Since the credit crisis emerged on August 9, 2007 when the credit agencies downgraded over 100 collateralized securities, I have tried to carefully follow the reasons for the problem, the depth of the crisis, and understand some possible solutions to the outstanding difficulties. My interests in part stem from my current emphasis on equities in my personal portfolios and in part from the failure of my own hedge fund in 1998 following the collapse of Long-Term Capital and the Russian Credit Crunch.
How big is the Problem?
Simply stated, the crisis is global, involving financial institutions, and financial investors throughout the world. First of all, some twenty percent of the Standard & Poor’s 500-stock index is considered financials. In essence, financial institutions have grown into behemoths globally, and their interlocking business activities promote an almost incestuous dependency. That is, the creation and sale of securities instruments throughout the globe has led to worldwide vulnerability. For example, recently German banks and British hedge funds have failed because of their exposure to delinquent United States sub-prime mortgages.
Why are so many regulators and market participants confounded by the problem?
In a nutshell, a brilliantly inventive generation has harnessed computing power and financial theory to transform the world of finance. Trillion-dollar global markets have sprung up on the back of techniques for converting loans, interest payments, default risk and who knows what else into new securities that could be chopped up and repackaged in mind-boggling combinations, sold and resold. Much good has come from securitization. That is, the new finance has let more people and businesses to gain access to credit on better terms.
However, this summer has shown that invention has raced ahead of intervention. Vital parts of the new finance take place in lightly supervised markets, as far from the glare of regulators as its practitioners can get. For example, the commercial banks such as Citicorp have set up off balance sheet conduits that hold significant inventory and are not subject to the same regulatory margin requirements as the bank itself. Thus, commercial banks, investment banks, and hedge funds tried to avoid regulation because regulation imposes costs, restricts innovation, and slows people down. However, with devastating speed, the crisis spread back into the heart of the most regulated parts of the financial system, the interbank markets and the market for central-bank reserves, which obliged the central banks to provide liquidity. For example, Citicorp currently faces a meltdown in their non-regulated conduits, because these off-balance sheet entities have insufficient capital and are funded by short-term borrowings. In a nutshell, the Chairman and CEO of Citicorp, Chuck Prince, made a classic mistake. That is, he bought $80 billion of questionable long-term securities and funded them with short term borrowings. This mismatch is a classic recipe for financial disaster.
Also, there can be no uniform pricing for much of the inventory held by financial institutions. That is, many of these instruments are arcane whose value varies dramatically based upon business psychology and volatility assumptions. Since the inventory value of these securities vastly exceeds the net worth of the respective institutions, any deterioration in their value or any forced liquidation will erode substantially the net worth of these highly leveraged institutions.
Lastly, the regulatory agencies involved have significantly different agendas. First of all, a meltdown of a global security can involve many central banks whose constituency desires different objectives. Secondly, within the United States, regulation is handled by a maze of regulators—the Securities Exchange Commission, the Federal Reserve, the Treasury Department, The Comptroller of the Currency, the Commodity Exchange, and their counterparts at the state level. Thus, on the one hand financial institutions are unregulated, and on the other hand they need to placate a variety of regulatory authorities.
What are the big problems that prevent quick fixes?
First of all, the price of houses has risen significantly in the United States and Europe. From 1997 to 2006, house prices in the United States rose by 124% and in the same period Britain experienced a 194% increase, Spain 180% and Ireland 253%. The price of houses rose significantly higher than real incomes. In order to purchase homes, buyers took out floating rate loans that are now subject to significant increases. Moreover, since some 20% of mortgages in 2006 went to sub prime borrowers, these borrowers cannot afford an increase in their mortgage costs. That is, many of these borrowers already pay more than 40% of the disposable income to fund their mortgage commitments. Proposed interest increases will result in a rise of their obligations to over 50% of their disposable income. Thus, much of the housing bubble could bust if housing prices decline by 10-20% over the nest twenty-four months. Stated differently, providing cheap financing to conduits that own sub-prime mortgages will not solve the problem if the underlying asset declines precipitously.
