Tuesday, September 15, 2009

Financial Meltdown, Part I

(not Charlton related, but interesting)

I’ve been intending to write something substantial about the ongoing global economic crisis, but events have seemingly been changing quicker than I can write.

Most of the write-ups in the general media have been disappointing, with the notable exceptions of The Economist and to a lesser extent, the FT.

Where I sought unemotional analysis, I typically found only self-serving or politically-motivated guff. This is seemingly only getting worse.

However with today being the anniversary of the collapse of Lehman Brothers on 15 September 2008, and with the recent rally in risk assets having provided something of a lull after the storm, it seemed an appropriate time for me to reflect on the extraordinary last twelve months.

I’m certainly no expert in finance, but I enjoy trying to explain its workings to those who know even less and feel overwhelmed by events. Hopefully you will find it illuminating, even if you don’t agree with all of it.

I will attempt to do so in three parts, beginning with the background to the meltdown:

It feels like an age since I first wrote about subprime mortgages (Mar 2007), and their possible implications (Jul 2007).

I’ve since argued in a couple of more recent pieces that US subprime mortgages were not ‘the problem’, but merely happened to be the first manifestation of the credit-fuelled madness of the last decade.

It could have initially revealed itself almost anywhere, but it is vital to understand that eventually the unsustainable credit boom had to turn to bust.

The full impact of that generalised madness is now all too apparent in the insolvency of major banks, the effective collapse of entire smaller countries (and their governments), and the sudden and shocking fall in global demand, leading to a recession and rapidly rising unemployment.

First, a personal and slightly unconventional recap of how we got here. A confluence of events occurred, which individually may have been rather beneficial, but collectively proved to be explosive especially when mixed with human greed.

In the developed West, low interest rates (generated in order to fight the worst vestiges of the late-1990s technology, media and telecoms [TMT] bubble) existed alongside the coincidental ongoing disinflationary effects from the rapid growth of emerging market labour supply, particularly in India and China.

An often overlooked aspect of the TMT bubble, is that the overinvestment it encouraged led to considerable and unnecessary spare capacity in key sectors of the economy.

As a result, after interest rates were cut in its wake, the cost of capital fell at a time when ‘natural’ opportunities to deploy it were somewhat scarce. Why build a new hi-tech factory, when the existing ones are not working at full pelt?

The capital instead flowed into ostensibly less exciting investment opportunities, albeit ones that could be easily leveraged at low interest rates.

This illusion of higher returns without higher risk, would be a key theme throughout what ultimately transpired.

Residential property was the most popular global recipient of these flows, and one that appealed to man’s base instincts for shelter and space.

Crucially however, in the developed world it remains ultimately a vital yet unproductive asset, other than what is required to cater for net new household formation.

Moving the working population from shanty towns to apartments in the developing world directly enhances their productivity, but building thousands of Yuppie apartments in the middle of Leeds does not.

The housing stock in the UK for example is not fulfilling its sheltering role any better today than it was a decade ago, and arguably somewhat worse given shoddy modern building standards.

Meanwhile the ongoing shift in Western economies (since the 1980s) away from manufacturing, and towards the service sector continued to serve ostensibly to reduce the ‘volatility’ of economic growth.

In the words of our own hapless PM, Gordon Brown, “No more boom and bust..

The most cyclical or costly aspects of Western corporate operations continued to be outsourced to the eager new companies in the above developing world.

Concepts such as ‘just-in-time’ inventory management, or ‘call centres’ were a direct response to this new source of cheap labour supply.

This combination of low interest rates, disinflationary forces and reduced volatility of business outcomes, inevitably led to a certain complacency.

This was not only on the part of the traditional consumption-led economies of the UK and US, but also from those that fed that consumption, notably the major ‘savings-rich’ Asian countries (especially China), but also Germany, the world’s engineering heavyweight.

One of the ironies of the bust is that the bloated debt-fuelled countries may emerge in better shape, than their more frugal counterparts due to these enormous imbalances.

