[Lee Jong-woo's Economic Reading] Overcoming the COVID-19 Crisis with the Basic Strength Developed During the Financial Crisis

Post-2008 Lehman Crisis Trauma, BIS and Fed Enforce Strict Bank Regulations
Few Financial Institution Failures...Liquidity Asset Ratio Exceeds 10%, Reserve Deposits Increase
7 Trillion Dollars Injected Globally...Effect of Funds Expected After Pandemic Peak

'Novel Coronavirus Infection (COVID-19)' and 'Trauma'. These have been the main culprits behind the global stock market decline that has shaken the world over the past month. COVID-19 needs no explanation. As a highly contagious disease, travel bans have been imposed worldwide, making economic slowdown inevitable. Corporate profits have also inevitably decreased, causing stock prices to plummet.

The trauma stems from the 2008 financial crisis. Few people were aware of the risks until the subprime mortgage, a relatively small product, went through a derivative process and manifested as mortgage defaults. In fact, it is more accurate to say that even those who fully understood the product details were few. Only after the crisis erupted did people realize how dangerous and large-scale it was, and now there is suspicion that a similar event might be occurring in the U.S. financial market.

If risks arise in the U.S. financial market this time, corporate bonds will play a leading role. The U.S. corporate bond market is about $9.6 trillion in size. Among these, high-yield bonds, which have lower credit ratings, account for $1.2 trillion. This is an increase of $400 billion compared to 2014, making up about 13% of the total corporate bond market.

Among companies with low credit ratings, energy firms are particularly problematic. U.S. shale oil companies need international oil prices to exceed $60 per barrel to break even, but if prices remain stuck in the low $20 range as they are now, losses will increase, eventually leading to bankruptcy. Of course, in terms of scale, energy companies might not be a major problem. A company's debt is calculated by combining bonds issued in the market and bank loans. The relevant figure for U.S. shale oil companies is only about 1.3% of the Gross Domestic Product (GDP). Since the total scale is in the 1% range, even if energy companies go bankrupt, it would not affect the entire U.S. credit market. The problem arises if widespread defaults occur among low-credit companies starting from these firms. Since the debt held by high-yield companies amounts to about 10.7% of U.S. GDP, it inevitably becomes a headache.

Therefore, Wall Street is paying close attention to Collateralized Loan Obligations (CLOs). These are products created based on loans banks have extended to companies. When banks sell these loan assets to asset securitization firms, these firms issue securities and distribute them in the market. These have been widely used as a means for low-credit companies to raise funds, and their structure is similar to the subprime mortgage that caused the financial crisis. It is still unknown how much of these products include bonds from low-credit companies and thus how risky they are. Only guesses exist, which is why the market is more unsettled.

Wall Street hopes that, just as the U.S. government purchased mortgage-related products during the financial crisis to stabilize the situation, it will intervene in the corporate bond market this time as well. The U.S. government has not yet provided an answer, as it judges that direct intervention in the private sector does not align with American-style capitalism. For this measure to be implemented, congressional approval is required, which is not easy. When the 2008 financial crisis occurred, the Bush administration submitted the Troubled Asset Relief Program (TARP) to Congress, but it was rejected due to opposition from the Republican Party. Even though they were the ruling party, the logic was that supporting financial institutions' bad debts with government funds was against capitalist principles. Eventually, after significant revisions and active support from the opposition Democratic Party, the bill passed, but its implementation was delayed and the scale reduced. Since the Republicans opposed supporting financial institutions with public functions, it is unlikely they will support handling the insolvency of general companies.

As the possibility of stabilizing the corporate bond market through policy decreases, the market has moved assuming the worst-case scenario, causing stock prices to fluctuate. Whether the U.S. government will engage in quantitative easing to purchase corporate bonds will be decided by public opinion. If the economy slows rapidly and problems arise in the credit market, increasing calls for quick resolution may lead to measures, but otherwise, the market will have to wait until it overcomes the situation on its own.

Once this hurdle is overcome, the situation will stabilize faster than expected. During the financial crisis, many financial institutions were already insolvent before Lehman Brothers went bankrupt. This allowed credit crunches to occur quickly and strongly, easily spreading to the real economy. Currently, there are not many insolvent financial institutions. This is thanks to the thorough banking regulations enforced over the past decade by the Bank for International Settlements (BIS) and the U.S. Federal Reserve (Fed). In 2008, liquid assets including cash accounted for only 3% of U.S. commercial banks' assets. This meant low preparedness for urgent situations, but now this ratio exceeds 10%.

The relationship with the Fed is similar. During the financial crisis, U.S. banks did not deposit excess reserves with the Fed. This was partly because the Fed did not supply funds as interest rates were rising, but also because banks could earn more profits by increasing real estate loans, so there was no reason to deposit money with the Fed. After the financial crisis, Fed regulations tightened, and deposits of reserves began to increase, now reaching $1.5 trillion. Households have also become more inclined to manage risks themselves. The loan-to-deposit ratio, which is the ratio of loans made from bank deposits, has decreased by 20 percentage points compared to the financial crisis. This is thanks to banks managing risks themselves, but also because households and companies have been reluctant to increase debt, which helped lower the ratio.

Although COVID-19 is causing turmoil, many corporate insolvencies have not yet surfaced. Vague concerns are at play, but once the disease is brought under control, the funds injected by advanced countries to stabilize the economy will take effect. During the financial crisis, the world injected $7 trillion to overcome the crisis. In the past month, advanced country governments have announced plans to spend over $4 trillion for the same reason. South Korea and the U.S. have announced unlimited funding supplies, which will help stabilize the situation.

There is no end to pessimism. It is acknowledged that there has never been an experience of controlling human movement before, and that COVID-19 occurred when advanced country stock markets were at their peak, so negative impacts are inevitable. Still, one must not ignore the fact that even worse financial crises have been overcome.