How did leverage contribute to the crisis?

Some argue that excessive use of leverage is the root cause for the current crisis. For example, in the United States, prior to 2004, the U.S. broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. In 2004, the U.S. Securities and Exchange Commission (SEC) granted an exemption to five firms that allowed them to exceed this leverage rule. Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley were granted this exemption and they levered up 20, 30 and even 40 to 1.[i] Over-leveraging throughout the U.S. economy has, in fact, become a major theme and the United States is entering a period of significant de-leveraging.

In addition, the “originate and distribute” model that characterized the market is generally seen as magnifying the risks and the reach of the exposures. Under this model, we saw the rapid growth of off-balance-sheet vehicles and securitization practices designed to improve returns on constrained capital resources substituting for the capital-intensive holding of mortgage-backed and other assets.

What makes this credit crisis different from those we have experienced in the past?

Credit crises in the past tended to be confined to the commercial banking and direct lending sectors. With the growth of the securitization market, investment banking firms became big players in the mortgage market, as well. This allowed the risk to spread far and wide, making this crisis that started with subprime lending in the United States both a bank and nonbank, as well as a global, problem.

How does the current credit crisis compare to others we have seen?

Even before the cataclysmic events that began in September 2008, former Federal Reserve Chairman Alan Greenspan, whom some have argued did not recognize the severity of the developing problems as they were unfolding, described the financial crisis in the United States as “the most wrenching since the end of the second world war." Others, like the well-known investor George Soros, said that there has been nothing like the events of late since the Great Depression.[ii] As the months have gone on, these views are now widely held by the public and private sectors alike.  

What are the estimates of the cost of the current crisis?

While it is extremely difficult to identify and measure losses attributable to the credit crisis accurately, in April 2008, the IMF said the worldwide losses stemming from the U.S. subprime mortgage crisis could hit US$945 billion dollars as the impact spreads in the global economy, about half of which would be lost by banks themselves. As of the end of October 2008, the Bank of England said that the world’s financial firms already had lost US$2.8 trillion as a result of the continuing crisis. In January 2009, New York University Professor Nouriel Roubini predicted that U.S. financial losses from the credit crisis could reach US$3.6 trillion.[iii]

To put the current crisis into perspective, what were the costs of prior credit crises?

According to an IMFGlobal Financial Stability Report released in April 2008:

·       The cost of the U.S. savings and loan crisis of the late 1980s and early 1990s is estimated to have totaled US$273 billion.

·       The Japanese banking crisis of the 1990s cost approximately US$745 billion.

·       The estimated cost of the Asian banking crisis of 1998-1999 was US$404 billion.