When reduced to mere equations, economics can be remarkably simple; every nation’s current account deficit (exports minus imports), must always be matched exactly by an equivalent capital account surplus. In short, spending must be financed.

Thus the property-led consumption boom that was ignited in countries such as the US, UK, Spain and Ireland, was matched by a willingness to fund that boom, by these frugal savers in the rest of the world.

Ordinarily these imbalances would be reduced via the effect of currency, but in the notable case of China, they continued to maintain a fixed exchange rate against the US Dollar in order to protect its low value-added export economy.

Germany meanwhile, the powerhouse of the Eurozone would be forced to accept a weaker currency than its bulletproof economy would otherwise warrant, generating even greater demand for its world-class cars and sausages.

In the absence of a tacit acceptance of enormous differentials in unemployment (or transfer flows to offset the effect thereof), then a currency can typically only be as strong as its weakest component.

In Germany's case, they had to accept a weaker than optimal exchange rate, in order to ensure that Italian shoemakers or Portuguese sherry makers could scrape a living.

Consider how much higher unemployment in the North-East of England would be for example, if so much of the taxes paid in the wealthier regions wasn’t directed there, notably in the form of so much public job creation.

These transfers are easier to undertake in a political union like the UK, than it is in a cobbled together currency zone like Europe.

In the case of Japan, the central bank regularly intervened in currency markets (selling Yen) in order to prevent its natural appreciation, thus favouring continued export strength over domestic purchasing power.

Economic theory would teach you that as a country begins to spend beyond its means, its currency should weaken in order to attract the foreign capital flows required to finance that spending.

The weaker currency would make its exports more attractive, thus shifting resources back towards investment in the export sector, and away from consumption on imports. The balances would thus if not close, at least be prevented from moving to extremes.

Instead the surplus countries generated enormous foreign assets and reserves, and their economies did not shift away from exports at all, and the consumption economies continued spending.

The ongoing recycling of this explosion in foreign assets was a fabulous boon to the Wall Street and City banks, who revelled in their traditional role as ‘middleman’ to these gigantic flows. The phrase ’red rag to a bull’ springs to mind.

As the size of these flows began to exceed the growth of (limited, see above) natural profitable investment opportunities to utilise them (the so-called ‘Law of Diminishing Returns’), then the banks started to get ‘creative’ instead.

It is in this context in my view, that the current uproar about bankers should be viewed. They got inventive because that’s simply what bankers do, and they got the opportunity to be so indirectly, because of our own addiction to consumption.

With the regulatory system so complicit, and the willingness of the surplus countries to save seemingly inexorable, the banks sought to persuade these somewhat dumb foreign investors that they could continue to earn additional return, apparently without additional risk.

One of the most popular tools was called ‘securitisation’, and its related alphabet soup of increasingly absurd offshoots known generically as ‘structured products’.

The tool of ‘securitisation’ is not toxic per se but it fell into the wrong hands at the wrong time.

A securitisation takes a pool of assets (usually loans or mortgages), and slices them up into different ‘tranches’, which are then sold onto investors depending upon their particular risk tolerance.

Rather than fund loans and mortgages direct from customer deposits in the traditional sense, securitisation permitted them to be turned into investments to be sold, thus freeing up a bank’s balance sheet for more lending.

To use an example, imagine a pool of 1,000 identical mortgages, all at 80% loan-to-value, and all paying 5% fixed interest rates.

In the absence of a bank getting ‘creative’, these mortgages could only be pooled to create a single security paying 5%, with any defaults (losses) in the pool being allocated equally amongst its buyers. There would be a market for such a security, but not a very deep one.

However imagine if the same pool could be sliced up in different ways, so that the different tranches might appeal both to very conservative buyers, as well as to far more speculative ones.

If the first losses solely got allocated to the latter (in return for higher yields), whilst only far greater losses were allocated to the former (in return for lower but more secure yields), then suddenly a rather uninteresting pool of identical mortgages was suddenly very interesting (not least to the banks doing the slicing, in return for a hefty fee).

