The price of the sub prime crisis

The overarching purpose of a sound financial system is to channelise effectively savings into productive investments. When the financial system is characterized by fear and panic, this function cannot be discharged. Investment spending falls and GDP shrinks. This more than anything else, is the real cost of a financial crisis.

Towards the end of 2008, as the crisis peaked, the markets for corporate bonds and commercial paper all but dried up. The spreads between risky and risk free instruments rose to phenomenal heights. Banks stopped lending and instead preferred to hoard cash. Economy after economy began to shrink in size with some countries showing double digit negative growth.

In the past six months, however, things have improved remarkably. The markets seem to be recovering. And global trade is gaining momentum. As we approach the end of 2009, the worst seems to be over, though we still do not know whether the recovery that began in early 2009 will be sustained. During the peak of the crisis, the governments and central banks were the only source of liquidity. Unless this perception goes away completely, recovery will be muted and halting.

Whatever be the nature of the recovery, we do know that we are paying a huge cost for the sub prime crisis and the bill is rising each day. The magnitude of the crisis is reflected in the scale of the government intervention. The value of sovereign credit and guarantees put in place during the crisis, already exceeds $7 trillion. (Estimates of course vary) There is hardly any major country in the world which has not announced a fiscal stimulus to boost spending and restore confidence. And obviously, central banks have been in the thick of things to provide liquidity to the financial system. The US Federal Reserve provided a bailout loan of $30 billion in case of Bear Stearns, a $85 billion credit facility for AIG and guaranteed $424 bn of losses on bad assets in case of Citibank and Bank of America. As of June 2009, the Fed’s total assets had risen to over $2 trillion compared with $852 billion in 2006. Only 29% of these assets were Treasury securities, compared with 91% in 2006.