Our friend, Satyajit Das, sends a note from Australia.
He is the credit derivative expert who was featured in Alex's story on our recent hour on This American Life.
Alex and I just love talking to Das (he goes by his last name). He can bring a sense of flair and drama to the discussion of credit derivatives. That is hard. We have not found a lot of opportunities to use the words "flare" and "drama" in the same sentence as "credit derivatives."
Das's book, Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives is, actually, a dazzling tour of credit derivatives. It's a good read, even if credit derivatives weren't an important part of the financial crisis.
It's nice to give Das's book a plug, since I've stolen ideas from it for stories. Like the one in which I explain risk management by looking at the pollen shakes when doused in water.
De-leveraging -- Fairy Tale Endings
By Satyajit Das
In the Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.
The drama and tumult of recent events are not symptoms of the disease but the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. In the lyrics of the Bruce Springsteen song -- many have "debts that no honest man could pay".
The "cure" is the reduction of the level of debt (the great "de-leveraging"). In 1931, Treasury Secretary Andrew Mellon explained the process to President Herbert Hoover: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. ... enterprising people will pick up the wrecks from less competent people."
The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalisation via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets (assuming bank system leverage of around 10 times) of around $4 to $6 trillion through reduction in lending and asset sales.
For example, the bankruptcy of Lehman Brothers resulted in $600 billion of debt being eliminated. In turn, this inflicts losses on holders of Lehman debt that in turn flows through the chain of capital. The destruction of Lehman Brothers' capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.
The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity (for example, as GE have done). This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
Feedback loops mean reduction in investment and consumption lowers economic activity placing stresses on corporations and individuals setting off defaults that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt. The process of destruction echoes W.B.Yeats' words: "All changed, changed utterly: A terrible beauty is born."
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. Fairy tales in financial markets focus on the "superhuman" abilities of regulators and governments to avoid the de-leveraging under way.
Central banks and governments have aggressively supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept baseball cards and Lehman, Bear Stearns and Washington Mutual ("WaMu"), Fortis and Dexia memorabilia (mugs, stress balls, desk-decoration cubes that open up to reveal Lehman Brothers' key operating principles -- "demonstrating smart risk management").
Central banks are acting as "buyers of last resort" rather than "lenders of last resort". They are providing cheap (negative real interest rate) term funding. The loans will have to be rolled over, as the banks cannot repay them. They will only be repaid from the underlying cash flows of the assets lodged as collateral.
Government and central banks have also "bailed out" a number of financial institutions using a variety of strategies to limit contagion. Lower interest rates and increased government spending has been used to try to reduce the effects of the financial crisis on economic activity.
The US government's $700 billion package is the latest magic potion. It is puzzling why this initiative is seen as the "silver bullet" that will "fix" the problems.
A cursory analysis of TARP (Troubled Asset Relief Program) reveals considerable confusion about even what problem it is addressing. The proposal to purchase up to $700 billion in "troubled" assets is not dissimilar to the existing liquidity support provisions in place. If assets are correctly valued in the books of the selling banks, then purchase at that fair value only provides funding to the bank. The difference is the risk of the securities is transferred to the government but so is any possible recovery in the price.
There are different views as to what price should be paid by the government for these assets. Under one approach, the government would pay a "hold-to-maturity" price that may be (perhaps significantly) higher than the "market" price or the value in the bank's book. This would provide the bank with liquidity as well as capital (the gain between the price paid and the lower value to which the bank has written down the asset). The alternative approach would be pay "market" values. This would provide liquidity to the selling banks but no capital. It may even trigger additional losses where the assets are carried at higher values creating incentives against participation. There is also a small problem that nobody, even the super bankers with super computers, seems to have a clear idea what the securities are worth in any case.
Purchases of troubled assets are also conditional on (correctly) protecting the taxpayers against losses. This requires banks to provide the government with equity or equity-like interests in exchange for participating in the program. Alternatively, the institutions selling the assets will need to enter into contingent arrangements to minimise the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to "profit" from the program. This creates potential conflicts for financial institutions whose fiduciary duties require maximisation of returns for shareholders.
It is not clear what securities will be eligible for purchase and exactly who will be allowed to participate. Amusingly, the recent short selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming of the system will be practically difficult to control.
In fairness, the final form of TARP has not been settled and may provide greater clarity on these points.
TARP and many of the other initiatives merely transfer the problem onto the US government and taxpayer balance sheet. Government support for financial institutions in this financial crisis is already approaching 6% of GDP (compared to less than 4% for the Savings and Loans crisis). This will ultimately place increasing pressure on the US sovereign debt rating and vitally the ability of US to finance its requirements from foreign creditors.
Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. The failures are unsurprising.
At the height of the boom, banks used a variety of techniques to increase the velocity of money. As the system de-leverages, the velocity of money has sharply decreased.
Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements. Around $2-3 trillion of assets are returning to bank balance sheets from the "shadow" banking system of off-balance sheet structures that can no longer finance themselves. In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund. Fear of bank failure (especially after the bankruptcy of Lehman and restructuring of WaMu) and shortages of capital also limit ability of bank's to on-lend.
The initiatives do not address the required re-capitalisation of banks to enable them to take on risk assets and also reduce fear of default allowing normal activity between institutions to resume.
Ultimately, "all the king's horses and king's men" cannot prevent the de-leveraging of the financial system under way. At best, the actions can smooth the transition and reduce the disruption to economic activity. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.
The extent of de-leveraging is substantial and likely to take time. It is clear that all asset prices must adjust significantly.
The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated. Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in US dollar denominated US Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.
Government and central bank actions need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.
Banks must be forced to write-off bad loans without delay even if this means breaching minimum solvency capital requirements. Bank capital needs must be addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central banks need to guarantee (for a fee) all major bank transactions to reduce counterparty risk enabling normal transactions between banks and other parties in the financial markets to resume.
Elements of these actions are already in place but the absence of a co-ordinated global strategy reduces effectiveness.
A global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) must be convened. It would bring together all the major players including the vital creditor nations -- China, Japan etc -- to develop a framework for the major economic reforms (currency policies, fiscal disciplines, trade barriers) to work towards a resolution of the crisis.
A principal objective of this conference would be ensuring supply of funding for the US in the transition period. Recent comments by China about US responsibility for the crisis and its resolution miss the point. As China's Premier Wen Jiabao observed the U.S. financial may "affect the whole world". As Wen noted: "If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital..." All creditors have much to lose if the de-leveraging process becomes dis-orderly.
Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.
The Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.
(c) 2008 Satyajit Das All Rights reserved.