United States: Don't panic!

With a slew of major US financial institutions due to report their second quarter earnings this week, including Citigroup on Friday, this once-rampant sector will plunge to new lows.  But there is no need to panic: while the US banking industry is in free-fall, and will plumb new depths over the medium-term, the risk of a more grievous systemic collapse may finally begin to fall.

Mania and meltdown

The 2007-08 credit crunch is a textbook US financial panic.  Exceptionally loose credit conditions, during the period from 2002-06, inflated a massive asset-price bubble -- chiefly in housing.  Surging housing prices, in turn, encouraged banks to relax their lending standards to the point at which, in some cases, they were non-existent.  Financial innovation -- in the form of new types of mortgages, and associated derivative products -- did what they were designed to do, in terms of spreading risk widely. 

But during the inevitable bust that followed, banks found that this risk spreading had concealed who actually owned the lion’s share of these questionable mortgage-backed securities and derivatives.  This produced a crisis of confidence that made banks reluctant to lend to each other, let alone new mortgage customers.  The cost of mortgages soared, reducing the number of buyers in the housing market, and further undermining house prices.  As more homeowners saw the value of their properties fall, slipped into ‘negative equity’, and defaulted on their loans a vicious circle developed. 

Financial markets have been caught in this deadly undertow ever since.  By July 13, it had destroyed confidence in the system to such an extent that the US Treasury and Federal Reserve felt compelled to make more explicit their implicit guarantee of the two largest government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac.

Past panics

During the wildly laissez-faire US ‘Gilded Age’ of the late 19th century, financial panics of this sort -– caused by excessive asset-price inflation, followed by a bubble collapse that destroyed confidence in financial institutions -- occurred as if by clockwork.  There were ‘panics’ in 1866, 1873, 1884, 1890, 1893, 1896, 1901, 1907, and 1910.  In every case, large numbers of regional banks went bust, wiping out depositors’ savings, and sometimes causing riots during bank runs.  However, the establishment of the Federal Reserve in 1913, and (especially) the Federal Deposit Insurance Corporation (FDIC) in 1933, reduced both the frequency and severity of post-Depression panics. 

The end is not nigh…

Thus, the current crisis, while severe, is manageable.  The federal government may ultimately have to assume hundreds of billions of dollars in losses on the books of Fannie and Freddie, and billions more from regional banks.  But in the context of the size of the federal budget and US economy, this would hardly be disastrous.  A public-private bailout -- perhaps in the form of a larger version of the Resolution Trust Corporation established in the wake of the Savings & Loan crisis in 1989 -- may ultimately become necessary.

…but prepare for a wild ride

However, there is still plenty of rough sledding ahead.  The Wall Street Journal’s latest analysis confirms that the housing market has fallen spectacularly in most regions, but that further declines -- and perhaps an ‘overcorrection’ -- are likely.  This will push more banks over the edge and deepen the nascent US recession, which could be both nasty and prolonged.  But the sort of wild unwinding of systemic risk that produced the Great Depression remains very unlikely indeed.