PALO ALTO – Early signs of a manufacturing rebound, already strong in Asia, lend hope for some modest recovery from today’s deep global recession. But a strong and durable economic expansion is unlikely until progress is made in dealing with the toxic assets poisoning the balance sheets of financial institutions and bedeviling policymakers almost everywhere.
The financial system is a complex interaction of lenders and borrowers, buyers and sellers, and savers and investors. When it functions well, it balances risk and reward, and innovation and safety.
Banks and other financial firms borrow short – increasingly in recent years from the commercial securities market, not deposits – and lend long at higher interest rates, taking on both credit risk (of default) and interest-rate risk. Increasing leverage boosts returns on the upside but is very risky on the downside. No surprise, then, that the large financial firms that failed – Bear Stearns, Fannie Mae and Freddie Mac, AIG, and Lehman Brothers – had the highest leverage, in the range of 30 or 40 times their capital.
From 2002-2007, trillions of dollars were loaned for sub-prime and prime mortgages, autos, credit cards, commercial real estate, private equity, and more, on the assumption by (most) borrowers and lenders that strong global growth, rising home prices and cheap, readily available short-term credit would continue for the foreseeable future. Once the music stopped, the assets plunged in value. The complexity of securitized pools of loans that were sold worldwide – bilaterally over the counter – as pieces of various tranches, meant that nobody was certain about who owned what or what it was worth.