Waiting for the Patient to Start Breathing Again
Liquidity Crisis and Credit Crisis
By blackhedd Posted in credit crunch | Economy | federal reserve | liquidity crisis | risk management — Comments (25) / Email this page » / Leave a comment »
As I told you yesterday, there are gathering signs that the liquidity crisis which has roiled money markets since early this year, and became a series of convulsions after the Bear Stearns collapse, is abating.
If conditions continue to stabilize and improve, then we can say that aggressive Federal Reserve intervention indeed solved a systemic liquidity problem that affected the financial system more seriously than similar problems in the past.
But if the defibrillator worked and the patient’s heart is beating again, we’re still waiting for him to start breathing. Dealing with the liquidity crisis doesn’t mean we’ve done anything to fix the credit crunch.
More…
The Fed’s extensive actions have now made it not only the lender of last resort, but also the counterparty of last resort. Large institutions can now worry less about counterparty risk, because there is an expectation that the Fed, which can create an infinite amount of cash at will, will step in and honor the trades of anyone who gets into trouble.
This is something new under the sun. Ever since commerce was invented, success has depended on knowing who you were doing business with. It remains to be seen whether the Fed will withdraw from this role, as they say they will, once normalcy returns.
But all of these liquidity issues are a problem for Wall Street, not for Main Street. There is still an ongoing financial crisis that does affect the real economy, and that is the unavailability of credit.
To (over)simplify, banks don’t want to lend anyone any money. Why not? In many cases, because they have taken such huge losses on mortgage-lending that they’re at risk of falling below their minimum capital requirements. They must curtail their lending, take in new capital, or both, in order to satisfy the regulators.
In addition to this, there is another phenomenon at work called de-leveraging. Many financial institutions around the world are cutting down their holdings of assets financed with short-term borrowing. The world is shifting from debt to equity. This tends to reduce the value of nearly all asset classes, which in turn adds to the pressure on banks. (Whenever an asset owned by a bank falls in value, accounting rules require the bank to take a charge against their earnings, even if the fall in value is temporary.)
And finally, although it’s not been discussed much, there is probably going to be a re-evaluation of the risk-management tools that have enabled market participants to greatly expand their asset holdings in recent years.
We’ve had perhaps eight major global financial crises during the era of modern portfolio theory, beginning with the 1987 stock-market crash. And none of them has shaken our faith that proper diversification in accordance with mathematical models can enable risk to be precisely measured, so as to allow people to take more of it.
This time may be different. This crisis has burned so many people in so many corners of the world that we may see great reluctance to go back to the kind of leveraged risk-taking of the past ten years.
And that means the great boom in credit formation that has fueled the global economy may slow or even stop.
It’s very true (and a subject for a different post) that the current distress is (so far) having a mild effect on the real economy. During the Great Depression, which also started with financial disorders that were then transmitted to the real world, GDP fall by half and unemployment rise to 25%. That’s an epic disaster, and for many reasons, we’ll see nothing remotely that bad.
But I’ve occasionally used the phrase "Great Depression II" to describe one of the possible futures in my crystal ball, for this specific reason: after the financial crises were finally damped out in the summer of 1933, bankers for years afterward showed a strong preference for highly-liquid, risk-free assets.
In other words, they used their depositors’ money to buy short-term Treasury debt. They didn’t lend it to cities and states, or to mortgage-borrowers, or to businesses, or to anyone else. This is the real reason why the Depression lasted as long as it did. The business cycle got back to normal (in fact, there was a fairly orthodox cyclical recession in 1937, as the Fed stomped on the monetary brakes), but everything operated at lower levels than before.
Something similar may be in our immediate future. What concerns me is that normal risk-taking, the kind that builds wealth and makes capital available for our children’s future, may not return to the US. It may simply flee to the emerging world, where the growth potential is much greater.
Is there a policy response to this? Yes, but not one that anyone is talking about in this “Democratic year”: lower taxes on capital and income, and reduced regulation for non-financial businesses.
The patient’s heart is beating, but he has yet to start breathing again. And at this point in time, it’s not yet clear what it will take to get him started.
-Francis Cianfrocca (“blackhedd”)
« The Credit Crisis and the Economic Outlook — Comments (19)
Waiting for the Patient to Start Breathing Again 25 Comments (0 topical, 25 editorial, 0 hidden) Post a comment »
now who does THAT remind you of... (hint - they serve in the Senate and represent the (self-styled) populares) :>)
The sad fact is that you have to drink the sour milk, puke it back up, and push through it. Recognize that this batch got sour and compartmentalize it, recall the bad lots, etc., but don't buy into a long term doom prognostications. Don't throw babies out with bathwater, and all that.
