In our last essay, we once again noted that the ongoing melodrama of the capital markets and the overall economy had some rather disturbing background music and warned that the next scene might contain some unpleasant plot developments, which would be known as the Great Unwinding. Only days later, the so-called subprime mortgage mess claimed its latest victim when BNP Paribas, a large French bank, disclosed that an off-balance sheet investment fund (effectively, a proprietary hedge fund) had shut its redemption window due to the disruptions in the market for securitized batches of U.S. subprime mortgages and various iterations and derivatives thereof. That so large and sophisticated an institution—and at so great a distance from the underlying collateral—could be gravely touched sent massive ripples through the credit and equity markets.
It could be said that the seventh year of every century is a dangerous one for lenders and investors, at least based on the last two. One hundred years ago capital markets witnessed the last financial crisis that historians label a panic—the Panic of 1907. Whatever they eventually call the crisis of 2007, they will surely remark on the similarities between the two. In the first, after a long period of prosperity, largely financed by foreigners, highly leveraged speculators on the New York Stock Exchange found their loans called by the big New York banks for no obvious reason. As they liquidated their positions, a disorderly decline in stock prices ensued, leading to general panic. At that time (perhaps like this time), calm was restored by one man—J.P. Morgan—who literally locked the chiefs of the big banks in his library and told them they could go home only after they
settled the matter. And so they did. Because episodes like these occur rarely—the last in 1998—and because this summer’s rightly attracted so much attention and could yet have more serious consequence for the capital markets and the “real” economy, it seems worthwhile to conduct a more extended inquest in these pages. Perhaps the most compelling reason, however, is that the “credit crunch” revealed, in rather stark terms, the new architecture of the global financial system. Its features include liberalization and deregulation (the emergence of unregulated entities as major providers of credit), financial innovation (essentially, securitization), technology (securitization and program trading) and globalization (massive U.S. capital account surpluses as the concomitant of massive current account—i.e., trade—deficits). At the broadest level what has happened is that the banking system, once the economy’s shock absorber backstopped by the Federal Reserve, has a much smaller role in the overall distribution of credit while new players such as mortgage brokers and non-bank lenders have assumed most of the origination function for mortgage lending and then have shed risk through other intermediaries and eventually to end-users, such as endowments, pension funds and hedge funds of various stripes. This process is called “disintermediation.” This process has had many benefits such as diffusing risk much more widely than it was when “money center” banks, large insurance companies and other institutional holders of government and corporate debt dominated the credit market, and by law the S&Ls owned the home mortgage market. Now, chiefly through securitization, the originators and holders of risk are greatly attenuated, and risk has become much more opaque. Whereas credit was once allocated by flinty-eyed committees at banks or nervous Wall Street underwriters of corporate bonds, today it is packaged and repackaged, sliced and diced, then festooned with now-dubious gold stars by the rating agencies and ultimately purchased by hugely leveraged hedge funds. The buck must stop somewhere, but everyone believed that it would stop somewhere else. All of this was greatly facilitated by the “imbalances” created by the U.S. current account deficit, which necessarily meant a massive capital account surplus. Enormous amounts of foreign capital came to the U.S., lowering interest rates and generally supplying astounding amounts of liquidity. Essentially, we all had to go into debt—consumers and the Federal government alike—because otherwise foreigners had no way to recycle their trade surpluses. Why save when foreigners are willing to lend or invest for peanuts? In simple terms, what happened next in the credit markets was that after the Bear Stearns affair described in our last essay and then the BNP Paribas bout of indigestion mentioned above, all the players suddenly realized hat they had no idea where the risk of the subprime mortgage debacle actually resided nor did they have a clue s to how big it was. The relevant obligations were, in fact, very widely held. As default rates on the underlying mortgages began to rise (essentially because of the shoddy underwriting standards of unregulated
mortgage brokers and lenders), the value of those AAA-rated subprime holdings, which were very thinly traded, came into severe question. Where they were held as collateral for loans, margin calls went forth, and efforts to sell them for liquidity were futile. A downward cascade ensued, with prices plummeting and interest rates in certain abstruse corners of the credit markets skyrocketing. Eventually, stock prices began gyrating in
sympathetic harmony. To illustrate: for generations, large companies have financed their short-term needs in what is called the commercial paper market, essentially issuing unsecured IOUs of no more than 270 days’ maturity. Well, it developed that as a result of the subprime-fuelled explosion of mortgage-backed security issuance, nearly one half of the commercial market consisted of “asset-backed” paper (ABCP). The asset in question was not an investment-grade corporation with a strong balance sheet and long record of earnings but a subprime-based security—nothing “commercial” about it, even though it may have had a AAA rating. In fact, the issuer was often a highly leveraged hedge fund seeking to earn a spread between the rate paid on the commercial paper it issued and the subprime obligation it held (and pledged). Effectively, it acted like a bank but with a classic
funding mismatch: the assets held were long-dated and illiquid, and the liabilities were short. The fact that commercial banks were playing this game with off-balance sheet proprietary vehicles only increases one’s astonishment.
The end was a classic “Minsky moment,” named for the late economist Harold Minsky, who in opposition to the prevailing “efficient markets hypothesis,” claimed, like the 19th century economist and journalist Walter Bagehot quoted above, that such episodic bouts of speculation and excessive leverage followed by panic and collapse are inevitable. In this case, the ABCP market simply dried up, and interbank lending rates (as exemplified by LIBOR) spiked. As one observer put it, it was like Keynes’s metaphor of musical chairs except that this time when the music stopped, there were no chairs. Trust and confidence evaporated, and everyone sat on his hands, not only unsure about his counterparty but about his counterparty’s counterparty.
Of course, central banks rode to the rescue. J.P. Morgan was unavailable, but his designated successor, Ben Bernanke, new chairman of the Fed1, went to work. At first, on August 7th, the Fed basically dragged out the fire hoses by lowering the discount rate and signaling to banks that credit was available. Then, only 10 days later, when further signs of “contagion” ensued2, the Fed opened them up and cut the fed funds rate by an unexpected half-percentage point. The fire was soon extinguished . . . so far. Looking back at these events, with the stock market having regained its earlier record high and credit markets mostly returned to normalcy, one must ask, at least tentatively, whether in the long run the Fed’s response was wise or whether, as James Grant suggests above, once again it rescued the hostages by bribing the hostage takers. Was it, to use the popular term, an instance of moral hazard? Were its actions more similar to providing government-subsidized flood insurance for seaside home owners or to building a new firehouse in an unserved neighborhood? For nearly 20 years, first under Alan Greenspan and now under Ben Bernanke, the
Fed has taken the position that it is unable to identify “bubbles” in asset prices and therefore will not attempt to deflate them. It will only seek to mitigate the after-effects when one bursts. Still, one must ask whether such a position only assures that clever people will seek to profit from bubbles when they occur and leave it to others to pay for the ultimate costs. Many argue that when it cut the fed funds rate to 1% in 2003 and left it there for two years, it inadvertently contributed to a very rapid rise in home price prices that looks like a now-deflating bubble and that ultimately led to last summer’s panic of 2007.
Jerome W. Anderson
October 7, 2007
1 Ironically, Congress created the Federal Reserve System a few years after, and in direct response to, the Panic of 1907 precisely
because of the perceived folly of relying on one banker to solve national financial crises.
2 Also ironically, the tipping point appears to have been a tentative government report that job formation had turned negative, a
report that just a few days ago turned out to be wildly pessimistic. |
