Mechanisms through which financial fragility affects macroeconomic outcomes

with reference to the US financial crisis.

By Maria Medvedeva

The definition of financial fragility is a state of economy where small shocks in investor

confidence, panic, Central Bank decisions or new market information spread beyond the

financial system and affect the real economy by causing bank runs, currency attacks and market

crushes. These shocks have a direct impact on the complicated web of economic financial

structure linked through dependencies of project portfolio allocations of investors.

When asset prices drop, consumers default on their loans causing investors to suffer losses on

portfolios and to break linkages by reallocating them into more secure assets. To the extent of

which investors are leveraged with debt, this decline leads to margin calls and further liquidation.

Continuous fall in prices expedites the deleveraging process. As the spiral continues, banks start

fire sales of assets, tighten lending standards and stop inter-lending transactions to protect

themselves from interparty defaults. Being unable to borrow short term, businesses can no

longer run their operations leading to rise in unemployment figures. Consumers are unable to

borrow and to repay dragging even further loan impairment and drop in asset prices – across

equity, bond and housing markets. The larger the economy in size, the larger and more

interconnected the portfolios are - the higher is the exposure to financial fragility.

The 2008 financial crisis that started in the United States and spread globally is the prime

example of how economic financial structure once fueled by macroeconomic policies

encountered the crisis in a wake of uncovering the disconnect between market prices and

fundamental asset values. The 2002-2007 macroeconomic policies of credit easing led to

accumulation of highly leveraged net worth on household balance sheets. As low interest rates

acted as stimulus for real estate prices, consumers enjoyed increased values of their properties

and responded by heavy borrowings against home equity to support lifestyles.

The shift toward debt financing in consumer behavior and increased risk-taking also impacted

the behavior of financial entities. The debt yield declined and private equity firms heavily

engaged in a highly leveraged M&A activity. As liquidity increased and demand grew, the move

toward securitization took place. Most of these securities were backed by a sub-prime housing

market with people having low credit history and little means to pay for the mortgage. As around

25% of US population fell into this category, lenders charged them high interest rates assuming

in case of default to repossess the properties and sell at high valuations. The subprime mortgages

were packaged into mortgage backed securities (MBOs) and collaterized debt obligations

(CDOs). The securities gave dividends to the holders as mortgages were being paid without

exposing whether assets were in prime or sub-prime markets. The securities market reached

nearly 1.7 USD trillion with investors all around the globe.

The “bubble” got pricked in 2005-2006 due to increase in the cost of borrowing with Central

Banks increased rates and rise in oil prices. Consumer confidence and purchase decisions shifted

bringing down sales of furniture, consumer durables and cars. The subsequent reaction was

devaluation of the housing assets and consequently financial instruments relying on them. The

first company impacted in the US crisis was Lehman Brothers causing interbank market distress

and run in equity markets. As counterparty default fears appeared, spreads increased and

haircuts on repo collateral went up causing breakdown in the sale and repurchase market for

short term securities, being utilized by banks to support long term investments. Amplification of

bank losses also occurred through fire sales that depressed asset prices and caused a

proportionally larger downward adjustment in balance sheets. While at the beginning of the

crisis, there was a divergence of the “toxic” assets and healthy markets; by 2009 money market

and interbank collapsed across the globe as most institutions have cross border investments.

The US and EMEA government stepped in to offer liquidity assistance by purchasing “toxic”

assets and continuously providing lending facilities. This expansion of balance sheets has a direct

macroeconomic impact that requires application of comprehensive policies to control

accumulating national debt and deflationary pressures. Analyzing this financial crisis, we realize

the interconnectedness of economic financial structure and macroeconomic factors. The

economy is driven by the policies that encourage innovation to increase internal consumption

and instill a knowledge society. Innovation drives speculation and the collapse of such leads to

worsening of macroeconomic conditions.

Recovery policies in US showed first results with improved unemployment rate in Q3 of 2009.

This should have a cross border spill-over effect with a positive implication for mature and

emerging markets.