COMMENT: Back to drawing board - a look at crises past and present

By bne IntelliNews October 28, 2008

Andrei Bogdanovich of Uralsib -

Learning from the past: The current crisis has wreaked havoc on the portfolio of virtually every investor. The seemingly unstoppable share slide on global stock markets has left many asking, "When will it all end?" We believe that now is a good time to try and gain an overview of previous crises and the current crisis. After all the crises of the past can tell us a lot about the current crisis and how long we should expect it to last.

New economic cycle: Economic cycles have two main trends - growth and decline - and four phases: recovery, boom, recession and depression. The graphs below clearly show that the most recent economic cycles in the US and Russia have been characterized by longer periods of growth followed by briefer periods of decline. They also show that these cycles typically last about 10 years with a five- to seven-year period of growth followed by a crisis and then a recession lasting two to three years.

... latest decline started in mid-2007: The start of the liquidity crisis in mid-2007 constituted the beginning of a period of decline in the US which quickly spread to the rest of the world economy. The reason for such rapid expansion was that the entire financial system was contaminated by the financial instruments which triggered the original problem in the US.

Currently, global financial markets are in the grip of the crisis phase, which has already lasted over a month. Usually the most intense phase does not last longer than three to six months. At this point, some of the worst is already behind, but the ultimate consequences remain far from clear.

... we do not envisage a recovery before 2010: During the most recent crises the decline period has averaged about 2.5 years. Based on this and given that the decline began in mid-September 2007, we are apparently in the most severe phase now - we expect it to end in first quarter of 2009 followed by a 0.5 to 1 year recession. However, extrapolating from historical parallels, the recovery period for the global economy will only start in 2010.

Recovery forecast based on data from previous crises: Typically, in the first year following a crisis the market corrects upwards by 30% relative to the low. Based on our assumption that the overall global upward trend will be sustained, index growth should continue.

The most striking aspect of the current financial crisis is its scale and epicentre. In the 1990s, the size of the global financial system grew substantially. As external economic and trading relations were gradually liberalized, national economies opened up and the global geographic distribution of production altered. The spread of digital technology and with it high-speed communication and financial transactions coupled with exponential growth in emerging economies, created new currency centres, a redistribution of capital flows and ultimately the globalization of financial markets. It is now clear that the interconnection of the world's financial markets is so powerful that all it takes is one major upheaval to quickly impact all the world's economies. The unprecedented reach of the current crisis is also exacerbated by the fact that it all started in the country which acts as the kingpin and benchmark for all other economies - the US.

The derivatives time bomb

The main culprit in the current crisis is the wide-scale use of derivatives, including collateralized debt obligations (CDO), collateralized mortgage obligations (CMO) and collateralized bond obligations (CBO), whose popularity was driven by their perceived safety, ie. high yields versus low risk. The easy availability of credit and the desire to maximum profits led to a decline in credit checking standards. At the same time, a rapid and uncontrolled expansion in the issuance of pools of loans (particularly mortgage loans) in the form of complex derivatives and all the associated investment funds and funds of funds, effectively placed a ticking time bomb under the global financial system. To make matters worse, the high credit ratings provided to these derivatives meant that they had proliferated throughout the entire global investment system, including national banks, governments, private hedge funds, insurance companies and investment banks.

The derivatives time bomb finally detonated when higher borrowing costs led to losses and a liquidity crisis in the global banking system. This in turn is leading inexorably to a crimping of global economic growth. The countries currently in the best position are those with decent cash reserves which if properly utilized can help their respective economies weather the storm. However. no nation is immune from the impact of a potential decline in global product demand.

Aggravating factor: The current crisis is now simultaneously driven by numerous factors - a multi-headed monster. Previous crises centred around one or two relatively isolated local factors, for example, the impact of soaring oil prices on importer nations in 1973, excess leverage and the liquidity crisis in the US in 1987 and in Japan in 1990, the Asian liquidity crisis in 1997 and the excess leverage and liquidity crisis in Russia in 1998.

However, the current crisis has expanded to engulf virtually all the previous crisis factors: excessive leverage, high natural resource prices and liquidity shortfalls. The resulting toxic mixture of negative factors could mean that this current crisis lasts for longer than previous crises and triggers a serious slowdown in the growth of the global economy followed by a recession and long and painful period of recovery.

Anatomy of a crisis

The graphs show the durations of three main phases of any crisis:

1st phase - the trigger becomes clear during the early decline of stock market prices coupled with higher volatility;

2nd phase - deterioration as liquidity contracts volatility increases rapidly and stock markets crash. The duration of this phase is usually from two to six months;

3rd phase - amelioration in this phase the rate of stock market decline begins to slow, volatility falls and the situation gradually normalizes. The graphs clearly show that stock market indices declines normally last from 3 months to 2.5 years.

The recovery phase is typically three to five times longer than the decline phase. The recovery period in which stock market indices rise to their pre-crisis levels is usually three to five times longer than the period of decline. Exceptions include Japan where the aftermath of the 1990 crisis remains in evidence.

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