Once the banks managed to persuade the ‘credit ratings agencies’ (eg. Moody's) that the large senior tranches of these pools were bullet-proof (‘rated AAA’), in any reasonable scenario for loan defaults and house prices, then the incentive for the banks to push the boat even further out was apparent.

The credit ratings agencies were paid directly by the banks, creating an enormous potential conflict of interest.

Cue the wonderful likes of the ‘self-certification’ mortgage (or ‘liar loan’), the interest-only mortgage (akin to renting, albeit with risk), and the 125% loan-to-value mortgage (a Northern Rock speciality). These products simply could not survive even the most marginal downturn in house prices.

And it wasn’t only mortgages that were pooled in this fashion. Loans that were issued to finance increasingly aggressive leveraged corporate buyouts (the target of many of which have already entered bankruptcy), were similarly pooled into so-called ‘CLOs’ (collateralised loan obligations).

Likewise commercial property loans, credit card receivables, car loans, student loans etc.. If it moved and could be financed, then the banks would lend against it, safe in the knowledge (or so they thought) that it could be quickly sold back to the cash-rich institutions of those surplus nations, hungry for extra yield.

Eventually the debt levels reached a ‘tipping point’. As the bears always warned us, the system was inherently unstable; it did not require an external shock such as unexpected higher interest rates, or higher unemployment. No such shock was present.

To use economics terminology, the system reached its ‘Minsky moment’ (named after Hyman Minsky), whereby borrowers are no longer generating the incomes and cashflows required to service their debts.

There are thus no longer any investors or speculators willing to pay the ever higher prices demanded for assets, and prices tumble into bust.

Just like a classic ‘Ponzi scheme’, the amounts coming in were swamped by the amounts required to go out.

Ironically if the system as a whole was a ‘Ponzi’ about to unravel, then the largest individual Ponzi scheme (Bernard Madoff's) was unravelling as a direct result thereof. I will write about his fascinating tale another time.

However the above described process should not by itself have led to the failure of several major banks. After all it so far largely describes the banks’ role as facilitator of these products, rather than investors therein.

The failure of the banks could be seen instead to be a result of adding further fuel to the fire as follows.

Firstly, there were routes for the banks to insure against the risk of default on any structured products via so-called ‘credit default swaps’ (CDS), or via specialist insurers such as MBIA or Ambac.

Bored of insuring against staid 'municipal' debt in the US (eg. hospitals, schools, police etc.), they saw an opportunity to grow earnings by insuring structured credit instruments. They are all in varying states of distress and bankruptcy today.

Regulators require banks to maintain an equity cushion to protect against losses on risky assets, but through these insurance mechanisms, the products were magically made ‘risk-free’ or at least ‘lower risk’ thus freeing up more capital to backstop further lending.

Little attention was paid to whether those entities that wrote the insurance would be in a position to pay.

The failure of AIG for example, was directly related to this process, via the activities of its ‘Financial Products’ division and the risks they underwrote.

Second, as the banks competed furiously to win business, they were increasingly required to hold the debt they had originated on their own balance sheets until a suitable buyer was found via securitisation (a concept known as ‘warehousing’).

When the music stopped, those banks left holding disproportionate amounts of these toxic assets were required to make enormous write-downs because as we now know, they weren’t worth what they thought they were.

This banking model (known as ‘originate to distribute’) is now fundamentally broken, hopefully for good.

Third, considerable initial profits were made by the ‘proprietary’ desks of major banks, as they traded these products amongst themselves using the bank’s own balance sheet, and created new deriviatives and indexes thereon. They also enticed in other trading-oriented entities, notably hedge funds.

Again when the fun was over, liquidity dried up almost to nothing (the ability to trade out of positions) and those left ‘holding the bag’ were stuck owning assets they couldn’t sell, and with a value they no could no longer ascertain.

Fourth, those banks who could not finance their targeted lending through traditional deposits, or through the above securitisations, increasingly turned towards ‘wholesale funding’ (via short-term lending in money markets), and other forms of less certain finance.

