A Year of Financial Trouble

August 25, 2008

It’s been a year since the financial crisis began in August of 2007. The February-March mini-panic of 2007 had presaged the oncoming troubles, but the crisis itself began in August, when the French bank BNP Paribas declared its inability to fairly value certain mortgage related assets. This has since been followed by a period of volatility in stock prices, currencies, bonds and other financial instruments; there have been periods of stability, and even euphoria, but it’s now clear to almost everyone that the financial markets are in a protracted period of risk aversion and deleveraging.

Almost immediately after the onset of the crisis central banks around the world intervened to make sure that the panic of financial participants did not lead to a severe withdrawal of liquidity from the real economy. Nonetheless, the true force of a credit squeeze on the real economy manifests itself with a lag of about nine to twelve months, and it’s fair to say that the world outside the US has so far suffered only modest consequences. Even in the US, the immediate impact has been moderate at worst, much better than what should have been expected in light of the severe nature of the unwinding: Commercial paper, especially ABCP, has suffered an unprecedented fall in issuance; the subprime mortgage has market all but evaporated; banks have had to recognise the losses of their off-balance sheet instruments early on, and gradually take massive write-downs as a consequence of deteriorating mortgage related assets. Libor rates also experienced far greater volatility than usual, before settling at the elevated levels of today.

Despite a number of very aggressive rate cuts by the US Federal Reserve which brought real rates to decisively inflationary levels, the markets continue to suffer from an increasing intolerance for risk. Meanwhile, consumer confidence has been suffering severely from rising unemployment, rising oil and food prices, and the generally pessimistic outlook, with house prices falling across the country, and stock prices collapsing. Home equity withdrawal is much harder, and the American consumer has since been readjusting himself to the difficulties of the new era. But so far the real economy has not been derailed as severely as some of us had expected.

This is mostly because the US government has been more than pro active in trying to avert a recession. And the rest of the world has also been growing at a healthy pace, at least until recently.

But it now seems that we are entering the period of maximal stress of the downturn.

I plan to take note of the developments in my journal.
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