Did last week mark the beginning of the end of the credit crunch, or merely
the end of the beginning? The answer depends on another question, which was
much in the news over the weekend: will the Bank of England and the Federal
Reserve start lending against mortgages, essentially without penalty and
without limit, as the European Central Bank has done since last year? This
may seem an esoteric technical question, but it will determine whether the
credit crunch can be resolved merely by tweaking the traditional techniques
of central banking, or whether vast sums of public money will be required.
And the answer to this, in turn, depends on another even more
obscure-sounding debate: has the “liquidity crisis” that started last August
in the US mortgage market degenerated into a “solvency crisis” for the
global banking system as a whole?
The relationship between liquidity and solvency has become so important that a
brief recap is required. Liquidity is the ability of a bank or business to
convert its assets into ready cash. Solvency is the ability to pay off or
“dissolve” debts. This seemingly semantic distinction is important because a
liquidity crisis can always be resolved, at least in principle, by central
banks buying long-term assets, such as bonds and mortgages, from the banking
system in exchange for cash. This process does not involve any public
subsidies, because the central bank merely swaps £1million in cash for
£1million-worth of bonds. An insolvency, by contrast, forces creditors to
accept a permanent loss of economic value or for some third party, such as
the government, to pay a subsidy so that the insolvent business can settle
its debts. Either way, there is a permanent loss of economic value.
Deciding who should bear this sacrifice involves serious political and moral
dilemmas.
Most economic commentators are firmly convinced that last year's sub-prime
liquidity problem has become a much more serious solvency crisis. In my
view, the past few weeks' dramatic events suggest the opposite conclusion: a
localised solvency crisis in US housing finance has been transformed into a
global liquidity problem. This problem is worrying because of its global
nature, but it can be addressed fairly readily by central banks.
The evidence for this reassuring interpretation lies, ironically, in the
failure of Bear Stearns. Bear Stearns did not collapse, as it might have
done - and perhaps should have done - last August because the sub-prime
mortgages that it did so much to invent and promote became worthless. It
collapsed because of the plunging market value of ultra-safe assets, such as
the bonds issued by Fannie Mae and Freddie Mac, the US government-sponsored
enterprises (GSEs). These triple-A bonds have, until recently, been treated
as risk-free assets almost interchangeable with US government obligations.
Similarly, Peloton, Carlyle Capital and several other respected hedge funds
were undone by their ultra-safe asset holdings, not by their speculations in
risky sub-prime bonds.
These hedge funds used preposterous amounts of leverage to buy triple-A bond
portfolios, which offered slightly higher interest rates than the cheap
money they could borrow in the markets for short periods ranging from 24
hours to three months. When banks became less willing to roll over the
short-term loans taken out by these hedge funds, they were forced to dump
their triple-A bonds on to unreceptive markets, thereby pushing down their
prices even though there had been no increase in the underlying probability
of these bonds ever defaulting. Although the GSE bond prices fell by only a
few percentage points, the hedge funds' leverage multiplied their losses and
they quickly went bust. These bankruptcies caused even more GSE bonds to be
dumped on the markets and triggered a further slide in their prices. But
Bear was among the world's largest holders of GSE assets - and used them as
collateral to back up its own leveraged obligations to other banks. With the
market no longer willing to accept the unimpeachable value of Bear's
triple-A collateral, the firm exhausted its capital by last weekend.
In other words, the latest phase of the credit crisis had nothing to do with
escalating losses on sub-prime mortgages or other risky loans.
Indeed, Standard & Poors reported just before the Bear collapse that US
banks had recognised most of their sub-prime losses - and this was supported
by the modest first-quarter writedowns reported a few days later by leading
US investment banks. The latest crisis, far from being caused by the banks'
dodgy lending, was actually triggered by the fact that their highest-quality
assets suddenly became impossible to sell in the markets, even though their
default risks have not gone up at all.
The probability of the American GSEs defaulting remains essentially zero, as
it has always been. If anything, the willingness of the US Government to
stand behind these enterprises is even higher today than it was before the
financial crisis. The market value of these bonds has fallen simply because
they have turned out to be less liquid assets than previously believed - and
liquidity has been recognised as a much more important and valuable
characteristic than investors suspected until a few weeks ago.