Secondly, the Central Banks throughout the world must worry about inflation. While globalization has slowed inflationary pressures, weak currencies add significantly to inflationary risk. Ben Bernanke has a particularly tight rope to walk, given the weakness of the dollar and the continued concerns about dollar parity given the outlook for further cuts in our interest rates. Inflation undermines incentives for real saving and real investment; thus, central banks cannot solve the current credit crisis without keeping a sharp eye on the dangers of loose money unleashing inflationary forces.
Thirdly, Central Banks cannot reward financial executives who bet the “farm” on leveraging their institutions. Currently, bank loan reserves are a little over 1% of total loans which is a relatively low number. Moreover, since the commercial banks have implicitly guaranteed conduits—off balance sheet related entities – the leverage in the system is unsustainable given the financial uncertainties that confront capitalistic societies.
Fourth, commercial banks have lent significant sums to finance leveraged buyouts by private equity funds. Billions of dollars of these loans are currently unsyndicated, leaving the banks vulnerable to owning questionable unwanted loans. Moreover, these loans might default if the country enters into an economic recession which some economists are predicting.
What are the long-term credibility problems of the Central Banks and Treasury?
Both of these institutions are accused of pandering to wealthy Wall Street investment bankers. Critics of the Secretary of the Treasury note disparagingly that Paulson said nothing about the sub prime problem until it impacted Citicorp. Moreover, Bernanke must overcome the Greenspan legacy of quick rate reductions post September 11, 2001 to ultimately 1%, and then holding these 1% rates for too long after the crisis had passed. In essence, critics want our regulatory institutions to be responsive on the up and downside. They note that Wall Street benefited financially handsomely from low absolute interest rates.
Stated differently, for monetary authorities to have credibility, they need to be as pro-active to the problems impacting Main Street such as the woes of the auto companies as they are to Wall Street. Globalization clearly helped the consumer and Wall Street; it had devastating impact on American manufacturing.
What we have not discussed?
We have not mentioned congressional financial irresponsibility fiscally. That is, we have not taxed for the Iraq War, the enhancement of drug benefits for Medicare, and the stupendous expenditures to improve our infrastructure. “Bad money chasing out Good” or the lack of confidence from devaluing the currency has been the bane of kings and politicians for centuries. There is an old joke. Louis XIV built the Palace of Versailles. Louis XV enjoyed it, and Louis XVI paid for it. Pete Person, the former Secretary of Commerce, the former Chairman of Lehman Brothers and the former Chairman of Blackstone wrote in his book, Running on Empty, that the United States is saddling future generations with an unsupportable transfer obligation both in the field of Social Security and Medicare. Peterson is appalled by the lack of fiscal responsibility by both Republicans and Democrats. Moreover, the growing ownership of United Stated Dollars by overseas creditors means that Sovereign Institutions, whose primary charge, is to invest globally will have increased dollar holdings from the current $2 Trillion dollars to $14 Trillion dollars over the next decade. Thus, we can expect substantial increase in foreign ownership of United States real estate and enterprises. Peterson commented that those who do not appreciate what is the difference from being a major creditor to a major debtor obviously do not understand the difference between being a plantation owner and a sharecropper.
We also have not discussed the pathetically low saving rate in the United States, and the growing income inequality. While rising housing prices obscured the risks associated with sub normal savings, the sad fact is that the United States in 2006 had the first negative saving rate since 1933, Defenders pointed out to rising assets such as home prices that were not in these figures. However, if house prices drop by 20%, then you have a double whammy. Secondly, the increasing income disparity between the super rich and everybody else is not healthy for a democratic capitalistic system. Anybody listening to the demagogic rhetoric by politicians in both parties should have a queasy stomach. As Tom Friedman pointed out, for the first time in our history we have not paid for a war with higher taxes. The Democrats cannot spend money fast enough on their laundry list of transfer payments. The recent Highway Bill reminded me of a bunch of pigs gorging themselves as they prided themselves on monumental expenditures in their home states and regions. Cost-Benefit analysis is no longer discussed in making fiscal allocations.
Originally published in the Sarasota Herald-Tribune
