also recognized that the real estate crisis threatened the economy. Over that time period, Bernanke was certainly balancing the financial system’s needs for liquidity against the real magnitude of the real estate crisis.”


Monetary Policy


The ECB and the Fed have responded to current conditions in the credit system and stock markets but they have yet to decide what road to pursue when it comes to interest rates. The ECB has reiterated on several occasions that the principal goal of its monetary policy is to keep inflation in the euro zone under control. It has done so by raising interest rates only so far as the current level of four percent. Along the same lines, the Fed indicated in its latest monthly meetings that its main worry is that “inflation might not remain controlled within the lines of its forecasts.” The Fed gave a lower priority to economic growth. This stance has meant maintaining the same 5.25% rate as it did last year. Given the new economic scenario, however, analysts believe that both institutions have already changed their position and their preferences.

As José Ramón Díez Guijarro notes, “The primary goals of central banks must be for the financial system to recover its confidence, and try to bring liquidity back into financial markets where it has practically dried up. This was something that had to be done in order to validate its policy positions, and in order to know the full scope of the crisis.” Starting now, he adds, “central banks are facing the greater risk of a ‘moral hazard.’ If they come to the rescue of the market, that will provide incentives for people to take risky credit positions once the storm has calmed down. And if that happens, we can continue to have bubbles that sooner or later lead to a global recession. The Fed seems to be on the verge of submitting to this temptation. Don’t forget that the declines of 1998 ended with a stock market bubble that exploded shortly thereafter.”


According to Sergio R. Torassa, a finance professor at the ESCI-University Pompeu Fabra, ”The big worry must be to ‘put out the fire’ by attacking the key reason for uncertainty, which is the potential increase in arrears payments associated with low quality credit, one of whose components is subprime mortgages.” Nevertheless, Torassa believes, “the immediate goal must be to be compatible with economic growth. There is no doubt that it has a more destructive impact on consumption than on unemployment. Economic activity and arrears payments have always gone hand in hand, with a slowdown in the former bringing an increase of the latter.”


Analysts interpreted the drop in the discount rate to mean that the Fed was on the threshold of dropping its short-term rates. But it wasn’t until August 31 that the true position of the Fed was revealed when Ben Bernanke gave a speech at the annual conference of the Fed, held in Jackson Hole, Wyoming.


Bernanke assured his audience that he “will act when it is necessary” to limit any damage that the subprime mortgage crisis has on economic growth. “The committee continues to monitor this situation and it will act when necessary to limit the adverse effects on the economy in general that can result whenever there is disorder in financial markets,” he stated.

Nevertheless, the Fed president warned, “It is not and it should not be, the responsibility of this institution to protect borrowers and investors from the consequences of their financial decisions.” However, he admitted that developments in the markets can have consequences on economic conditions, which can have repercussions on those people who find themselves outside the market. He added, “The Fed must take into account these kinds of effects when it determines policy.” Nevertheless, Bernanke recognized that the market crisis could be harmful for the overall economy.


A Wait and See Attitude


Following those statements, the market now believes that the Fed is moving closer to lowering interest rates at its next meeting, which takes place on September 18. How much will it lower rates? According to the latest report from American Express Funds, the Fed will carry out a cut of between 25 and 50 basis points at its next meeting. Its goal will be to bring interest rates down to 4.75% by the end of the year, compared with 5.25% at the moment.

However, forecasts for
U.S. interest rates are plagued by uncertainty. As Altina Sebastián notes, “people have yet to understand Ben Bernanke, whose style is very far from his predecessor Alan Greenspan.” Sebastián recalls that until the Fed meeting in early August, Bernanke was reaffirming his commitment to control inflation. “In his day, Greenspan pledged to give a dominant role to the stability of financial markets. In contrast, Bernanke has focused on the Fed’s forecasts for upcoming quarters. Whenever financial markets were weakening, Greenspan would emphasize current conditions in his speeches, and that enabled him to achieve rapid changes in policy.”


In Europe, markets now expect that the ECB will maintain interest rates at 4%, while waiting to see how things turn out. Like the Fed, the ECB spelled out its forecasts during the latest public appearance of its director, who is Jean Claude Trichet. At his latest appearance at the 22nd annual conference of the European Economic Association in Budapest, Hungary, Trichet said that the ECB “is evaluating the medium-term risks for price stability” and that it will make its decision at the meeting of the bank’s board of governors on September 6.

After that meeting in August, the ECB explained that along with injecting liquidity into the market, it was maintaining an attitude of “strong vigilance” on inflation. The ECB uses this expression whenever it announces a tightening of the cost of money at its subsequent meeting. As a result, many analysts interpreted Trichet’s comment as a sign that the ECB will raise its rates by a quarter of a point to 4.25% just as it had forecast earlier, despite the current financial “storm.”

Nevertheless, Trichet has avoided using the same expression again because he apparently recognizes that the current scenario is very different from conditions that existed during the August meeting. The market interpreted his attitude as an indication that the ECB is undecided about what direction to take in response to the credit crisis.

“Regarding the Fed, the position of the ECB seems more appropriate to me because it even contributes to the short term stabilization of the financial system,” said José Ramón Díez Guijarro. “[The ECB] does not seem to have changed the course it is taking over the medium term. While it is not clear that the recent instability is going to affect its medium-term forecasts for growth and inflation, its goals for rates during upcoming months will not change.”

According to Díez Guijarro, “It seems as if there are differences between the Fed and the ECB when it comes to the impact that the events of August have had on the economy.” He warns that both institutions cannot be right. “In this sense, my forecasts are that the Fed will lower its interest rates by 50 to 75 basis points over the next two months, while the ECB won’t raise its rates in September but will do so during the final quarter of this year, winding up at 4.50%.”

Speaking more generally, Torassa believes that “If the confidence of investors does not return, it is extremely likely that central banks will be obliged to cut interest rates to avoid the contagion of market uncertainty about consumption and consumer spending…. Day by day, this possibility is lessening but we cannot discard it if new elements of risk appear on the horizon,” he warns.

“In this scenario, the greatest challenge to achieving that goal is not to be satisfied with any moves that give top priority to the medium term future over what is happening right now. Monetary authorities must move quickly, and they must make statements that are precise and coherent in order to promote the orderly functioning of markets,” Torassa suggests.