At this point the problem is at least as psychological as it is structural, and people are ultimately going to decide how long-lasting and havoc-wreaking this crisis is, through their behavior and their ability to muddle through.
Start muddling! Tough times build character.
[Note: This isn't meant as advice to you, Gordon. I already know you're muddling through it, as we are.]
And he survived the Great Depression in the steel foundaries of Massachusetts:
"There are two kinds of people when times get bad, Alex: The ones who work to end them, and the BUMS."
He was right.
what really irks me is I misspelled it thrice!
a whole mouthful of moths.
===
When small men cast long shadows, it is a sign that the sun is setting on the Democrat Party
answer my fears though. First, it is still too early to tell if the credit crisis is over. I can tell you the mortgage market continues to be in flux and at the rate we are going we will soon be down to a tradition thirty year fixed and an FHA thirty year fixed and that is it. My concern is this. The Fed is powerful enough as it is. They have nearly total control of the money supply. That is quite a bit of power. Furthermore, they have regulatory power over banks. Soon, that regulatory power will extend to all financial institutions. Now, they acted as nothing more than super powered investment bank in procuring the Bear Stearns deal, in which they not only brokered the deal, but also backed the deal up, and they used their immense power to force all the players to agree to the deal. Now, I firmly believe that absolute power corrupts absolutely and at what point will we say enough is enough, the Fed has enough power and we can't allow it to have any more.
Was it over when the Germans bombed Pearl Harbor
of two evils during this crisis, IMO.
We need limited and EFFECTIVE regulation of the finance industry and corporate governance issues.
It is interesting to note that in the three most recent crises - the dotcom bust, the corporate crime wave and the mortgage bubble- government authorities were basically asleep at the switch. No one acted preemptively to restrain behavior that was illegal or borderline illegal until the 11th hour and 59th minute, and then the action was delayed a little longer.
didn't act to bring calm to the market, however my question is at what point do we say enough is enough with the power grab of the Fed. Isn't controlling the money supply enough power? No, they also have regulatory power over banking, and soon financial services entirely, and also, if they think it is necessary then the fed acts as an investment bank and forces the players to haphazardly take the deal. Don't you see a potential problem with centering this much power in the hands of one organization?
Was it over when the Germans bombed Pearl Harbor
HTML Help for Red Staters
"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
however at least in Nancy's so called hands, a law must go through committee, then to the other side, then get passed by both sides exactly the same, and then survive a potential veto. Here, you have one person making all the decisions.
Was it over when the Germans bombed Pearl Harbor
HTML Help for Red Staters
"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
that board almost always cedes to the chairman. Look, all I am saying is that I am troubled by all of the recent new found power of the Fed. I believe this organization already has an enormous amount of power and anymore power is quite dangerous.
Was it over when the Germans bombed Pearl Harbor
I have a very strong sense that neither Bernanke nor Tim Geithner (President of the New York Fed) are interested in a massive increase in the scope of the Fed's activities. I got rather the opposite sense. They know they're treading on very thin ice.
Unfortunately, because their power over money is essentially infinite, they have the potential to do incredible harm if they choose to participate directly in markets.* They're well aware of this.
We'll see what happens in six months or so.
------
*Yes, I know about their, well, let's say their "subterranean" trading activities on several desks in New York. I'd guess that those are basically espionage, not policy-driven activities.
you maybe right that Bernanke doesn't want to exhibit too much power, however that is exactly what he did in procuring the Bear Stearns deal. Say what you will about the deal but one thing you cannot say is that it was a humble use of Fed power. The Fed has enormous power and unlike other branches its power is usually centered in one or a few hands. If the Fed can act as an investment banker to make sure there isn't panic, then there are really no limits to what it can and will do. That is what concerns me. This is a very dangerous precedent he set, and future chairs will see this precedent for their own power grab. Here is the problem. We will have many more situations where markets are near panic. Bernanke has now set the precedent that the Fed can do almost anything to subside a panic.
Was it over when the Germans bombed Pearl Harbor
They have whole armies of market participants watching their every move. And those participants would start selling everything in sight within microseconds if ever the perception took hold that the Fed was becoming evil (which would be bad) or adrift (which would be worse). This exerts powerful discipline on the Fed.
