Tony Jackson writes in the FT this morning:
In a study covering 17 developed economies over three decades, the IMF came up with three findings of particular relevance.
First, recessions preceded by a financial crisis tend to be deeper and longer than others.
Second, they tend to be worse again if the crisis is in banking, rather than in securities markets or foreign exchange.
And third, the countries hardest hit are those with so-called arm’s length financial systems, such as the US or UK. If banks are free to innovate, they tend to build up more pro-cyclical leverage.
In practical terms, the IMF found that recessions linked to banking crises lasted twice as long on average as those not linked to any financial crisis, and the cumulative loss of output was about four times as great.
You can read the IMFs latest edition of the World Economic Outlook here.
In terms of historical lessons to apply to the current crisis, there seem to be two salient points. The first is that the current housing price collapse is far worse than any of those modelled in the past. The second is that corporate leverage appears to be holding up well. The IMF notes:
The deleveraging process by households in the United States is proceeding faster than in the typical recession, although deleveraging by firms seems to be proceeding somewhat more slowly and from a stronger initial position.
You can see this pretty clearly across this selection of key indicators from the IMF. The yellow and black lines representing historical precedent.
There appears then, to be something of a disconnect. House price declines indicate a severe recession, while corporate earnings and other credit indicators show a maintained position of relative strength.
Why are corporations apparently faring better this time? Is there really less relative leverage in the US system compared to, say, Japan, 1990?
Possibly not. Structured finance has provided a way of allowing corporations to run huge levels of off-balance sheet leverage over the past decade. In an extreme corporate form, consider the UK’s Punch Taverns. Most of the business is securitised. The leverage is, up to a point, utterly invisible. And that’s the payoff, because after the point – the cliff risk – the leverage suddenly reappears in a massive, overwhelming way. The rule applies, to a lesser extent, with other businesses, which have sourced cheap credit by silently partitioning themselves.
Invisible leverage then has created a more binary corporate world: stability up to a point, beyond which, sudden collapse.
All of which makes some of the more sanguine conclusions from the IMF’s report (e.g. graphs 5, 10 and 11 above) more doubtable.
As the IMF notes, in spite of those sound indicators, house prices are still the most important things to be watching (the first of the above series of graphs):
… the sheer size of the U.S. mortgage market, which is at the heart of the crisis, and the role of residential investment suggest that household saving and consumption behavior may play a much larger role in the current downturn than in the past.
Indeed, corporate earnings are beginning to fall. As Jackson notes, Citi analysts see a 50 per cent fall in earnings globally (of which just 10 per cent has happened already).
In a corporate world augmented by structured finance then, how could this play out?
Peculiar to this recession might be the steepness of some adjustments: bankruptcies and defaults are often surprises, but all the more so this time, perhaps.
One thing does seem very clear: stock markets – even assuming only the mildest of recessions – are not yet underpriced. The average peak-to-trough fall following a banking crisis is 55 per cent, in real terms.
The DJIA is currently 35 per cent down from its peak. Succour at least, can come from the fact that monetary authorities have so far been extremely proactive in cutting rates and supporting the banking sector.
One final metric. The IMF has a special formula for modelling financial stress, the FSI, which takes in a whole range of different inputs to see how economies are faring. Predictably, this index shows that countries are undergoing serious financial strains; the worst since at least 1980. But the true measure of this crisis is perhaps just how total it is. The below graph shows the percentage of the world’s countries which are showing a “stressed” FSI:
As you can see, it’s in the mid 90s. This is a global crisis.