Jewish World Review
Feb. 4, 2008
/ 28 Shevat 5768
Preventing a Panic
The fireworks of the primary season, climaxing on February 5, are like having a carnival on a beach while a tsunami gathers force offshore. "Hope" and "Change" as slogans may make people feel good, but they have the same relevance to the financial complexities threatening us as the clueless castaways on Lost, the quirky ABC melodrama.
The castaways are truly lost because they don't understand their new world. Understanding our new world should be the first requirement of all the White House hopefuls because what we are facing is a credit crisis so severe that it threatens the working of the economy. And so deep that it may take as long as two years to unwind even assuming the top policymakers understand how the new world works. The problem is so complex that nobody can give the right answers before knowing the right questions and gathering the right information. This is a much tougher task than Congress applying band-aids of tax and investment relief. The financial community itself is bewildered, unsure of its risks and liabilities and taken by surprise almost daily. The story of the 31-year-old trader at Société Générale, one of France's largest banks, reads like the script of a movie thriller. He bet $73 billion of the bank's money that European and German stock indexes would go up. When they turned down, the bank discovered the unauthorized trades and unraveled them at the stupefying cost of $7.2 billion.
Questions: How could one junior trader have bet so much without senior management knowing? How could the bank fail to monitor properly the sophisticated trading techniques and the computerized analyses that underscored the bets? How could it not be aware of the risks inherent in the incredible leverage by which banks borrow 80 to 90 percent of every $1 they invest?
Oversight failure. These failures are shared by many American investment and commercial banks. Merrill Lynch held subprime mortgages exceeding the net worth of the firm. Citigroup had $80 billion of sub-prime mortgages held off its balance sheet in so-called structured investment vehicles. In effect, this meant Citibank had guaranteed the financing to support a massive investment literally unknown to the financial community and much of its management. This at the same time it was holding an additional $50 billion of subprime paper on its balance sheet.
These and other banks invested heavily in all this paper because big profits come from borrowing inexpensively in the short term and reaping higher returns from longer-term securities (many of which earned AAA and AA from the rating agencies). Nice, but just as profits are magnified by leverage, the 1-to-9 ratio of cash equity to borrowing, so are the losses. If the price of the longer-term securities grew by 5 percent when the security had been financed to the tune of 90 percent credit, the result was a 50 percent return on the equity. But if the prices fell by 5 percent, there was a loss 10 times greater in the value of the equity. Your original dollar was worth 50 cents. In many cases, the equity was wiped out. The way up is also the way down.
The markets provided easy, almost unlimited financing to buy securities. But this bubble depended primarily on another bubble the one in housing. The assumption had been that house prices would continue to rise, enabling overextended borrowers to refinance the growing equity value in their homes. But when prices began to fall in 2007, mortgagees went into default. Bad enough it was the first time house prices had fallen year over year since the Great Depression. But worse, the defaulters, like falling dominoes, took down with them the institutions that had invested in subprime mortgages bundled into bondlike securities (collateralized debt obligations or CDOs).
The risk in these securities was supposed to be reduced and dispersed by a variety of bond insurance mechanisms (credit default swaps or CDS) but the rising tide of defaults in CDOs and corporate bonds has imposed heavy burdens on the insurers. The insurers can get the bond they guaranteed, but it is now worth much less than its face value. If the insurer can't afford these losses or goes bust, the bond bounces back to the "original" holders of the CDOs, who bear the losses they thought were guaranteed not to happen. The result can be a fire sale of billions of dollars or securities.
It is now clear that the assumptions underlying the pricing of CDOs and the like were based on over-optimistic computer-based evaluation models or on untested historical patterns especially during periods of acute market distress. Computers can make fast, accurate mistakes: garbage in, garbage out. The rating agencies too often relied on the information provided by the companies issuing these new securities. Now it is clear that this was a blunder, even by the rating companies themselves, a top official at Moody's rating service acknowledged.
