I. Introduction
Ninety-one years ago a young American journalist named John Reed happened to witness the fall of the Czars and the rise of what would become the Soviet Union. His overly sympathetic account, published a year later, was entitled Ten Days That Shook the World. Well, for this observer, whose first job as a lawyer at Sullivan & Cromwell took him to 48 Wall Street now 38 years ago (where he became the youngest member of the Goldman Sachs team), there were ten days that shook the world of finance this September to a degree not seen since the Great Depression. As The Economist magazine described it (September 20th issue), “Ten short days saw the nationalization, failure or rescue of what was once the world’s largest insurer [AIG], with assets of $1 trillion, two of the world’s largest investment banks [Lehman and Merrill], with combined assets of another $1.5 trillion, and two giants of America’s mortgage market [Fannie and Freddie], with assets of $1.8 trillion.” If that were not enough, several days later the last two large, stand-alone investment banks, Goldman and Morgan Stanley, announced they would seek shelter and become deposit-taking bank holding companies.1 Then, almost as afterthoughts, first the country’s biggest savings bank, Washington Mutual, failed and was laid in a shroud at the door of JP Morgan Chase, and now Wells Fargo and Citigroup are fighting over Wachovia’s carcass like two hyenas. Utterly amazing.
In light of these Richter-busting events it seems more appropriate, for the third time in less than a year, to devote these few pages to a reprise and analysis of these extraordinary events rather than to the macroeconomy (in or near recession, almost certainly) and the capital markets (held hostage to the financial crisis).
II. What Has Happened
As noted previously in these pages, the roots of the crisis lie chiefly in the extraordinary rise of debt in American society in the last 20 or 30 years. Tellingly, it occurred in essentially only two places: the consumer and financial services sectors. Thus, consumer debt was 163% of GDP back in 1980 but hit 346% by 2007. Over the same period the financial services sector’s debt as a proportion of GDP exploded from 21% to 116%. That parallel rise is no coincidence, of course, for in a crude sense the financial services sector leveraged up and then on-lent the money to consumers—including, of course, for mortgages. And especially through Fannie and Freddie, it became the off-balance sheet arm of the federal government.
Where did this cornucopia of capital come from? Again, in simple terms, globalization and relatively free trade meant, in an era when the dollar is untethered to gold, our trading partners—petrostates and the new behemoths of Asia—had every mercantilist incentive to recycle their surpluses into the world’s sole reserve currency, and we printed all they wanted. The U.S. financial services sector was happy to help them just as the U.S. government was pleased to take its portion in exchange for Treasury and other official or quasi-official obligations. The result was a classic credit bubble, aided and abetted by deregulatory zeal and accommodationist monetary policy at the Fed. Essentially, our foreign friends issued us credit cards so we all went on a shopping spree, and Wall Street went on a bender. For all of these fun and games, mortgages provided the perfect combination of opacity and leverage, and little prevented originators and securitizers from going down market into the nether regions of subprime. And all of this machinery was greased by over-the-counter derivatives, which Warren Buffet called back in 2003 “financial weapons of mass destruction,” in their role in securitization (CDOs) and bond
market speculation (CDSs).
In the sober light of dawn, which began to break in the heretofore obscure subprime subsector of the mortgage market nearly two years ago, the financial system—commercial banks, investment banks, hedge funds and other “players”—began the painful process of deleveraging. A lot of them did not make it, starting with Bear Stearns and, at this writing, including Wachovia. The list of fallen icons is astounding, and the end is certainly not in sight.
III. Why It Has Happened
In 1933, the economist Irving Fisher2 first described the systemic or secular threat of debt deflation, which the U.S. disastrously experienced in the Great Depression as Japan did to a milder extent in its “Lost Decade” following the collapse of its property and stock markets in 1989. The problem, in simple terms, is that when everyone is overleveraged and suddenly needs to sell—and when what they want to sell is, in some sense, distressed—prices will plummet and markets may seize up. This, of course, is exactly what we have been watching for almost two years, and the process has only accelerated and now is a full-blown, international banking crisis so profound that banks are afraid to lend to each other, and companies cannot roll over their commercial paper.
This time the process has been compounded by complexity—the complexity of the instruments that provided the leverage in question. Many of them were not designed to be sold or, rather, resold by the initial purchaser in the “originate and distribute” business model that propelled Wall Street in the credit boom. That circumstance had two baleful consequences. First, at a time when “fair value” accounting (that is, mark-to-market valuation) had been imposed on most financial institutions, these opaque securities left balance sheets exposed to the sheer “unknowability” of their value, and huge writedowns had to be taken. Second, when the pressures of deleveraging forced their sale, they could be sold only at massive discounts to par.3
This opacity and complexity produced a final, fatal phenomenon: credulity among regulators, auditors and credit rating agencies. All wanted to believe, and for a while, they did, and there was no harm. One hears echoes of the 1990s’ tech stock boom.
AIG is a good case in point. Over a century in business, it was the world’s largest insurance company, but then it entered the “structured finance” business only a few years ago. A small group of people, mostly in London (out of a total workforce of over a hundred thousand), created a huge business in derivatives-based transactions and products—chiefly interest-rate swaps and the more nefarious credit default swaps—that accounted, at the peak, for only 5% of AIG’s revenues but between 20 and 25% of its profits. A cynic—or a realist—would say that all they were doing was renting (one can think of a less polite term) AIG’s pristine balance sheet and AAA credit rating on the confident promise that nothing could go wrong. Alas, their own forced deleveraging as well as that of their counterparties and their counterparties’ counterparties created a cascade of asset write-downs, margin calls, rating downgrades and stock price free-falls. AIG, now effectively the ward of the federal government, is no more. IV. Where Do We Go From Here?
At this writing, Congress has adopted the Administration’s proposal—after many months of ad-hocery (“Sunday night specials”)—to buy up to $700 BILLION of the toxic waste that has nearly frozen the financial system. Humpty Dumpty, however, will not be put together again. Thus, back in June the undersigned made a speech here in Boston in which he made bold to say that the business model of the publicly held investment bank was broken. Well, little did he know that the four then still standing would all be gone by mid-September—either bankrupt, merged or, in two cases, reborn as commercial banks.
Looking forward, it seems likely that having signed up for the federal dole and insulted the electorate’s sense of decency, the investment banking business will evolve into some kind of regulated utility, as commercial banking has been for nearly a century (despite the lighter hand on the tiller felt in recent years as a result of deregulation). Many of the functions of investment banking associated with raising capital will be performed by hedge funds and private equity funds in the “shadow banking system,” which in some sense are similar to old-fashioned merchant banks with the important distinction that they use the longest green of all, Other People’s Money. In this case, however, it comes mostly from large institutional limited partners and not public—and often fickle—shareholders.
Otherwise, it will doubtless take many months if not years for the banking system to resume normal functioning. One way or another, we will all pay the price.
Jerome W. Anderson
October 3, 2008 |
