Larry Summers – picking up on a phrase perhaps first used by Michel Camdessus -- liked to call the Mexican crisis the first financial crisis of the 21st century. Mexico’s decision to exhaust its reserves defending its dollar peg in 1994 led to difficulties rolling over its tesobonos in 1995– so Summers and Camdessus were ahead of the (naming) curve.
But Mexico -- because of the tesobonos -- was the first sovereign financial crisis that could not be addressed by calling together a group of big banks and getting them to agree to modify the terms of their maturing loans to provide the borrower with more time to pay. It consequently required a different kind of response.
The August 2007 subprime crisis is in some sense the first real financial crisis of the 21st century. The bursting of the tech bubble in 2000 feels like the denouement of the roaring 90s. Argentina’s 2001 crisis also feels like the conclusion of the mini-boom in emerging market sovereign bonds that characterized another part of the 1990s. Argentina’s crisis was in some sense one the last of the series of emerging market crises that started with Mexico. Brazil and Turkey still had trouble in 2002, but they – with more than a little help from the IMF – avoided default. Today most emerging economies (setting some parts of Eastern Europe aside) are in a far, far better financial shape.
The debts – and a lot of the instruments – that caused trouble in the late summer of 2007 are entirely a product of the 21st century.
This crisis centers in the securities market, and indeed in some of its more esoteric corners.
SIVs look like the securities market analogue to banks: they sold short-term securities (ABCP) to buy long-term securities that yielded more (often CDOS or MBS). The mortgages that have caused so much trouble went straight from a mortgage broker into a security before that security (or parts of it) were repackaged into another security. Many never seem to have spent much time on bank balance sheets – in part because the regulatory regime favors holding (now illiquid) MBS over holding (formerly illiquid) mortgages.
Even Northern Rock -- which this week is in the throes of an old-fashioned bank run, with depositors lining up to withdraw funds – got into trouble in no small part because it relied heavily on the interbank market rather than depositors for financing (its loan-to-deposit ratio was 300%). And the interbank market has come under pressure in part because the banks’ sponsoring SIVs and conduits had to take them back on to their balance sheets, they had less money to lend out to other banks …
The fact that this crisis centers on a set of acronymized securities that didn’t exist a few years ago has led naturally to a set of questions about whether the technology for addressing twentieth century financial crises still works.
The technology for addressing twentieth century financial crises, at least non-sovereign crises, arguably has two core components.
- Central banks that can act as a lenders of last resorts to the (regulated) banking system, helping to keep liquidity crisis from turning into something worse.
- And securitizing bad loans to take them off banks’ balance sheets – and, one hopes, off the off-balance sheet portion of banks’ balance sheets.
The problem now is that the banks aren’t the only institutions that now need of liquidity in a crisis -- and central banks are still set up to act as a lender of last resort to the banking system. Central banks are understandably reluctant to extend credit (i.e. discount their illiquid but hopefully still good assets) to the unregulated parts of the market, or for that matter to inject liquidity into the market by making a market for some complicated and now illiquid securities. So they are effectively providing liquidity to the banks and relying on the banks to provide liquidity to those who really need it. The Fed has been quite explicit about this.
Call it a twentieth-century solution to a twenty-first century problem. The central banks lend to the banks and the banks decide who else gets credit.
It may just work. One feature of the current crisis is that a lot of problems that a lot of different kinds of exposure that previously had been taken off bans' balance sheets is now either staying on the banks' balance sheet longer than expected or is migrating back to the banks' balance sheet. That is one reason why the banks have been among the biggest sources of demand for liquidity – and rather unwilling to part with the cash they have.
For example, a lot of LBO loans that previously would have been securitized are now sitting on bank balance sheets. And perhaps as importantly, a lot of the assets of the banks' off-balance sheet credit hedge funds are likely to emerge on banks' balance sheet.
In some sense the liabilities of affiliated conduits were always part of the banks’ true balance sheet, even if their liabilities didn’t have to be disclosed to investors or counted against regulatory capital. In bad states of the world, the banks commitment to provide financing to their affiliated conduits meant that they would effectively take them over. SIVs apparently are a bit different: they have slightly long-term liabilities than conduits, more mortgage exposure and at least in theory, smaller backstop facilities than conduits. David Reilly, Carrick Mollenkamp and Robin Sidel of the Wall Street Journal report:
“The two kinds of vehicles [conduits and SIVs] are closely related, although SIVs can also issue longer-dated notes, can use leverage and have tended to have greater exposure to mortgage debt. Banks affiliated with the vehicles typically agree to provide a so-called liquidity backstop -- an assurance the vehicles' IOUs will be repaid when they come due even if they can't be resold, or rolled over -- for all the paper in a conduit. For SIVs, three to five banks typically offer a liquidity backstop, but only for a portion of the vehicles' debt.”
No doubt many SIVs have tapped any available credit line, but some also have had to sell their assets to raise cash or call on their parents for more capital. For all I know, some may still need to sell; they may have been holding out for a rebound. That puts pressure on others holding the same asset.
In addition to backstopping conduits and SIVs, the banks – and the broker-dealers – have also extended a fair amount of credit to the world’s hedge funds. And right now the last thing the banks – or, for that matter, the world’s central banks – want is for a large share of hedge fund assets to migrate to balance sheets of either the broker-dealers or the banks.
