Sunday, April 06, 2008
Trillion Dollar Meltdown? The 2008 Credit Crisis
Foreign Policy Magazine has a good summary of Charles Morris's new book Trillion Dollar Meltdown, which purports to explain how we got into the credit crisis that is currently beginning to wreak havoc in financial markets, the collapse of Bear Stearns being just the tip of the iceberg:
No, it’s not the Great Depression, but the United States is facing a nasty economy-wide retrenchment following the excesses of the 2000s, with no easy way to dance through it. Think 1979 to 1982, when then U.S. Federal Reserve Chairman Paul Volcker exorcised consumer price inflation from the economy. The difference today is that the inflationary explosion has been absorbed by prices of assets—houses, stocks and bonds, office buildings—rather than by the prices of things you buy at the store. Here’s how it happened.
1. The Fed spikes the punch bowl. In the wake of the dot-com bust and 9/11, the Fed lowers interest rates to 1 percent, the lowest since 1958. For more than 2½ years, long after the economy has resumed growing, the Fed funds rate remains lower than the rate of inflation. For banks, in effect, money is free.
2. Leverage soars. Financial sector debt, household debt, and home prices all double. Big banks shift their business models away from executing transactions for customers to “principal trading”—or gambling from their own accounts with borrowed money. In 2007, the principal-trading accounts at Citigroup, JPMorgan Chase, Goldman Sachs, and Merrill Lynch balloon to $1.3 trillion.
3. Consumers throw a toga party. Soaring home prices convert houses into ATMs. In the 2000s, consumers extract more than $4 trillion from their homes in net free cash (excluding financing costs and housing investment). From 2004 through 2006, such extractions exceed 7 percent of disposable personal income. Personal consumption surges from its traditional 66 to 67 percent of GDP to 72 percent by 2007, the highest rate on record.
4. A dollar tsunami. The United States’ current-account deficits exceed $4.9 trillion from 2000 through 2007, almost all for oil or consumer goods. (The current account is the most complete measure of U.S. trade, as it encompasses goods, services, and capital and financial flows.) Economists, including one Ben S. Bernanke, argue that a “global savings glut” will force the world to absorb dollars for another 10 or 20 years. They’re wrong.
5. Yields plummet. The cash flood sweeps across all risky assets. With so many people taking advantage of cheap loans, the most risky mortgage-backed securities carry only slightly higher interest rates than ultra-safe government bonds. The leverage, or level of borrowing, on private-equity company buyout deals jumps by 50 percent. Takeover funds load even more debt onto their portfolio companies to finance big cash dividends for themselves.
6. Hedge funds peddle crystal meth.
Aggressive investors pour money into hedge funds generating artificially high returns by betting with borrowed money. To maximize yields, hedge funds also gravitate to the riskiest mortgages, like subprime, and to the riskiest bonds, which absorb losses on complex pools of lower-quality mortgages known as collateralized debt obligations or CDOs. The profits from selling bonds based on very risky underlying securities override bankers’ traditional risk aversion. By 2006, high-risk lending becomes the norm in the home-mortgage industry.7. A ratings antigravity machine. Pension funds cannot generally invest in very risky paper as a mainstream asset class. So, banks and investment banks, with the acquiescence of the ratings agencies, create “structured” bonds with an illusion of safety. Eighty million dollars of “senior” CDO bonds backed by a $100 million pool of subprime mortgages will not incur losses until the defaults in the pool exceed 20 percent. The ratings agencies confer triple-A ratings on such bonds; investors assume they are equivalent to default-proof U.S. Treasury bonds or blue-chip corporates. To their shock, investors around the world discover that as pool defaults start rising, their senior CDO bonds rapidly lose trading value long before they suffer actual defaults.
8. The Wile E. Coyote moment arrives. Suddenly last summer, all the pretenses start to come undone, and the market is caught frantically spinning its legs in vacant space. The federal government responds with more than $1 trillion in new mortgage lending and lending authorizations in multiple guises from Fannie Mae, Freddie Mac, the Federal Housing Finance Board, and the Federal Reserve. Home prices still drop relentlessly; signs of recession proliferate; risky assets plummet.
What now?
The collapse of Wall Street investment bank Bear Stearns may be a watershed moment. Participant reports suggest that JPMorgan Chase came into weekend negotiations last month prepared to do a deal without Fed support. But after examining Bear’s balance sheet, which looks completely conventional, except for $46 billion of hard-to-value mortgage assets, Morgan apparently said, “Hell no!” The $30 billion backup line of credit Morgan got from the Fed implies that they expect mortgage portfolio losses of some 70 cents on the dollar. Had Morgan recognized those losses, they could have forced comparable write-downs on a string of other banks. Bear’s default, in addition, could have triggered huge cash liabilities by thinly capitalized “bond insurers” and hedge funds that had guaranteed Bear’s debt. Many of the guarantors might have failed to have made good their guarantees. The Fed chose to pay up.
Analysts at Goldman Sachs recently estimated the total losses from this mess at $1.2 trillion, including nearly $500 billion at the banks. The cleanest solution would be for regulators to force banks to revalue their assets down to realistic levels in one fell swoop. (If the Fed and the Securities and Exchange Commission drive such a process, it might be accomplished within a single quarter.) The revaluations would almost certainly wipe out all or most equity capital at a number of the larger banks. Since it is unlikely that new private, nongovernmental capital could supply the entire shortfall, the federal government would have to act as the equity supplier of last resort.
But what about the homeowners who are stuck with mortgages they can no longer pay? Helping them will be simpler once their problems are untangled from the banks’ goal of protecting overpriced assets. A change in the bankruptcy laws, for example, could empower judges to convert excessive mortgages into market-rate rentals, which are usually much cheaper.
All current rescue proposals being floated in the U.S. Congress have the taxpayer buying up the loans the banks no longer want, absorbing the losses just as taxpayers did in the savings and loan crisis of the late 1980s. As an equity investor, however, the U.S. government would get the same terms as other private investors, leaving the losses to fall on the shareholders and executives who either caused the debacle or allowed it to happen. Concerns about the government’s holding bank stock directly could be allayed by depositing the shares in the Social Security trust funds. As the banks return to normal operations, they would become quite valuable securities and probably greatly improve the system’s returns.
Bank shareholders and executives made extraordinary financial gains during the 2000s. Now that their Ponzi scheme has been exposed, they are demanding that the public absorb much of their losses, and the Federal government has been responding with huge showers of money. The Bear Stearns rescue demonstrates the need to draw a line. From now on, the banks, their shareholders, and their executives should eat their own losses. If that wipes out the capital of essential depositary institutions, the federal government should step in. Save the banks and help struggling homeowners, yes. But no more largesse for bank executives and shareholders.
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