A financial crisis erupts when a large volume of financial assets suddenly appears risky and investors want to get rid of their holdings. These assets become ‘toxic' – not simply risky, but carrying a risk that cannot be quantified. Given that their risk cannot be calculated, their owners just want to sell them – sometimes at any price.
In 2007-08, this was the case for a class of securities based on residential mortgages in the United States (RMBS, or residential mortgage-backed securities). During the boom, these securities were sold as risk-free, on the assumption that US house prices could not decline, as this had never happened before in peacetime.
But this assumption was shattered when real-estate prices began to fall in 2007. Initially, there was little basis for re-pricing them rationally, because a broad-based drop in house prices was unprecedented. Moreover, financial institutions, which held large volumes of RMBS, were ill-equipped to measure the risk, and some would have been bankrupted if forced to sell their holdings at the fire-sale prices.
The euro crisis followed a similar pattern. Public debt was considered the ultimate safe asset, underpinned by the ‘fact' that no advanced country had defaulted in the post-1945 era. Indeed, its risk-free status was embedded in the European Union's regulatory framework, which allows banks to hold large volumes of any eurozone country's public debt without having to put aside capital to cover potential losses.
The de facto default by Greece early this year ended investors' complacency. The government bonds of peripheral eurozone countries thus became toxic. Given the unprecedented nature of the Greek default, the market valuation of peripheral debt has fluctuated widely.
Moreover, many banks held so much public debt that they would have been bankrupted in the event of a full-blown default. This led to extreme instability in the eurozone's banking system.
A financial crisis ends when either the doubtful debt has been socialised, or its valuation has stabilised and it has migrated to investors who are solvent enough to bear the risk. This was the case in the US. The authorities acquired some of the ‘toxic' assets, which over time became easier to value.
The market prices of most RMBS rebounded as losses resulting from homeowners simply abandoning their properties were much lower than feared. Moreover, RMBS migrated to institutions that were able to manage the remaining risk. Today, RMBS are no longer considered toxic, allowing the market to function normally again.
This pattern can be only partly repeated in the eurozone, where both debt socialisation and a return to normal risk assessment appear more difficult.
Limited capacity for debt socialisation reflects the EU treaty's ‘no bail-out' clause, which bars outright mutualisation of (national) public debt at the eurozone level. Moreover, the new rescue fund, the European Stability Mechanism, can lend no more than €700 billion, a fraction of the public debt of the countries that may need financial assistance.
Only the European Central Bank (ECB) could implement true socialisation of national debt in the eurozone. But EU law expressly forbids any form of ECB financing of deficits.
A return to normal risk assessment is also more difficult in Europe. The European Council has declared that Greece's default remains a unique case. But a return to the status quo ante of risk-free public debt is not compatible with the continuing limits on the socialisation of national debt. Indeed the risk has become more concentrated, as banks in the periphery have increased investment in their own countries' bonds.
These differences imply that the return to normal market conditions will be slower in the case of the euro crisis. Nevertheless, the crisis should abate somewhat, as the most risk-averse institutions have sold their holdings of peripheral countries' sovereign debt. Moreover, the ECB has clearly stated that it will not allow the euro to disintegrate. That guarantee has insured investors against their biggest risk.
Daniel Gros is director of the Centre for European Policy Studies. ©: Project Syndicate, 2012.