Until last month, it was still widely assumed that the danger of illiquidity
affected only inherently risky assets, such as sub-prime mortgages, complex
derivatives and leveraged loans. But this assumption completely changed when
the US bond insurers started to be downgraded in January. Suddenly,
ultra-safe municipal bond prices plunged to levels normally associated with
the riskiest junk bonds. This was not because the Port Authority of New York
or the California Water Board suddenly looked like defaulting. It was simply
because municipal bonds became illiquid as investors were forced by
regulations to dump them into a market with no bids.
After the municipal meltdown, forced sellers of top-quality mortgages, and
even of government-backed GSE bonds, suddenly could find no buyers. It was
this disappearance of liquidity - not a growing risk of default by borrowers
in the non-financial economy - that caused the collapse of Bear Stearns.
By last week, the liquidity crisis had spread even to assets whose default
risk was literally zero. A widely quoted story on Bloomberg read: “The risk
of losses on US Treasury notes exceeded German bunds for the first time
ever, amid investor concern the sub-prime mortgage crisis is sapping govern-
ment reserves.” The evidence cited was a sale of credit-default swap (CDS)
insurance on US Treasuries, which implied a default probability of 0.16
percentage points, as against 0.15 points on German bonds. But what did
these “probabilities” actually show? After all, Washington can always print
the money with which it pays for its bonds - and, like all governments,
invariably does so. Moreover, in the vanishingly improbable event that the
US Treasury really did decide to stop printing dollars, would the
underwriters of CDS insurance still be in business and pay up? What court
would enforce a private CDS deal if contracts with the US Treasury were no
longer in force? And what currency would such a judgement be paid in, since
US dollars would no longer exist?
This extreme example illustrated a market reaching reductio ad absurdum.
Prices had become completely detached from the risks they were supposed to
reflect. Instead of measuring default risks, credit-market prices were
becoming a pure measure of liquidity. Traders were pricing assets purely on
their value as emergency collateral for raising cash, not as a source of
prospective profits and cashflows.
This liquidity distortion cannot be tolerated much longer, since it destroys
the main functions of financial markets - to send signals about potential
profits and to create long-term stores of value. Luckily, liquidity is a
quality that central banks can create at zero cost. All they have to do is
lend against the vast quantities of high-quality, but illiquid, assets held
by financial institutions - without limit and without penalty. The time has
come to enact the famous injunction of Walter Bagehot, the father of modern
central banking: “Lend freely, boldly, and so that the public may feel you
mean to go on.”
anatole.kaletsky@thetimes.co.uk
As house prices rise to infinity, it only takes a small fall in prices and one default to cause a bank to become bankrupt.
Basically as a credit bubble inflates and then falls back the loss per default rises dramatically...it doesn't take risky lending or a rise in defaults for this mathematical certainty to take place (although they certainly help the process along) - the system simply becomes unstable.
This is what has happened on the back of a trebling of house prices funded by cheap credit. And banks have woefully small amounts of capital set aside for loans that will no longer be supported by collateral.
harry e, London,
It seems that most commentators here either don't understand the basics or choose not to. They should take time to study AK's piece above and work through the mechanics step by step. Ignorance of capital markets is common place but willful ignorance combined with a desire to propagandize is corrosive. Fear and ignorance, in mass scale, could turn a liquidity problem into into a real economy recession with very adverse welfare consequences for us all.
AndyG, London, UK
The reason there is a liquidity crisis, is because the banks won't lend to one another. The reason they won't lend to one another is that i. they don't trust one another; ii. they don't trust their balance sheets; iii. the value of the underlying security ie. properties, is falling ... maybe by 30%+ accoprding to the IMF.
So if it ain't secure enough for the banks to lend against, why is it good enough for the government to lend tax payers money?
When interest rates were cut, the banks pocketed the difference instead of passing it on to hard pressed customers. Banks keep their profits to themselves and their shareholders, not the good of the community. Banks charge customers £39 for each unauthorised overdrafts etc., etc.
There was no government assistance for our now defunct car industry, our farmers, or countless other industries lost.
The banks created this problem, so let them and their shareholders solve it; or fail. After all, that is the law of the jungle.
