Global Fallout of the US Subprime Crisis

Data released on 8 April by the International Monetary Fund illustrates the magnitude of the present financial crisis. Mark-to-market losses on mortgage-backed securities, collateralised debt obligations and related assets through March 2008 approximate $945bn. In absolute terms this represents the largest financial loss in history, exceeding asset losses resulting from Japan’s banking crisis in the 1990s ($780bn) and far surpassing losses emanating from the Asian crisis of 1997-98 ($420bn) and the US savings and loan crisis of 1986-95 ($380bn).

The damage extends across a wide range of investor classes. Commercial banks stand to lose $440-$510bn, insurance companies $105-$130bn, pension funds $90-$160bn, governments $40-$140bn and other financial institutions $110-$160m.

Innovations in mortgage securitisation in the early and mid-2000s enabled loan originators to sell high-risk assets to downstream financial institutions around the world, thereby globalising the US subprime crisis. Against US bank losses of $144bn, European financial entities stand to incur $123bn in mortgage-related losses. Within the latter group, British institutions face $40bn in asset write offs, nearly matching the combined losses of the euro area ($45bn). Financial institutions in Asia and other regions are far less exposed.

The imprudent lending practices that precipitated the US subprime collapse are not confined to the country. The IMF estimates that housing prices in the Netherlands, Ireland and the UK are 30% higher than justified by economic fundamentals. British housing prices fell by 2.5% in March, the sharpest monthly fall in the country since 1992. Australia, Belgium, Denmark, France, Norway, Spain, and Sweden also face sizable housing bubbles.

Housing prices in OECD countries with more conservative lending practices (Austria, Canada, Finland, and Germany) are more closely aligned with market fundamentals, underscoring wide country variations in mortgage markets.

A surge in corporate defaults and debt downgrades in the US and Europe indicates spillover of the subprime crisis to non-financial companies, as commercial lenders re-price their risks and de-leverage their portfolios.

Together with the contraction of household spending resulting from the mortgage crisis, the tightening of corporate credit portends a slowing of economic growth worldwide. The IMF forecasts global economic growth to fall from 4.9% in 2007 to 3.7% in 2008. The US faces a steep decline from 2.2% to 0.5%, with a non-trivial possibility of a prolonged and deep recession. GDP growth in the Euro zone, UK, Canada, and Japan is expected to fall to the 1.2%-1.6% range in 2008-09.

The US Federal Reserve and the Bank of England have slashed interest rates in an attempt to stimulate economic growth. But there are serious doubts about the efficacy of monetary policy in the current downturn, as the contraction of global credit stems less from the high cost of money than from the reluctance of financial institutions (whose battered balance sheets heighten risk aversion) to lend it. Meanwhile, rising inflation has dissuaded the European Central Bank from deploying its interest rate weapon to spur growth.

GROWTH OPPORTUNITIES AMID THE DOWNTURN

While the deterioration of international financial markets presages slower growth and heightened uncertainty, globally active mid-sized companies enjoy strong commercial prospects in coming years. Indeed, the dislocations arising from the current crisis offer unique opportunities to strategically agile middle enterprises.

Financially stressed companies face mounting difficulties obtaining credit. However, companies with healthy balance sheets are holding their own in the global downturn. German exporters (led by world-class manufacturers in the Mittelstand) continue their strong performance despite euro appreciation, posting 9% export growth in January 2008. Industrial production in France registered a larger than anticipated increase in February, auguring favourably for that country’s ability to weather the downturn.

The 1 April report of the Institute for Supply Management confirms persistent sluggishness in the US manufacturing sector. But the dollar’s fall is proving a boon to US exporters, particularly manufacturers of electrical equipment, machinery, appliances, paper products, primary metals and transportation goods. Dollar devaluation presents a major untapped opportunity for medium US manufacturers: A recent survey by the National Association of Manufacturers indicates that three-quarters of US small/middle manufacturers generate less than 10% of their revenues from exports, while 25% do no exporting at all.

Dollar devaluation also creates opportunities for middle enterprises to launch mergers and acquisitions in the US. Recent data indicate that foreign investors from Europe and other regions are in fact exploiting currency shifts to expand their US positions.

The financial crisis has not derailed the large emerging markets from their robust economic growth paths. China’s GDP growth is projected to decline from 11.4% in 2007 to 9.3% in 2008, India’s from 9.2% to 7.9%, and Russia’s from 6.8% to 6.3%. Nor has the West’s subprime problem endangered the financial systems of those countries. Indeed, sovereign wealth funds based in China and other emerging economies are serving as liquidity buffers by injecting capital into beleaguered Western financial institutions. Middle enterprises active in emerging markets thus have good reasons for optimism about their future growth prospects.

Profitable growth opportunities abound in global market niches that play to the strengths of technologically nimble middle enterprises. For example, rising hydrocarbon prices and mounting concerns over global warming are stimulating investment in renewable energy. Parallel increases in food prices are spurring R&D in cellulosic processing and related technologies that do not depend on diversion of food crops to biofuels.

More broadly, previous economic downturns have proven excellent opportunities for middle enterprises to undertake counter-cyclical moves that strengthen their competitive position for the inevitable rebound: Lean enterprise campaigns; strategic acquisitions; discounted purchases of advanced equipment on secondary liquidation markets; hiring of talented employees released by downsizing companies. The present financial crisis offers similar possibilities for mid-sized companies taking a long view of their global growth trajectories.