Northern Rock was a notable victim of this ‘borrow short, lend long’ culture that was always vulnerable to any breakdown in its aggressive assumptions.

As a result of all of the above factors, banks became absurdly overleveraged, piling increasingly dodgy assets upon a tiny sliver of permanent equity.

At the time of its bankruptcy filing, Lehman Brothers was leveraged perhaps 30:1, implying that little more than 3% of losses on its assets, or a temporary inability to finance those assets, would wipe out its shareholders (as they did).

You don’t need a background in banking regulation to know this is crazy, yet every major bank was levered to a similar degree. This is the reason why so much ongoing new regulation is focused upon enhancing bank capital requirements and thus limiting leverage.

The main difference between those banks that failed and those that survived (so far) is a function of the assets they were leveraging (and the quality and liquidity thereof), the cost and permanency of their financing (deposit base = good, capital markets = bad), and simple good fortune.

In Part II, I’ll reflect upon the breakdown of the credit boom and the implications thereof, and in Part III I’ll do my best to predict what is likely to come next.


At 8:28 AM, Blogger Wyn Grant said...

Very good analysis. I thought that the Chinese were undertaking a modest, slow revaluation but I suppose in effect that amounts to a fixed currency.

At 8:49 AM, Anonymous newyorkaddick said...

They did embark on a creeping revaluation of a few percent (which has since stopped). In a way this made the situation worse, attracting speculative flows in anticipation of further adjustment.

A short sharp and large revaluation is/was needed,but they were caught between a rock and a hard place since this would hammer the value of the huge dollar rserves/assets they'd built up.

At 5:07 PM, Anonymous Anonymous said...

*Head explodes*

At 12:30 PM, Anonymous stuart said...

very coherently explained as always.

your analysis at the start implies fault with the governments/ central banks -they kept real interest rates artificially low. I think this is too simplistic and that low nominal interest rates caused the whole world from banks to individuals to misprice risk. Ironically given the bailout for the risk takers (e.g. 100% recovery of cash with Icelandic Banks –the biggest disgrace of this whole saga) the risk has not been as mispriced as it should have been and so the moral hazard continues.

At 10:15 PM, Anonymous West Dublin Addick said...

Sorry had to print off and read today. Thanks again for another incisive finance/economics blog. Please keep up good work and I'm looking forward to next parts.

p.s. I enjoy the Charlton blogs too, especially after the dark days of last season.

At 4:13 PM, Anonymous Tim said...

Yes, great analysis thanks NYA. I am sat here a year after lehman in my peripheral finance job wondering what if anything has really changed within the banks, and firmly of the view that now things look somewhat better, the banks are going to lobby as much as possible so that they can make the same mistakes again...

At 4:19 AM, Blogger Kings Hill Addick said...

To be fair there has been a significant increase in the cost of borrowing, not only in relation to the Repo rate and LIBOR but also in actual rates. Some of this is a result of a a shortage of funds to lend due to increased capital requirements. However I think the banks ( in the UK if not the US and the Euro zone ) are pricing acording to risk.

I do have some reservations about the likelihood of this all changing once the big banks find that they can securitise their lending books again. Simple supply and demand is always going to put pressure on the banks to change how they price risk. As soon as securitisation rears it's head again ( as it surely will ) the underwriting will go out the window.

As the UK has a massive shortage of housing the public believe that it is only a matter of time before house prices start to rise dramatically again. As always, if enough people believe this it becomes a self fulfilling prophecy.

Once house prices start to rise and Sky News decide that it's all rosey again the banks will start to increase their loan to values and the whole thing will start again.

One thing that we have learned is that we never learn. I doubt we will see the exact same mortgage schemes or the same financial instruments that were, in part, responsible for this recession, but sure as eggs are eggs someone will come up with something that seems too good to be true, until it turns out to be just that.

Gordon Gecko ( spelling? ) has a lot to answer for.


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