Roger, Rock, Cornwall.,
We need to get away from the idea that paper money and bank debts are some abstract concept. Banknotes and credit are exchanged for real tangible assets (food, clothing etc). If a bank has lost money, it has lost real assets and is poorer. Money is a commodity like any other, increasing the supply, decreases its value.Pumping new money into the system will not, create assets out of thin air, all it will do is inlfate the supply of money. inflating the money supply is the same as increasing the rate of taxation on the public. Somehow this basic truth seems to have been lost on Kaletsky and many commentators. He mentions that Solvency is the ability to pay off or “dissolve†debts, well by this definition, nearly all banks are insolvent. In our fractional reserve banking system, banks only need to keep about 10% of the value of thier deposits available to customers on demand, making any bank valunerable to a bank run.
oliver, Cambridge, Uk
This is like saying I'm poor because I've spent all my money.
stephen hulton, eure, france
All banks are highly geared - that's what a bank does. Lend long, borrow short, lend multiple times the deposit base. Borrowers then deposit their funds in a bank which then lends a multiple of it. This is banking. This is now money is created, not note and coin which is not important but the real money that drives the economy.
In any liquidity crisis, if not addressed then it becomes a solvency crisis for any particular bank - leverage ensures that loss of liquidity means they can't pay their creditors.
The key Point here is that the market is not functioning and therefore needs (like in all cases of market failure) intervention: Whole classes of valuable/viable (certainly not "worthless") mortgage and other non-mortgage securities are wrongly priced. Their prices are not consistent with their returns, instead they reflect the banks current liquidity preferences i.e. extreme cash preference.
Andy G, London, UK
If Bear Sterns was leveraged 80 to 1, where was the regulation and control. Central banks, FSA, etc - what do they do. Is this not a crime - to let this happen. All these guys get so much money & then let this happen. Is the capitalist way of growth & greed good for the West now. How much can you grow when you have shrinking & ageing populations in the West. None of this would happen if we put a salary or earning cap on every individual, whatever he/she does.
mani, london,
If no one will buy an "ultrasafe" bond for $1000 it is not worth $1000.
Therefore its a solvency issue, not a liquidity issue,
End of discussion
Dominic, MAnchester, UK
The US is up the creek and using a rake to paddle. Real interest rates are now negative, putting enormous inflationary pressure on the dollar at a time when commodities are at all time highs. Bottom line is, USA, YOU WILL take a recession and it IS going to hurt.
The UK is better positioned, not being exposed to MBS and ABS like the US is, and so US volumes of inflationary monetary policy are not as necessary in the UK to shore up the economy. Hence we have a fairly sensible borrowing rate which will cause some pain but is pain we MUST take!... Lest we wish to sustain massive inflationary pressures like the US are. This Government, and the BoE, owe it to the country not to let that happen, as the pain will only be compounded in the medium term (you won't need to wait for the long term for it).
Equity markets are yet to reflect the true extent of potential balance sheet deflation. Time to batten down the hatches with the prospect of a cold economic winter looming.
Richard Sarsfield, London,
As unpalatable as it may seem to have the authorities bail out our financial institutions, the modern economy runs on credit, so to let them fail would be to commit mass economic suicide. Is that worth it just to prove a point?
John Lewis, London, UK
Should we really sit back and allow our central banks to bail out the financial system with no consequence for the failure of leadership at its core? The financial system put itself on the horns of this prisoner’s dilemma and should be smart enough to find the way back. A closed wholesale market is the route of the liquidity problem but its not ‘the market’ that is at fault, the major financial institutions are the wholesale market and self interested individual decisions not to lend are a collective decision to jump off the cliff. What leaders do we have in this industry to pull away from such destructive behaviour?
Every ten years we relearn that highly levered financial risk models are not capable of taking into account collective psychology or liquidity constraints. Our current financial managers are culpable for not learning from LTCM, portfolio re-insurance or the S&L crisis. It’s time for our leading financiers to step up to the plate, provide the liquidity that we have i
patrick earle, london, london
The simple fact is that the banks have no assets: just empty promises written on pieces of paper. As the world wakes up to this fact, those nations with real assets (oil, gas, minerals, timber etcetera) are going to out-perform countries like Britain, France and Germany who have greedy, lazy populations and little in the way of assets of their own.
Adrian Gilbert, Tonbridge,
If free markets are to function in the way it is believed they should (and in a preferable way without artificial distortions resulting from excessive regulation) there needs to be severe penalty of the moral hazard type if possible abuse (for example assumption of safety of levels of extreme leverage historically demonstrated to have a high probability of ending in tears) is to be avoided.
If something seems too good to be true, it usually is.
Most machinery or systems can be driven well outside their safety tolerance for a short while. That is not sufficient evidence for abolishing the idea of empirical safe tolerance limits.
dr venables preller, Warminster, UK
So Fannie and Freddie will still buy mortgage securities, and they are GSE's, and it is inconceivable that the US Government would let them go bust. True. But they will only buy AAA mortgage securities at a fraction of face value now, because the US housing market is in freefall and nobody knows if the fall can be stopped any time soon.
