Monday, May 18, 2009

Cost of current credit crunch surpasses that of past Mexican and Asian crises

Published on May 19, 2009 

Thanks to the immense

Thanks to the immense size of the recent bail-out efforts, the current credit crunch has now become the most expensive financial crisis of all time, says Sprott Asset Management.

"In the UK and the United States, the bail-outs have grown to eye-watering proportions in a matter of months. As it currently stands, the commitments and guarantees of the US and UK governments are equivalent to almost 90 per cent of their gross domestic product," the report issued last month said.

"It makes the Mexican 'Tequila Crisis', the Asian currency crisis and the often-referenced US Savings and Loan debacle in the late 1980s look tame in comparison. Its cost, in GDP terms, is equivalent to that of the largest global military conflicts in world history."

The report raised an interesting question about the trillions and trillions of US dollars being ploughed into the financial sector to keep it afloat when as a matter of fact the financial sector represents only 30 per cent of the GDP of Western countries.

The size of the financial sector is significant, yet it does not on paper warrant bail-outs of this scale. For instance, the cost of the bail-out of the US financial institutions last year was US$12.8 trillion (Bt439 trillion), equivalent to 89 per cent of GDP. At the same time, the UK government churned out $2 trillion to bail out the British banking system, also equal to 89 per cent of GDP.

On April 23, Bloomberg reported UK-government support for the banking system had risen to ฃ1.4 trillion (Bt73.52 trillion) and might climb higher as the financial crisis spread to developing societies and economists warned lenders might need more aid.

"The size of this financial bail-out is unprecedented," Alan Clarke, an economist at BNP Paribas in London, told Bloomberg.

"The worry is that this is not going to be enough and the government may need to come back and step in again."

In 1997, when Thailand faced the financial crisis, the bail-out cost was only $17 billion, or 12 per cent of GDP. This was compared with $21 billion, or 9 per cent of GDP, for Indonesia and $57 billion, or 11 per cent of GDP, for South Korea.

The underlying reason for the too-big-to-fail mentality among the banking authorities is the exposure of the banks to the derivatives market. The size of the derivatives market is now about $743 trillion, equal to more than 11 years of what the world can produce.

The size of the world's equity markets is only $31 trillion.

Once one understands the size and limited disclosure information available in the over-the-counter derivatives market, one begins to see why some of the largest financial institutions cannot be allowed to fail.

"The impact on the financial system would be too unpredictable and potentially massive. The failure of a large derivatives counterparty would create 'black holes' on balance sheets, from which the value of quality assets would never emerge," Sprott Asset Management said.

"As it stands, whether the major banks are 'too big to fail' or have 'too many counterparties' to fail is a purely academic quandary, because given the proliferation of these financial instruments, the derivatives fallout of a failed counterparty could be

immensely damaging to the entire financial system."

For this very reason, the US Federal Reserve and the US Treasury had to come to the rescue of the American International Group (AIG), which is the major player in the credit-default swap, by ploughing almost $200 billion into this insurance firm alone. If AIG had been allowed to die a natural death, the global financial system would have collapsed beyond repair.

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