On the other hand, those same market participants would like nothing better than for the Fed to just take over the whole economy and make all of their risk calculations easier.
So I wouldn't say that you're wrong. But the other side of the coin is that the global financial system has been demonstrating a fragility, a brittleness if you will, that has surprised a lot of people. So far, I can't really envision a future without a powerful Fed.
become evil. All I am saying is that an organization with an obscene amount of power just created all sorts of new power in brokering the Bear Stearns deal. That, to me, is quite troubling.
Was it over when the Germans bombed Pearl Harbor
While the Fed temporarily did ape the role of investment bank, it was as lender of last resort and liquidity gurantor to calm a panicking market.
A "normal" investment bank exists to become stinking rich doing their thing - proprietary trading, underwriting, brokerage, etc.
That's why a fleet of limos descends on Wall Street every day bringing the movers and shakers. (I am searching, so far in vain, for blackhedd's limo!)
Great post Blackhedd, keep them coming.
Do you share the Greenspan view that housing prices will begin to rebound in the first half of 2009? That's hard to believe given the current credit climate (or lack thereof).
That I thought looked interesting enough to pass along:
Citigroup is in the process of selling $12 Billion of loans and bonds that it had been stuck with on its balance sheet to a Private Equity consortium- I'm sure at a nice discount. Hopefully this is a positive sign, if creative steps like this can clear up some of the massive debt backup the banks are stuck with, maybe they will be able to turn the spigot back on a little bit again.
http://www.cnbc.com/id/24018760
The other interesting tidbit is that the Fed is considering "further steps to address liquidity problems in financial markets."
Although the steps they mention- for the Treasury to borrow in excess of requirements and deposit the overage at the Fed, issuing debt under the Fed's name and seeking authority to immediately pay interest on commercial bank reserves - are beyond my small techincal knowledge base in terms of what the impact would be.
Any idea if any of these items would make a big difference and/or is a good idea?
http://www.cnbc.com/id/24028116
As always, great article, just wish it wasn't so depressing.
No time to read the story you linked, but I heard that the loan portfolio will be sold at 90 cents. I couldn't tell you whether that's close to a market price for the lot, but it's a bright, clear sign that Citi are trying to shrink their balance sheet. And this confirms the thesis of my post.
Another interesting thing is who the expected buyer will be: some of the same private equity firms that took out the loans in the first place (I don't know if they are exactly the same ones, buying in their own debt.)
But that's exactly what I had in mind when I said that debt is being converted to equity. A lot of "covenant-lite" private-equity financings are giving banks heartburn because they have no easy way to call them. So Citi evidently decided to throw in the towel. It's another question entirely whether the PE firms taking over the loans will actually benefit.
I haven't gone through the commentary on the new musings from the Fed yet.
I just did a quick back of the envelope on the return calculation. Assuming the loans were priced at L+2.5%, which I believe was solidly within market pricing coming out of 2007, and current LIBOR is approximately 3%, the loans are purchased at a 10% discount, and the loans have a 3 year avg life to maturity, I get an approximate return of 8.5%-9.0%, which I think would be rather unattractive to private equity, even given the lack of alternatives in the M&A market right now. So it is difficult to see how this is an attractive play.
Perhaps the PEs were able to use some degree of leverage in their sources of funds to enhance the return- but the whole reason the loans are trading at 90 or lower is because such leverage is not available to the folks who had been taking these loans for the past 3-4 years, so I don't know how the PEs could get it.
Perhaps there are intangibles such as desire to hold signicant debt in their own portfolio companies, but otherwise it is hard to understand the attractiveness of the investment.
And second, whenever you can prepay a loan at 90% of par, you do it, so long as you have an attractive alternate source for the funds.
And if you don't, then this may just be a strategy for winding down some underperforming deals. (Chrysler LLC spring to mind, although I'm not saying they're involved in the Citigroup transaction.)
What concerns me is that normal risk-taking, the kind that builds wealth and makes capital available for our children’s future, may not return to the US.
Scary, and I can see it happening. Unless things have changed recently, China is still the biggest capitol sponge. I know, capitol is capitol, but with so much less of it being made available, and those that lost theirs here in the US it may sour the milk for some time to come.
Remember, The Roman empire lasted for 800 years, but it still had an end. Perhaps our rule over the banking world will also take the fall.