Friday, March 26, 2010

Debunking subprime contagion

Original posted on FT Alphaville by Tracy Alloway:

Flashback alert!

And so on.

But here’s an interesting idea, contained in a just-published Federal Reserve discussion paper, by Steven B. Kamin and Laurie Pounder DeMarco, and asking: “How Did a Domestic Housing Slump Turn into a Global Financial Crisis?”

In it, the authors assert that the global financial crisis was not caused by direct exposure to the US subprime market. In other words, banks’ CDS spreads and stock prices during the crisis were not correlated with their holdings of US mortgage-backed securities (MBS) or dependence on dollar funding.

Instead, the contagion was caused by something else; namely a general “disillusionment” with bank models around the world, or, a sort of global bank run.

Perhaps that’s not a huge shock, but the theory is interesting:

To summarize our key findings, we found scant evidence of a direct channel of contagion spreading the U.S. subprime crisis abroad . . . Moreover, even if holdings of U.S. toxic assets and exposure to dollar funding were more important than we were able to document, we still believe that a number of indirect channels stressed in the growing stock of commentary on this crisis were relevant as well:

(1) a generalized run on global financial institutions, given lack of information as to who actually held toxic assets and how much;

(2) the dependence of many financial systems on short-term funding (both in dollars and in other currencies);

(3) a vicious cycle of mark-to-market losses driving fire sales of ABS, which in turn triggered further losses;

(4) the realization that financial firms around the world were pursuing similar (flawed) business models and were subject to similar risks; and

(5) global swings in risk aversion supported by instantaneous worldwide communications and a shared business culture. At an extreme, the U.S. subprime crisis, rather than being a fundamental driver of the global crisis, may have been more of trigger for a global bank run and for disillusionment with a risky business model that already had spread around the world.

The authors say there’s some uncertainty in the MBS data but, overall, it’s certainly food for thought.

And the standout bit from the paper: according to the authors international losses on US portfolio holdings didn’t even stem from assets related to American mortgages, but from other things:

In fact, it is ironic that, although the global financial crisis appeared to originate in the U.S. sub-prime sector, losses on U.S. ABS accounted for only a small part of the total losses taken by foreigners on their holdings of U.S. assets. As indicated in Table 4, foreigners experienced some $1.3 trillion in losses on their portfolio holdings in the United States, but only $160 billion of those losses were linked to ABS. By far the greatest losses were on their holdings of U.S. common stock.

And the table:

So, not the subprime crisis but your-run-of-the-mill stock crash?

It doesn’t have quite the same ring to it.

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