Bum and bummer; sub-prime doesn't pay

The right approach for Australians is to tighten our belts, reduce borrowings whenever possible and increase personal and business productivity.

The first news of the US sub-prime crisis generated no great alarm. The general view was this was a minor glitch in a buoyant American economy, itself part of a massively buoyant world economy.

Two developments gradually raised levels of concern. It became evident that there were many more sub-prime (American for “dud”) housing loans than could have been imagined when the problem first emerged. Second, the dud loans had been sliced, diced and packaged in innovative ways - often combined with other assets - and then passed from owner to owner. As the size of the problem grew, also growing was uncertainty about exposures to the dud loans and to valuations of complex asset packages.

The success of the “sub-prime” strategy by US lenders depended on house prices continuing to rise. As the inevitable housing downturn took effect, prices began to fall and borrowers began to default. There are a lot of dud loans that cannot be serviced once interest rates are “reset” to much higher levels, compensating for low (or even zero) initial rates. This effect is expected to peak in the first half of 2008.

Uncertainty about valuation of complex asset package has created what is in effect an old fashioned banking crisis. Banks and other financial institutions that played pass the parcel with packages including dud loans no longer trust each other and so much normal inter-bank lending and borrowing has dried up.

The US government has explored radical solutions, including imposing interest rate holidays for loans unable to be serviced. The US Federal Reserve has cut its discount rate, lent freely to commercial banks at the lower rates, purchased assets freely from banks and auctioned chunks of discount credit so banks need not be shamed by excessive use of the discount window. Other central banks have participated in this global bailout.

US monetary policy has been eased - certainly faster than it would have been without the “ripples” from the sub-prime crisis. The first real signs of inflation showed up in 2007 but with increasingly fragile financial markets the US Fed has faced a particularly acute dilemma.

US Fed chief, Ben Bernanke, last week said: "Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability"

This was the concluding thought in a speech presented recently in Washington.

The speech itself contained the Fed chief's usual calmly rational exposition. He sketched US economic outcomes since the most recent recession, awarding implied praise to his predecessor. He explained with considerable thoroughness what went wrong during the sub-prime imbroglio. Effects outside the USA have been larger than might have been expected, partly because "the subprime crisis led investors to reassess credit risks more broadly". There is also an ongoing issue. "... the subprime shock is that it has contributed to a considerable increase in investor uncertainty about the appropriate valuations of a broader range of financial assets, not just subprime mortgages".

Mr Bernanke then gave a detailed account of the Fed's response so far. But the bit the audience was waiting for came, as usual, at the end. What does it all mean for the future of interest rates? The Fed’s ongoing concern for inflation has already been noted, but just at present concerns for economic activity seems predominant.

“A number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008". These things might get worse. The latest report on jobs growth was disappointing and if workers begin to fear for their jobs, confidence will fall further.

Overall, commentators have concluded on the basis of Mr Bernanke’s speech "More US rate cuts to come".

In Australia, economic activity continued strong in the December quarter. Retail sales and job vacancies both grew strongly - too strongly to be sustainable - in the year to November. Business investment remains strong and exports of resources have finally risen in volume terms, adding another layer of potential prosperity (on the top of sharp export price increases) to Australia’s boom.

China, India and other emerging economic powers seem likely to continue their dramatic growth even if the US economy slows substantially or even enters recession. With continuing strong demand for Australia’s resources, domestic inflationary pressures are likely to increase. As Treasurer Wayne Swan has said, he has inherited a lot of inflationary pressure from his predecessor. Interest rates are already rising both from policy hikes and as a result of sub-prime “ripples”. More rate hikes are virtually certain.

It seems that important Australian companies have so far avoided major problems. A property company, Centro, is having trouble refinancing a large slab of debt and the four major banks are reported to have a billion dollars of exposure to a US company that seems in even bigger trouble. To the extent our banks finance loans in global wholesale markets they cannot avoid the more subtle influence of rising global rates of interest.

Of course, continued worsening of the US crisis, more sub-prime “ripples” here and the expectation of further increases in domestic interest rates are likely to damage household and business confidence. The first signs of this are in fact to be seen with the latest Morgan survey of consumer confidence, released yesterday.

The Australian economy is likely to be favourably “dislocated” from the US crisis, as we were from the Asian crisis in 1998. Our inherent strength will carry us through unless there is some major shock, such as failure of a major US bank or $US150 (per barrel) oil following a geopolitical accident of some sort.

Clearly, however, the world economy is more vulnerable to such a shock than it has been for some time. The right approach for Australians is to tighten our belts, reduce borrowings whenever possible and increase personal and business productivity.

More on Ben Bernanke’s speech here.