Increasingly complex instruments have contributed to the development of a far
more flexible, efficient, and hence resilient system than the one that
existed just a quarter century ago.
—Alan Greenspan, 2005
One man’s rescue is another man’s bailout.
—Anonymous
No industry [other than banking] has a comparable talent for privatizing gains
and socializing losses.
—Martin Wolf, Financial Times, Jan. 16, 2008 |
I. Introduction
Given last quarter’s baleful developments, it seems appropriate, for the second time in a year, to
comment only briefly on the usual subjects of the “real” economy and the stock market and instead to discuss the on-going “credit crunch”. As to the economy, suffice it to say that it is likely that we have entered a recession. Three successive months of negative net job growth are a powerful sign of such a condition. The only real question is how severe it will be and how long it will last, though a true housing crisis would assure a deep and protracted one. As to the stock market, we came close to a technical bear market (down 20% or more) early in the first quarter, but since then prices have recovered partially. We seem to have entered the proverbial “trading range.” Looking forward, valuations remain reasonable if a bit elevated, especially as corporate profit margins and earnings growth, which have been stellar for some time, begin to mean-revert under the pressure of a slowdown in revenues as the economy contracts.
II. The Credit Crunch
It was certainly appropriate, if not inevitable, that Bear Stearns, the Wall Street investment bank that essentially inaugurated the crisis last June when two of its proprietary hedge funds collapsed, pushed the crisis into a new and more dangerous phase when it itself nearly collapsed in March. In a shotgun marriage arranged (and largely financed) by the Federal Reserve, the scrappy bank, always an outsider next to the rest of the Street and the most leveraged of them all (plebian or patrician), was acquired by before that time total debt was 1.2 times GDP, but then it rose annually at a 45 degree angle until it reached 3.1 times.
For large financial institutions, especially investment banks, so-called “structured finance,” the
umbrella term for the alphabet soup of new derivatives-based instruments and vehicles, arrived at a
most fortuitous time in the late 1990s and early 2000s. Commercial banks for years had been losing market share for commercial lending as a result of disintermediation, and Wall Street, the great disintermediator, had seen its traditional lines of business like underwriting, conventional trading and M&A begin to dry up, especially after the tech bust in 2000.
And so it was that financial innovation and deregulation allowed the industry to gain access to the
massive home mortgage market, which was, as noted above, itself growing rapidly through the
wonderful new world of Alt A and subprime mortgages with lovely adjustable rates (eventually to
include Ninja loans—no income, job or assets). Clever accountants, lawyers and financial engineers found ways to move these assets off the industry’s balance sheet but allowed it to book the profits, themselves inflated by Wall Street’s new love of leverage. The industry also enabled rapidly proliferating and growing hedge funds to do the same thing. As prices rose, ROEs (return on equity) were wonderfully raised and thus stock prices, too. It was all “pro-cyclical” (i.e., self-reinforcing) and all based on the premise that house prices could never decline nationwide (as they had not since the Depression), even though they had been rising for some time at rates far in excess of household incomes or rents. Soon enough, they began to fall and the 100-year flood arrived even though it had been less than 20 years since the last one—the S&L crisis of the early 1990s.
And so it was, too, that over the last year or so the rest of us have come to know the surrealistic world of asset backed commercial paper that was not really backed by anything a 10th grader would call an asset; of auction rate securities that fail to auction; of collateralized debt obligations whose AAA-rated collateral has no market and may be worthless; of “monoline” insurers (of municipal bonds) that decided it would be more fun and profitable to add a second line and insure CDOs but could not possibly now make good on that insurance; etc. Of course, the problem is not limited potentially to things linked one way or another to residential mortgages. Another potential time bomb is called the credit default swap (CDS). Originally, they provided a form of insurance (though not regulated as such) for corporate bond holders but soon morphed into a speculator’s paradise. Only a few years ago they aggregated a few hundred billion dollars, but at latest count the total stands at $45.5 trillion, vastly in excess of the debt insured.
So where do we go from here? The most directly analogous experience is probably the S&L crisis
referenced above. That, too, had its roots in ideologically driven deregulation and capital markets
innovation with more than a touch of fraud involved. It cost the equivalent of 3% of GDP to wipe
away the mess. At this point write-offs, bankruptcies and bailouts from the present crisis are likely to cost at least this much, but that assumes that none of the other time bombs salted around by structured finance (like CDSs) explodes. All in all it is going to be dicey and expensive to clean up the Street’s Augean stables.
Jerome W. Anderson
January 3, 2008 |
