Posted on 03/24/2008 4:12:05 AM PDT by TigerLikesRooster
March 24, 2008
Loss of liquidity, not insolvency, caused credit crunch
Anatole Kaletsky: Economic view
Did last week mark the beginning of the end of the credit crunch, or merely the end of the beginning? The answer depends on another question, which was much in the news over the weekend: will the Bank of England and the Federal Reserve start lending against mortgages, essentially without penalty and without limit, as the European Central Bank has done since last year? This may seem an esoteric technical question, but it will determine whether the credit crunch can be resolved merely by tweaking the traditional techniques of central banking, or whether vast sums of public money will be required. And the answer to this, in turn, depends on another even more obscure-sounding debate: has the “liquidity crisis” that started last August in the US mortgage market degenerated into a “solvency crisis” for the global banking system as a whole?
The relationship between liquidity and solvency has become so important that a brief recap is required. Liquidity is the ability of a bank or business to convert its assets into ready cash. Solvency is the ability to pay off or “dissolve” debts. This seemingly semantic distinction is important because a liquidity crisis can always be resolved, at least in principle, by central banks buying long-term assets, such as bonds and mortgages, from the banking system in exchange for cash. This process does not involve any public subsidies, because the central bank merely swaps £1million in cash for £1million-worth of bonds. An insolvency, by contrast, forces creditors to accept a permanent loss of economic value or for some third party, such as the government, to pay a subsidy so that the insolvent business can settle its debts. Either way, there is a permanent loss of economic value.
Deciding who should bear this sacrifice involves serious political and moral dilemmas.
Most economic commentators are firmly convinced that last year's sub-prime liquidity problem has become a much more serious solvency crisis. In my view, the past few weeks' dramatic events suggest the opposite conclusion: a localised solvency crisis in US housing finance has been transformed into a global liquidity problem. This problem is worrying because of its global nature, but it can be addressed fairly readily by central banks.
The evidence for this reassuring interpretation lies, ironically, in the failure of Bear Stearns. Bear Stearns did not collapse, as it might have done - and perhaps should have done - last August because the sub-prime mortgages that it did so much to invent and promote became worthless. It collapsed because of the plunging market value of ultra-safe assets, such as the bonds issued by Fannie Mae and Freddie Mac, the US government-sponsored enterprises (GSEs). These triple-A bonds have, until recently, been treated as risk-free assets almost interchangeable with US government obligations. Similarly, Peloton, Carlyle Capital and several other respected hedge funds were undone by their ultra-safe asset holdings, not by their speculations in risky sub-prime bonds.
These hedge funds used preposterous amounts of leverage to buy triple-A bond portfolios, which offered slightly higher interest rates than the cheap money they could borrow in the markets for short periods ranging from 24 hours to three months. When banks became less willing to roll over the short-term loans taken out by these hedge funds, they were forced to dump their triple-A bonds on to unreceptive markets, thereby pushing down their prices even though there had been no increase in the underlying probability of these bonds ever defaulting. Although the GSE bond prices fell by only a few percentage points, the hedge funds' leverage multiplied their losses and they quickly went bust. These bankruptcies caused even more GSE bonds to be dumped on the markets and triggered a further slide in their prices. But Bear was among the world's largest holders of GSE assets - and used them as collateral to back up its own leveraged obligations to other banks. With the market no longer willing to accept the unimpeachable value of Bear's triple-A collateral, the firm exhausted its capital by last weekend.
In other words, the latest phase of the credit crisis had nothing to do with escalating losses on sub-prime mortgages or other risky loans.
Indeed, Standard & Poors reported just before the Bear collapse that US banks had recognised most of their sub-prime losses - and this was supported by the modest first-quarter writedowns reported a few days later by leading US investment banks. The latest crisis, far from being caused by the banks' dodgy lending, was actually triggered by the fact that their highest-quality assets suddenly became impossible to sell in the markets, even though their default risks have not gone up at all.