It is hard for me to judge the relative scale of “deleveraging” and “reintermediation.” But there is little doubt that both happened, on a significant scale.
George Magnus argues that "reintermediation" will ultimately create a deeper crisis, since banks tend to act in ways that reinforce the economic and credit cycle. But reintermediation, ironically, makes it easier to apply the world’s 20th century technology for resolving financial crisis to a 21st century technology.
Central banks know how to supply liquidity to big banks – even if they debate whether or not they should do so. The ECB, for example, has supplied euro 75b in three month money to the European financial system.
Apparently some British banks -- those with with European operations -- were among those borrowing from the ECB, back at a time when the Bank of England was a bit less keen to supply liquidity to the market. That may be changing though -- Anatole Kaletsky suggests that Northern Rock may end up needing to borrow an awful lot of pounds from the Bank of England.
What of the second tool for resolving twentieth century crises – securitization?
Lots of twentieth century crises involved banks that made bad loans. The solution to such crises often involved securitizing the bad loans in some way – and getting them off the banks balance sheet.
The most obvious example if the LDC debt crisis of the 1980s. The Brady plan turned syndicated bank loans to what are now called emerging economies into more easily traded bonds, and in the process moved the impaired asset off bank balance sheets.
But securitization also played a role in the resolution of other crises – including crises that required the large scale injection of public money. Rather than passing losses on to depositors (the creditors of a bank), governments often bought bad loans from bad banks with newly issued bonds (bonds that could in turn be discounted by the central bank, providing the bank with liquidity), and the repackaged the bad loans and sold them off into the market.
This often took the form of securitization as well. At a minimum, players who raised funds in the capital markets – not just banks – were big buyers of “distressed debt.”
This basic solution – taking bad bank assets, repackaging them in some way and selling them into the market -- was applied to a range of crisis in the 1990s. It was the solution the US generally suggested to emerging market banking crises, which were a regular feature of the 1990s. But it was also the solution – to a degree – to Japan’s banking crisis. The standard criticism of Japan’s response to its bubble economy is that it was too slow to take dud real estate loans off the books of the Japanese banks, leaving the banks in a position where they couldn’t extend much new credit. If the banks had taken losses more quickly – something that likely meant that Japan’s taxpayers would have had to absorb losses to protect the banks depositors – and freed up their balance sheet to lend to new sectors, Japan’s economy could have recovered more quickly.
Or at least Japanese housewives could have discovered their interest in taking a punt on the Aussie dollar – an interest apparently shared by Goldman’s in-house hedge fund – a bit more quickly.
The problem? It isn’t quite clear how you can solve a crisis of confidence in “securitization” technology with more securtization. Many of the instruments at the heart of the August crisis involve payment streams that already have been securitized not just once (bundling a bunch of mortgages into a mortgage backed security) but twice (different MBS were bundled together in CDO) or even three times (CDOs of CDOs).
Right now, a lot of market participants are now demanding simplicity. Think T-bills.
And some central bankers also think simpler, easier-to-understand, easier-to-value and easier-to-trade instruments would facilitate the re-emergence of liquid markets.
Simplicity was one virtue of the Brady plan, which helped to remove “subprime” emerging market debt off the banks balance sheet in the early 1990s. True, Brady bonds were not necessarily the simplest of all bonds to price -- many were collateralized, for one thing. But repackaging a large number of loans into a smaller number of bonds with fairly standard terms still created an instrument that was far more liquid than the initial loan. The risks associated with the resulting securities were relatively easy to understand: if you thought Brazil was a better bet than Argentina, you bought Brazil’s Brady bonds and sold Argentina’s Brady bonds.
Try explaining why one CDO tranche is a better bet than another in a single sentence
But how can the current set of hard to value complex securities that contain some subprime exposure (and thus are likely to experience real losses that someone needs to absorb) be turned into something that is less complicated and more liquid?
Twentieth century financial technology created a blueprint for turning illiquid loans into more liquid securities in a pinch. The technology for turning illiquid and now unloved securities into something more palatable to the market still seems to be under-development.
There is one similarity though between bank crises and today’s securitization crisis. In order to securitize illiquid loans, the banks first had to be willing to recognize their losses. The same holds with illiquid securities. So long the securities are “marked to model” – or “market-to-myth” – it will be hard to for much to change. Securities firms – and even some hedge funds – may be the new banks, determined to wait out a bout of bad news.
Gillian Tett, as usual, is on top of an emerging debate over whether the regulators encouraged a bit too much credit risk transfer, and in the process, helped create today’s problem with the financial equivalent of lemons. But the question of how to best avoid creating new lemons is in some sense distinct from the question of what to do with existing lemons.
My wild guess is that some kind of new financial innovation will be necessary to end the (financial) droid wars …
Either that or there may be a lot of CDOs containing some housing exposure may be sitting around on various firms balance sheets for a very long time.
At least in August those who didn’t have to sell – those who believed in the securities that they had bought – weren’t willing to sell at the current market price. And those who really needed to sell had trouble finding buyers, since the buyers worried that those wanting to sell knew something about the security (or the particular tranche of the security) that they did not.
One big disclaimer: this post pushes a bit beyond my true areas of expertise. There is a meaningful risk that I have gotten a few details wrong. If so, I apologize.
Note: I edited the title of this post. My first title was meant to allude to the twenty-second century sounding names of all the financial instruments at the heart of the crisis, but it was perhaps a bit too obscure.