By Hans-Werner Sinn (China Daily)
Updated: 2008-03-12 15:08

In Europe, particularly Germany, a mortgage-backed security (Pfandbrief) is an ultra-safe asset, as normally banks finance no more than 60 percent of a house's value.

By contrast, such US securities are like a lottery ticket. US banks finance up to 100 percent of a house's value, sometimes even more, and the subprime market even includes loans to people without jobs and income.

Many European banks may not have understood this, yet they still shied away from revealing these dubious investments on their balance sheets. Instead, they placed them in conduits based in low-tax countries.

Those conduits are now showing gigantic losses that have to be covered by the parent banks, some of which are being driven to the brink of bankruptcy. This spring will show the necessary write-offs in the annual balance sheets, but the full truth will not become known before the balance sheets are published in the spring of next year.

As American assets have lost their attractiveness, their prices have dropped. This has meant either a decline in asset prices quoted in dollars or in dollars quoted in other currencies. Indeed, adjusted for inflation, the dollar is now nearly as low against the euro as it was against the deutschmark in 1992, when German unification resulted in the breakdown of the European currency system.

The prices of US homes are also declining at an accelerating rate, in many areas by more than 10 percent per year. The prices of traded mortgage-backed securities have followed house prices down.

Only US stock market prices have remained relatively stable. But it is only a matter of time until they fall, too. After all, the Standard & Poor's US price-earnings ratio is still above its long-term average - 26.84 in 2007, compared to its long-term average since 1881 of 16.31.

This asset meltdown is the reason for the likely recession. First, consumers, faced with tighter credit and falling house values, will need to cut spending, slowing the US economy and affecting all countries via world trade.

Second, with banks losing substantial amounts of equity capital - estimates now reach $300 billion and more - the need to maintain minimum equity-debt ratios will force them to curtail business lending, hindering investment demand.

True, the US Federal Reserve has tried to prevent a recession by cutting its interest rates. But the Fed cannot endow the banks with new equity capital and prevent a credit crunch.

More promising is the $150 billion tax cut that the US Congress recently enacted. Equivalent to one percent of US GDP, it is large by all accounts. Whether it is enough to compensate homeowners for the wealth losses resulting from declining house prices and to prevent the impending recession remains to be seen. But, whatever happens, the party is over.

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