The probability of the American GSEs defaulting remains essentially zero, as it has always been. If anything, the willingness of the US Government to stand behind these enterprises is even higher today than it was before the financial crisis. The market value of these bonds has fallen simply because they have turned out to be less liquid assets than previously believed - and liquidity has been recognised as a much more important and valuable characteristic than investors suspected until a few weeks ago.
Until last month, it was still widely assumed that the danger of illiquidity affected only inherently risky assets, such as sub-prime mortgages, complex derivatives and leveraged loans. But this assumption completely changed when the US bond insurers started to be downgraded in January. Suddenly, ultra-safe municipal bond prices plunged to levels normally associated with the riskiest junk bonds. This was not because the Port Authority of New York or the California Water Board suddenly looked like defaulting. It was simply because municipal bonds became illiquid as investors were forced by regulations to dump them into a market with no bids.
After the municipal meltdown, forced sellers of top-quality mortgages, and even of government-backed GSE bonds, suddenly could find no buyers. It was this disappearance of liquidity - not a growing risk of default by borrowers in the non-financial economy - that caused the collapse of Bear Stearns.
By last week, the liquidity crisis had spread even to assets whose default risk was literally zero. A widely quoted story on Bloomberg read: “The risk of losses on US Treasury notes exceeded German bunds for the first time ever, amid investor concern the sub-prime mortgage crisis is sapping govern- ment reserves.” The evidence cited was a sale of credit-default swap (CDS) insurance on US Treasuries, which implied a default probability of 0.16 percentage points, as against 0.15 points on German bonds. But what did these “probabilities” actually show? After all, Washington can always print the money with which it pays for its bonds - and, like all governments, invariably does so. Moreover, in the vanishingly improbable event that the US Treasury really did decide to stop printing dollars, would the underwriters of CDS insurance still be in business and pay up? What court would enforce a private CDS deal if contracts with the US Treasury were no longer in force? And what currency would such a judgement be paid in, since US dollars would no longer exist?
This extreme example illustrated a market reaching reductio ad absurdum. Prices had become completely detached from the risks they were supposed to reflect. Instead of measuring default risks, credit-market prices were becoming a pure measure of liquidity. Traders were pricing assets purely on their value as emergency collateral for raising cash, not as a source of prospective profits and cashflows.
This liquidity distortion cannot be tolerated much longer, since it destroys the main functions of financial markets - to send signals about potential profits and to create long-term stores of value. Luckily, liquidity is a quality that central banks can create at zero cost. All they have to do is lend against the vast quantities of high-quality, but illiquid, assets held by financial institutions - without limit and without penalty. The time has come to enact the famous injunction of Walter Bagehot, the father of modern central banking: “Lend freely, boldly, and so that the public may feel you mean to go on.”
What about all the teaser rate mortgages that are due to reset this year? There are many. Those losses haven’t shown up yet.
What are all the downward resets of the Fed Funds rate for?
They are helping ARM rates, but not as much fixed rate mortgages.
Cheers!
If you notice the FFT rates have not put any downward pressure on mortgage rates; if anything, the opposite is true.
The Fed does not affect long-term rates, only short term rates.
What the Fed is trying to do is add liquidity to the market. The rest is not under their control.
Whoops, he gives it away here. When your business model demands that you are CONSTANTLY borrowing money, and you fail virtually immediately when you can't, you were insolvent the whole time.
For individuals, it's called "kiting checks". For businesses, it's called "rolling over short-term loans".
Well that’s true, but the teaser rates were very low. So we’ll see.
Problem 1 is that these so-called high-quality assets are already highly leveraged.
Problem 2 is that this market for 20 years has been rewarding speculation rather than the creation of productive assets that have long term value.
He lost me right here. Bear Sterns did not invent sub-prime loans. HUD, Fannie-Mae, and Freddie -Mac at the direction of the United States Congress invented sub-prime loans and Bear found a way to market them at a profit.
BTW, did the United States bail out any of the investment banks that went under back in the 1980's when the junk bond market collapsed?
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