Don't Fear the Credit Crunch.(residential real estate industry in crisis)

Byline: Mohamed A. El-Erian (El-Erian is the president and CEO of Harvard Management Company and a member of the faculty of Harvard Business School.)

When the U.S. subprime-housing crisis first made the front pages of the financial press a few months ago, it was generally dismissed as an isolated event that would not have wider implications. Fast-forward to today and the tone is very different. Increasingly, there is talk that it may be a preamble to a major credit crunch. The concern is that this could throw

the United States into recession, undermining the global economy.

Views differ on who is responsible for the crisis--reckless lenders, imprudent borrowers or lax regulators. What is undeniable is that it was facilitated by an innovation that is having an impact on many segments of the financial industry: the use of derivative products and "structured" securities. They are traded just like stocks or bonds and form the basis of what are more commonly known as exotic mortgages. Over the long term, such financial innovation is welfare-enhancing. It serves to reduce the cost of financial intermediation, to distribute risk widely and make markets work more efficiently. But like any such shift, the journey to this long-term destination is inevitably characterized by excesses and accidents.

It is not just that too many people are sucked into activities that are too new to be well understood and tested. It also takes time to retool market infrastructure, upgrade supervision and develop appropriate valuation and modeling techniques.

Not surprisingly, then, several financial markets are now feeling the type of liquidity dislocation that affected subprime. Indeed, at one stage a few days ago, activity in the market for corporate bonds almost came to a standstill. The risks of using these new types of financial devices are particularly potent if investors assume a high level of leverage. Just witness the recent demise of two Bear Stearns hedge funds.

Given all this, concerns about a U.S. recession and a subsequent derailment of the global economy are understandable. But they will prove warranted only if three major and distinct "circuit breakers" fail to operate in the months ahead: