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The Impact of the Subprime Crisis on the Global Financial Order

January 18, 2008

Overview

The "subprime crisis" can be divided into three major stages. In Stage 1, from late 2006 to the spring of 2007, a number of mortgage specialists collapsed. In Stage 2, from the spring to the summer of 2007, the collapse of hedge funds under the umbrella of major securities brokers triggered a failure of the ABCP (asset-backed commercial paper) market and a liquidity crisis in the short-term lending market. In Stage 3, from the early autumn of 2007 onwards, major subprime-related losses have emerged in the accounts of leading European and US banks and the liquidity crisis has become a financial system crisis.

The subprime crisis has exerted downward pressure on America's macroeconomy by a number of routes, including (i) a fall in employment in construction, finance and related industries, (ii) a prolonged period of adjustment in the housing market due to the reduced demand and increased supply caused by a tightening of lending criteria and rise in the number of auctions, and (iii) a fall in consumer spending due to the reverse asset effect caused by a fall in housing prices and the tailing-off of the cash-out effect. Looking to the future, there is likely to be a rise in the default rate, and the situation is not likely to stabilize before the second half of 2008.

Meanwhile, the financial and capital markets have been affected by (i) a further tightening of lending criteria by banks, (ii) turmoil on the credit market, and (iii) the contraction of the ABCP market and a shortage of liquidity on the short-term lending market. There are fears that the future will bring (i) a rise in the number of banks falling into difficulties due to mounting losses, (ii) a deterioration in the business performance of other financial business formats such as monoline financial guarantee specialists, and (iii) a contraction of the M&A market due to a fall in LBO finance.

There has been much discussion and many different estimates have been made as to the likelihood of banks suffering greater losses. For the purposes of this report, two estimates were made of the worst-case scenario for the subprime crisis. In the first, the additional losses, including both losses on securitization products and losses arising on non-securitized mortgages, come to an estimated total of $142 billion. In the second, where the scope includes Alt-A/Alt-B and synthetic CDOs as well as subprime mortgages, global subprime-related losses come to an estimated total of $463.6 billion.

In some respects, the subprime crisis was aggravated by accounting-related problems. The new accounting standards (FAS157) adopted in the United States in November 2007, forced a review of valuations of CDOs, etc., which caused banks to post substantial losses. Moreover, it is now clear that excluding SIVs for which risk was not entirely eliminated from the scope of consolidation was an error in accounting terms.

The root cause of the current subprime crisis is excess liquidity due to global imbalances. The sources of this excess liquidity are the four new power brokers of oil money, the central banks of Asian countries, hedge funds, and private equity funds. Oil money and the Asian central banks in particular are rapidly gaining importance in global finance by lending to European and American banks whose equity capital has suffered through the medium of SWFs (sovereign wealth funds).

The current subprime crisis may lead to a change in the global flow of funds, which has, until now, been towards the United States. With nowhere else to go, money is now also flowing into the markets of newly industrialized countries and commodity markets and, in addition to bringing about worldwide asset inflation, this may increase the volatility of the markets. Moreover, as SWFs may sometimes move for political motives, it may become more difficult, in future, to achieve international harmony in the field of finance. In future, it will no doubt be necessary to reconsider how market conditions are maintained to ensure the efficient movement of funds on the international financial markets (regulation and supervision of banks, rules under international accounting standards), taking into account these risks. 2008 is likely to be a turning point, seeing the beginning of changes in the global financial order brought about by the subprime crisis.

For more information on the content of this report, please contact Lirong Li, the Japan Research Institute, Limited.

Tel: 03-3288-4338
E-mail:li.lirong@jri.co.jp

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