The giant US mortgage company, Thornburg, is on the brink of filing for bankruptcy, and many of the mortgage securities it has recently sold on will have a very low face value, because many of the mortgages are going fo be foreclosed at distress prices perhaps 50% below mortgage value.
Jumbo mortgages do not even have a Freddie or Fannie backstop and nobody want to know about them except at massive discounts to face value that make many of the financial institutions holding them an insolvency risk.
Nothern Rock went bust because of lack of liquidity, but that lack of liquidity was driven by future insolvency fears.
David Goldsby, Cheltenham, England
Dear Anatole:
"In other words, the latest phase of the credit crisis had nothing to do with escalating losses on sub-prime mortgages or other risky loans. " This is like saying that the Great Chicago Fire had nothing to do with Mrs. O'Leary's cow kicking over the lamp!
For years the banks, the rating agencies, the mortgage brokers, Fannie Mae, Freddie Mac etc. etc. have been too busy (making money and cooking the books) and greedy to see that they were undermining the system that they perverted in order to achieve "profitability". They killed the goose that was laying golden eggs, finally. And now we're going to return to more conventional banking practices with the "shadow" banking system created by the use of ultra complex instruments, inclindg mortgage-related and non directly mortgage-related (CDSs) stuff, trading with closer supervision and increased transparency. Hopefully!
Meanwhile, we're having "a hot time in the old town, tonight."
All the best, Peter Adam
Peter Adam, Chevy Chase, MD
Printing money is inflationary and will not solve this crisis. We must go through the pain of recession and cut back the consumption of US and UK economies to a sustainable level. That means brave political decisions in the UK where we have an overgrown public sector. Perhaps a 20% cut in Public Sector spending would just about bring our economy to an even keel in trading terms.
Steve Marchant, Broadhempston, UK
I doubt whether this article has got to the root of the issue.
You say " Standard & Poors reported just before the Bear collapse that US banks had recognised most of their sub-prime losses", but even if this is correct, they have recognised the sub-prime losses they know about. If real estate keeps dropping, then these loses increase. The bottom hasn't been reached.
Which leads on to the core question, why won't banks provide liquidity to each other. They don't trust that the other banks are *solvent* to lend to, and they might lose their money.
So it still returns to being question of confidence in perceived insolvency, not liquidity, that is causing the chronic constipation in the credit markets, requiring helicopter Ben to provide the temporary laxative of *yet* more cash, which the banks just hoard, and trashing the once-mighty dollar in the process.
Jon Layman, London, UK
Surely one lesson that can be learned from this is that every crisis of confidence reveals opportunities. If you consider that the directors of banks are buying shares and if you consider that all these bonds, tripple AAA, or Junk, still produce an income, and a very good one now that capital prices have subsided and if you consider the outlook for interest rates now are decidedly on a downward trend, then there are some outstanding opportunities for investors in good high yield bond funds who have some bottle and can stand back from the capital performance for a few months.
David Nammory, Liverpool,
Nice article - but surely no-one has the right to expect that there is an immutable law that says everyone must make money forever by borrowing short and lending long?
The super-smart thought they could leverage themselves up to the hilt and beyond on a dead cert. Like all infallible wheezes, it went wrong and now we must all suffer because of their crowd-like delusions accompanied by spineless regulatory weakness.
Stevie B., Eastbourne,
Using examples numbered in the millions is misleading.
Bear Stearns was leveraged to the tune of almost 80 to 1 at the time when it had $17 billion, or about $1.3 trillion. At the end of a week during which just a few of its creditors were demanding payment its cash reserves had dropped to around $2 billion, sending its leverage even higher into the stratosphere. How many trillions can you expect to throw at this problem. Bear Stearns is a smaller bank, I believe that it ranked fifth among American investment banks, and using it as a template shows the 'liquidity' needs of the industry to be well beyond the ability of the world to supply.
The banks of the world are insolvent. They are beyond the help that the world can offer them.
Dennis, Seattle, USA
All they have to do is lend against the vast quantities of high-quality, but illiquid, assets held by financial institutions.
And what are these 'assets' Anatole? They wouldn't be vast piles of IOUs on unsaleable property would they?
eric campbell, harrogate, uk
fantastic article......i'm quickly tunring into a super-bear
matt s, London, UK
"that was Anatole Kaletsky's understanding of the credit crunch.... and we call ourselves the Aristocrats!"
MacLovin, London, UK