The net effect is that instead of transforming risks and disbursing them widely, the derivatives have turned out to be a liability. Banks have had to take back tens of billions of dollars of lending onto their balance sheets bonds that are declining in value, either because the credit of the guarantor has declined or in response to market expectations of more defaults as equities continue to evaporate in home prices. Quite simply, a lot of smart people took a lot of foolish risks. The result has been a bursting of the credit bubble and a dramatic tightening of credit in the financial system.
Nobody runs faster than a sophisticated banker who gets scared. Banks are calling in loans or boosting the amount of collateral required to secure financing. Even interbank lending, the core of the financial system, was hobbled because banks had to preserve their liquidity and had lost confidence in the finances of other banks. So, today, the credit system has been virtually frozen. Lending across the economy is plummeting as banks undergo a huge deleveraging, with central banks almost powerless to control this contraction. This poses a grave risk to our financial system since few people even know where the liabilities and losses are concentrated, and they may not know until it is too late. Everybody fears more skeletons will be coming out of the banks' closets.
Fed limits. Lower interest rates promoted by the Federal Reserve Bank cannot fully counter the forces of credit and liquidity contraction created by these large losses, which in the case of banks may require them to reduce their loan portfolios by a multiple of 10 times those losses. Further, lenders are disinclined to lend when credit markets are in turmoil. Many companies, especially small and midsize companies, will now find it much harder to get the money they need to fuel their businesses as banks seek higher rates and more collateral. This freeze will not be corrected until the bad debts and losses work themselves through the financial system.
In other countries where a banking crisis was transmitted through to the economy, it took an average of at least two years for growth to return to normal trend lines, and sometimes even longer. It is hard to see how the U.S. economy will bounce back more quickly.
The crisis has prompted the president and the House of Representatives to agree to a package of stimulants. By no means will it be adequate to the hour. The depreciation allowances will help only at the margins since lack of demand is the issue, not lack of capacity. Businesses won't develop more capacity until they know their customers are capable of purchasing their products. The tax rebates won't have effect until the summer, and then are most likely to be used to pay off debt rather than be spent in the marketplace. Many older people, having lost substantial equity in their homes, and who will lose more as home values continue to shrink, will now begin to save out of income and thus reduce their consumer spending. The December unemployment rate hit 5 percent, the clearest harbinger of the future. Other labor market indicators are similarly negative, including initial and continuing job layoffs and the assessment of job availability. Now some 23 states are estimated to be in a recession, and seven more are verging on a recession.
Quite simply, this financial crisis is the worst since the panic that led to the Great Depression. As a result, the recession may well be deeper and/or longer than any since the end of WWII. No one knows where the bottom is. That is why the level of confidence in both consumers and producers has declined and must be restored if the financial fiasco is not to turn into a crisis for the broader economy.
The first pressing issue and there is no time to lose is to get more equity into the bond insurers before the rating agencies downgrade them, or they go bust, and create a devastating financial panic. As former Secretary of the Treasury Lawrence Summers pointed out in the Financial Times, "Their failure or loss of an AAA rating is a potential source of systemic risk."
The prime official responsibility for getting the repairs started swiftly falls on state insurance regulators. The New York state insurance superintendent, Eric Dinallo, has led the way in asking banks and big investors like Warren Buffett to inject fresh equity. But clearly there should be a national policy with the Fed involved.
The second pressing issue is to see what more can be done to rebuild confidence in the financial system. There is one imperative that should drive these reviews. The amount of bank borrowing and leveraging and its inevitable deleveraging must never be allowed again to convert a banking crisis into an economic crisis. The Federal Reserve and the Congress will have to improve, directly or indirectly, scrutiny of the activities of the financial industry that migrated outside normal review. New financial instruments, including default swaps, will have to be regulated and so, too, will the rating agencies that almost literally took the place of the Federal Reserve in controlling lending capacity through securitized obligations.
We have yet to see the problems emerging from the securitization of credit card debt, auto loans, and consumer debt, which will also have to be reviewed and incorporated into a reasonable regulatory system.
It would be revealing to see before February 5 how the candidates in either party respond to the knotty issues. Our perilous times require expert knowledge and managerial abilities, in addition to uplifting rhetoric.
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© 2005, Mortimer Zuckerman