The credit crisis is an example of systemic risk, whereby the effects of a crisis in one area of the economy quickly spread to a wide range of others, writes David Sandham

One of the surprising things about the subprime crisis is how quickly and widely it spread. Like a sticky goo that gets everywhere, what began in 2007 as a relatively local sector-specific crisis – a problem in the subprime mortgage market in the United States – quickly spread out of control into a crisis gumming up much of the world’s financial system.

Before the crisis, there was a long period of “innocence”, expressed perhaps by those who spoke of the “end of financial cycles”; it was a period of cheap cash, booming housing assets, and a world in which investors had an appetite for higher yields, and acceptance of greater risk.

There were, to be sure, doomsayers who warned Adam not to bite into the apple of toxic debt. Not few were the number of those who warned that the period of innocence could not last.

Like sensible mothers berating their errant, spendthrift sons, the doomsayers warned us of the dangers of gearing up on a housing boom.

But although there were more than enough of them (and now they are all coming forward pointing out how events have proved them right), no one predicted how widespread and systematic the backlash would be when it occurred.

Who could have guessed that the consequences could have spread so far beyond the housing market, and way beyond the borders of the United States?

The fall of the monolines, the nationalisation of Northern Rock in the UK, the nationalisation of Freddie Mac and Fannie Mae, HBOS sold, the nationalisation of AIG … who could have guessed it? Who could have predicted the ending of an era on Wall Street: Bear Stearns sold for a song, Lehman in Chapter 11, Merrill sold to the Bank of

America, and the remaining surviving main investment banks – Goldman Sachs, Morgan Stanley – bowing their necks to the yoke of Fed regulation for the first time in two decades?

New type of catastrophe

Though the banks have borne the brunt, the fall-out will not leave the reinsurance sector unscathed. Even before the terrible events of the week of 15 September, warning bells were sounding. “While we are retaining the stable outlook we have had for the past two years, our caution is heightened due to macro-economic challenges, both in terms of investment performance and claims in the future,” said Peter Grant, director, financial institutions ratings services at Standard and Poor’s, in an

interview with Global Reinsurance in Monte Carlo on 8 September (before the collapse of Lehman and the nationalisation of AIG). “If prices do not

stabilise at the January renewals we would change our outlook to negative,” he added.

Guy Carpenter, in a presentation in Monte Carlo, pointed to the financial catastrophe hitting both sides of insurers’ balance sheets. “We are witness to a new type of catastrophe – the financial catastrophe,” said Peter Zaffino, president and CEO of Guy Carpenter, prophetically (he was speaking just days before the collapse of Lehman and AIG).

According to Chris Klein, global head of business intelligence at Guy Carpenter, speaking at the same event: “If the credit crisis persists, there could be a post-loss liquidity crunch – particularly for credit.”

Even with sidecars and cat bonds to supplement traditional reinsurance, he warned, “risk transfer is only as effective as the capital behind it”.

David Sandham is editor of Global Reinsurance.

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