Changes Resulting from the Credit Crisis

Let's face we are in the middle of the credit crisis, unemployment is going to get worse, we are in for a long severe recession (on a good day), the housing market is in the tank, the stock market is down 40% from its high point and will probably hit new lows in 2009, etc. We already know all that. The only real question now is how deep and how long the recession will last. This is difficult to answer because this is a dynamic process and so the answers will only emerge over time.

The question I have is what will the business environment look like in 3 or 5 or 10 years from now as we emerge on the other side of the current crisis. Below are excerpts from a editorial in the WSJ that I believe have some relevance. Text in bold is my emphasis.

There have been more than a dozen financial crises since the end of World War II. The aftermath of each was transitory, and markets rebounded rather quickly. The current crisis will be different; it will usher in profound and lasting structural, behavioral and regulatory changes. Here are some of the more important:

- International portfolio diversification has been undermined. This long-heralded investment strategy has failed to weather the test of the current credit crisis. Many non-U.S. stock indices have fallen more than U.S. equities markets, a trend especially pronounced in very popular developing countries, where there was a growing belief among investors that their economies would perform largely independently of the industrialized world.

But developing nations depend heavily on the developed world to consume their products and services and to finance their business activities. When liquidity is ample and credit readily available, developing economies thrive. When global credit comes under pressure, they suffer even more than their more developed counterparts. This is why the strategy of international portfolio diversification needs to be rethought and improved if it is to remain an abiding principle of asset allocation.

- Risk modeling will lose popularity. Elaborate modeling formulas for options and other complex financial derivatives that are useful for dynamic hedging under normal circumstances are of little use when transactions cannot be made without huge price concessions. Stated differently, most models rest on assumptions about normal, rational financial behavior, but lose their predictive power during times of financial euphoria or panic. Consequently, the magnitude of the current crisis calls into question whether, even after markets stabilize, sophisticated risk modeling can ever regain its former status.

- Financial concentration will gain even greater momentum and influence. This is the most profound long-term consequence of the current credit crisis. Leading independent investment banks already have been taken over by large financial conglomerates that are controlled by commercial banking entities, as have giant deposit institutions. Within the next year, many smaller and medium-sized financial institutions also will lose their independent identities.

Today, more than half of all nonfinancial debt (debt held by households, nonfinancial companies and government) is held by the top 15 institutions. These were the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex new credit instruments. They also pushed for legal structures that made many aspects of the financial markets opaque.

In the years ahead, the influence of these financial conglomerates will be overwhelming -- and they will limit any moves toward greater economic democracy. These conglomerates are and will continue to be infused with conflicts of interest because of their multiple roles in securities underwriting, in lending and investing, in the making of secondary markets, and in the management of other people's money. And because there will be fewer market participants of importance, the price volatility of financial assets likely will remain high.

Through their global reach, these firms will transmit financial contagion even more quickly than it spread in the current credit crisis. When the current crisis abates, the pricing power of these huge financial conglomerates will grow significantly, at the expense of borrowers and investors.

(The comments about the financial conglomerates are interesting. I thought the purpose of the financial conglomerates is to make them easier to regulate, but the author sees these same issues in a different light. One thing that may happen is that the "normal" banking portion of the financial conglomerates may be split off and treated more like a public utility than a traditional corporation. When I say normal I mean checking, savings, credit cards, auto loans, mortgages, etc. The more common consumer products.)

- The end of an era of ballooning nonfinancial debt. The rapid growth of nonfinancial debt has been a key driver of U.S. economic growth in recent decades. Since 2000 alone, nonfinancial debt outpaced the growth of nominal GDP by nearly $8 trillion -- more than double the $3.5 trillion gap of the 1990s, which already was excessive. But the techniques and institutions that generated the tidal wave of debt creation now are in disarray. Already we are seeing a dramatic slowdown in rate of growth of household and business debt, a trend that will continue for some time. (The source of deflationary pressure.)

- U.S. government borrowing will continue to swell, at least for a few years. New net U.S. government debt issuance could exceed $1 trillion per year -- as federal revenues slow, spending increases, and funds are needed to rescue additional financial institutions.
There is a silver lining: The combination of shrinking private sector demands and expanding federal demands will on balance improve the credit quality of many portfolios. But the central question will be whether policy makers can define and implement a strategy that will slow government borrowing as private-sector credit demands reassert themselves in the medium term.

- Americans will begin to save again. The personal savings rate (as a percentage of disposable family income) has been tepid for years, and actually fell below zero in 2006. Since then, it has increased slightly into positive territory. Although this perplexes many economists and policy makers, I see no mystery. The erosion of personal savings is chiefly the result of massive debt creation.

A brief review of debt and savings rates since 1960 shows the correlation. From 1960 to 1990, according to the Federal Reserve, the growth of nonfinancial debt exceeded that of nominal GDP by 1.5 times on average, while the savings rate averaged 9% per year. From 1991 to 2000, debt exceeded the growth of GDP by 1.8 times, while the savings rate averaged 4.7%. Since 2001, debt has grown twice as fast as GDP, while the savings rate has averaged a mere 1.4%. The lesson is clear: If the savings rate is to return to healthy levels, we must put an end to the reckless creation of debt.

- Regulatory reform of financial markets will carry high stakes. While the need for reform is widely acknowledged, less well understood is the extraordinary balancing act that U.S. lawmakers must achieve. On the one hand, the new regulatory regime needs to be comprehensive enough to take into account major structural changes that have unfolded in recent decades. On the other hand, it must assure reasonable credit growth and competitive credit markets. Every new measure will impinge on embedded interests, making the whole enterprise -- essential as it is to our nation's economic health -- a major political contest.