THE GLOBAL CREDIT CRUNCH: A CRISIS OF CONFIDENCE

The meltdown in the U.S. subprime mortgage market that began last year has triggered a crisis of confidence in U.S. markets – and the ramifications are global.

Call it the deleveraging of the United States. Ready or not, individuals and businesses have no choice but to cut back on debt. It is creating a domino effect, bringing down companies ranging from small, regional banks to global financial institutions.

This is a painful contrast to the past decade of easy credit, which prompted massive spending and borrowing on Main Street, on Wall Street and by governments. Between 2002 and 2006, U.S. household borrowing grew at an average annual rate of 11 percent, while financial institution borrowing rose an average of 10 percent annually. In short, borrowing far exceeded the U.S. economy's overall rate of growth.

Today, many of those borrowers can't pay back their loans, affecting everything from the subprime mortgage and auto loan industries to the credit-default swaps markets. Even nations have felt the impact of the credit crisis. According to data from CMA Datavision, U.S. sovereign debt has never been riskier, with the five-year probability of default reaching a historic high of 2.8 percent on October 6, compared to 1.3 percent for Norway and 2.2 percent for Germany. CMA is a subsidiary of CME Group.

The housing market is where it all started. According to the Standard & Poor's/Case-Shiller home price indexes, housing prices rose 85 percent in real terms from 1997 to 2006. That represented the biggest housing price boom since 1890. One reason people could buy more expensive homes was that their mortgages could be bundled into financial instruments such as mortgage-backed securities, which were sold to banks, Wall Street firms and sovereign wealth funds, among others. Rising demand for housing and housing-related securities fueled the growth of risky subprime mortgages. The bubble burst as subprime borrowers began defaulting on their mortgages, and the crisis spread to other markets.

Confidence remains low as the steady drumbeat of dismal headlines continues around the world.

"We are clearly at a credit gridlock right now... and there's some selling in the marketplace that has nothing to do with the fundamentals," says Phil Falcone, senior managing director of Harbinger Capital Partners, at CME Group's Global Financial Leadership Conference. "I think that there will continue to be some pretty decent opportunities, probably more in the equity markets than in the credit markets. You're talking about some really good companies that are trading at levels we haven't seen in quite some time. But we also have uncertainty about what the Fed's going to do, what the Treasury's going to do... I think it's keeping people out of the marketplace."

CNBC reporter Maria Bartiromo, who also participated in the September conference, says, "You look at the environment and you recognize that these truly are extraordinary times. I have this front-row seat and the amazing fortune to be able to sit down with some of the players on the front lines. It seems that we're going to see a further deterioration of the economy, with all of these layoffs and with the financial system continuing to weaken." She adds, "One executive I spoke with today said to me, 'I wasn't here in 1929, but I can't imagine that the destruction of wealth is any different.'"

Opportunities for managing risk

Yale University economics professor Robert Shiller sees the crisis as an opportunity for innovation, especially when it comes to managing risk.

"It's when there's a crisis like this that we can get new and important things done," Shiller says. "I'll remind you the last big housing crisis was in the 1930s. Both the private and public sector made major changes and as a result, this country emerged far stronger from the Depression crisis. Other countries in the world at the time didn't respond as constructively and their outcome was not as good. Many of these countries are belatedly imitating some of our institutions that were invented in the 1930s."

As co-founder of Case Shiller Weiss Research Group (now part of Fiserv) and of MacroMarkets LLC, Shiller has developed several innovative risk-management products, including futures and options on the S&P/ Case-Shiller home price and composite indexes. Shiller thinks new products could help manage risk and restore stability to the housing market. He suggests home equity insurance and continuous workout mortgages that would essentially ensure that a homeowner wouldn't lose all home equity in a declining market. These new products could be hedged in the futures markets, where improved price discovery also could help temper future real estate bubbles.

"What we're doing is after-the-fact bailouts," Shiller says. "To make the longer-term situation more stable, I think it's really fundamental to create new hedging markets. Fannie Mae and Freddie Mac could have hedged their real estate risk if we had had a big and active hedging market for real estate. Such a market could prevent the need, somewhat, for this kind of bailout to occur in the future."

To Shiller, the futures markets are an example of the democratization of finance. He says that making financial services more available and transparent to all would be a highly desirable outcome to the current credit crisis.

"A few big institutions on their own account have been creating all kinds of products that are then vulnerable to the counterparty risk of those institutions," he says. "We have been living in a world where it's just our excessive faith in the institutions that supports everything. That's the world we're leaving. With clearinghouse sponsorship of products, the counterparty risk is gone... a futures market is an example of a more democratized financial institution, and that's what's going to come."

RESTORING CONFIDENCE THROUGH CENTRALIZED CLEARING

In many respects, CME Group is like an insurance company. It offers hedging and risk management products that allow investors, borrowers, lenders and commercial companies to protect against price risks in interest rates, equities, foreign exchange, commodities, energy and other instruments.

Central counterparty clearing is one mechanism that helps CME Group customers manage risk – backed by CME Clearing's $7 billion financial safeguard system, which guarantees the performance of every transaction on the exchange. No customer has ever suffered losses as the result of a clearing member default at CME Group. The central counterparty model provides full transparency of market activity, prices and exposures. It also provides the added benefit of marking positions to market twice daily to transparent prices, so market participants and clearing firms know where the positions stand throughout the trading day. This concept could help stabilize the $55 trillion credit-default swaps (CDS) market, says CME Group Chief Executive Officer Craig Donohue. Donohue presented his view on this market at a recent Council of Institutional Investors meeting in Chicago.

Credit-default swaps allow investors to either bet on the chance of a debt default, or protect themselves from that risk if they own the underlying corporate bonds. Essentially, one party pays an annual fee to another in exchange for a promise of compensation in a default. Credit risk is therefore syndicated out among numerous investors, rather than concentrated in the hands of fixed income investors.

The CDS market was severely challenged as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual were settled. Because this market is so opaque, it was unclear for weeks how many contracts were to be settled and whether payouts on the defaulted contracts were concentrated with any particular financial institutions or market participants.

To restore confidence in the over-the-counter derivatives markets, Donohue recommends greater product standardization, price transparency, central counterparty clearing, independent and objectively determined prices as "marked to market" by a clearinghouse, automated trade processing and greater customer protections. In short, he recommends that the OTC markets function more like the regulated futures markets.

"I believe we are about to enter a new era in U.S. financial markets where transparency, market integrity and central counterparty clearing safeguards will take on greater importance," says Donohue. "We have a unique opportunity ahead to play a key role in reshaping financial markets and regulation for the 21st century."

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