from Follow the Money

Systemic crises

October 2, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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A systemic financial crisis is one that affects the "system" -- not a single institution. In my view, the US -- and perhaps the US and Europe -- are now facing one.

Systemic crises aren’t new. Many emerging economies experienced a systemic crisis when their currencies crashed in the 1990s, as most of their financial institutions either than foreign currency denominated debts and domestic loans or had lent in foreign currency to domestic borrowers who had no foreign currency revenue. Nor are foreign currency denominated debts the only cause of systemic crises: Japan experienced a systemic crisis in the 1990s because its banks had lent heavily against domestic real estate.

American financial institutions recently lent too much money to American households on the assumption that real estate only went up. The also assumed that macroeconomic and financial volatility had been vanquished, which meant that higher level of financial leverage made sense. The result is now obvious.

Systemic crises are particularly hard to resolve because most large institutions, by definition, have the same underlying financial exposure. If a host of large institutions all have the same problem and all want to get rid of the same bad bet, the overall result is that there are structurally far more sellers than buyers. If most leveraged institutions made the same bet, the problem is compounded: leverage magnifies the downside as well as the upside. The result is something not far from the "great unwind" -- though the trigger for the unwind is a bit different than the one Staiman and Kips initially identified. A host of leveraged institutions all want to cut back on their leverage and sell their risky assets -- something that is hard so long as everyone is trying to sell at the same time. Warren Buffet (hat tip Steve Hsu of Information Processing) puts it well:

all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.

That doesn’t necessarily imply the only possible policy response is buying bad assets; equity injections could play a role too. There are plenty of ideas out there -- including this proposal by Morris Goldstein. It does though imply that the government has to play a role in resolving the crisis.

Anna Gelpern* has noted that the dynamics of a systemic crisis also apply to over-stretched households. Normal processes break down when too many households are in the same position -- namely underwater on their mortgage. She writes:

In ordinary times, failure is resolved case by case. People and companies negotiate with their creditors, and when all else fails, file for bankruptcy. There is a judge for every case, a plan for every debtor and a price for every asset. But in a mass crisis, there are not enough judges or hours in the day to process failure. When everyone is selling, the right buying price is anyone’s guess. That is when governments resort to wholesale, one-size-fits all solutions.

She is right. If only a few home owners cannot make payments, a case-by-case approach works. But in circumstances when many homeowners are under-water and bankruptcy is, at least in some places, the norm, the case-by-case approach breaks down. The courts -- indeed, the banks -- are overwhelmed.

While all systemic crises are unique, they do -- as Gelpern notes -- give rise to similar choices: choices over whether to renegotiate contracts in mass rather than rely on a case-by-case approach even if this sacrifices a bit of equity (Gelpern writes "The good are punished with the bad, and the bad are bailed out with the good ") for efficiency, and choices over how to allocate losses among creditors, debtors and the taxpayer.

The choices that the US has to face now aren’t a surprise -- at least not to those who have thought extensively about systemic financial crises. The surprise is that the United States is having to face these choices. As former Treasury Secretary Summers notes in the Wall Street Journal:

"Superpowers do not normally ask their diplomats to reassure other nations on questions of credit-worthiness"

They also haven’t generally had to struggle with the same difficult choices emerging economies faced in the 1990s.

* Anna and I worked together when we were both at the Treasury from 1997 to 2001; she is a dear friend. She also is now a blogger!

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