(Editor – see also Reaping What You Sow: Hedge Fund and Housing Bubble Edition;
No Rich People Were Harmed In Making This Recession;
Sub-Prime Market Earthquake is Felt Worldwide;
On the Conservative Mortgage Crisis Meme;
And, The Yen Carry Trade Unwinds.
To understand the accelerating financial crisis that is afflicting various global markets you have to realize there are two credit creation processes at work in the world today. The first is the traditional one run by the central banks through the commercial banking system. This process has increasingly been shunt aside in the past ten years by a new credit creation mechanism run by the Wall Street investment banks. It is this new lending machine which is now imploding, and which threatens to impose severe economic pain.
There were warning signs from the Federal Reserve itself that this parallel universe of credit creation was running out of control. About a year ago the Fed announced it was no longer publishing its M3 money supply statistic. This seemingly obscure technical matter was actually very revealing. M3 is the broadest measure of money supply and includes corporate and investment bank money stock, as opposed to M1 and M2 which focus on cash and consumer credit. The Fed was implicitly saying it no longer had control over the credit being created through the investment banks, hedge funds, and various securities markets ”“ and that it was not going to be responsible for any problems that developed.
The Fed also argued that M3 could be reconstructed from existing data if anyone cared to do so, and some economists have done just that. The result shows an astounding growth in M3 balances of 12% in the past year, double the growth in either M1 or M2, and clearly a sign that the debt process was running amok on Wall Street. No wonder the Fed wanted nothing to do with it.
Banking Then and Now
Credit is the lifeblood of any modern economy, and traditionally banks have been at the center of the credit creation process. The design of the Federal Reserve System is intended to provide some control over bank lending, and a necessary back-up to the banking system in times of crisis.
The control is done in part through periodic supervision to monitor the credit process, encourage best practices, and stamp out dangerous practices. More importantly, the Fed can increase or decrease interest rates, change the amount of deposits banks must hold at the Fed for the loans they make, and open or close the discount window that allows the Fed to extend lender-of-last-resort credit to banks in trouble. These practices are liberalized during recession, and progressively tightened as the economy expands.
The Wall Street investment banks have never been a formal part of the Fed’s system, which is open only to commercial banks. Firms like Goldman Sachs, Merrill Lynch, and Morgan Stanley cannot borrow directly from the discount window, they cannot maintain reserves at the Fed, and they have no direct access to the interbank money market in Fed Funds. Some investment banks in the past have indirectly been supported by the Fed, which has opened the discount window to commercial banks willing to lend money to an investment bank in trouble. But this is the extent of Fed support, and it is only provided if the failure of the investment bank threatens the money markets in the U.S.
So how did the investment banks become rivals to the commercial banks as credit providers? To some extent, ever since the investment banks began helping corporations obtain credit through the issuance of corporate bonds or short term commercial paper, the investment banks have had their hands in the lending business. But in the past ten years there has been an explosion of new products and new syndication processes that has allowed Wall Street to push the commercial banks out of the way when it comes to global finance. Helping this process along in the U.S. has been the quasi-central banks of Fannie Mae and Freddie Mac.
The GSEs Supplant the Fed
Fannie Mae and Freddie Mac were chartered by Congress to help the housing market in the U.S. This charter has enabled these two Government Sponsored Enterprises (GSEs) to act in the markets as if they were the government. This has allowed them to borrow at rates close to those of the U.S. Treasury, to explode their balance sheets by loading up on trillions of dollars of mortgages, and to spur the market on even more by providing their guaranty against credit loss for banks which own mortgages.
The Fed has complained to Congress about the GSEs and their central bank-like behavior, and Congress has formally stated that it is under no obligation to bail out the GSEs in a crisis. The market doesn’t believe this, and Wall Street has peddled GSE securities around the world by describing them as the equivalent of government paper.
Central banks worry constantly about creating ”œmoral hazard risk”, which occurs when commercial banks lend foolishly because they believe they can dump their losses on to the central bank. The GSEs should have also worried about this risk, but apparently did not, because from the early 1990s they either bought or guaranteed up to $6 trillion of mortgages. This kick-started the housing boom in the U.S., which got an extra boost from the Fed itself when Alan Greenspan authorized interest rates as low as 1% in 2003.
Eventually the GSEs got into serious accounting trouble trying to hedge the prepayment risk of their mortgage portfolio, using complex derivatives products from Wall Street. The GSE regulator intervened, executives at both Fannie Mae and Freddie Mac were fired, and to this day a cap exists on the amount of mortgages that can be bought or guaranteed. Fannie Mae still hasn’t been able to publish proper accounts for nearly five years.
Wall Street Creates a Debt Machine
The GSEs have had to sell trillions of dollars of securities to fund their purchases of mortgages, and Wall Street investment banks have been eager to oblige them in the issuance and distribution of these securities to investors. This ”œsecuritzation” process was in itself a credit creation mechanism that by-passed the Fed, though it served the business purposes of many commercial banks that are members of the Fed system. The more GSE securities Wall Street could sell, most recently to foreign investors like the Chinese central bank, the more mortgages that could be created. The Federal Reserve was powerless to stop this process as long as Congress either welcomed or ignored the explosion in mortgage growth occurring in the U.S. and at the GSEs, and we can postulate that someone as politically sensitive as Alan Greenspan knew enough not to stand too much in the way of this development.
The important point, though, is that securitization took mortgages and other loans off the books of the banks and into the hands of investors, many of them overseas. This did have the benefit of reducing the credit risk in the banking system, and Alan Greenspan in particular was fond of extolling the securitization process and instruments like derivatives as risk-reducing measures for banking and the economy. But while the commercial banking system had less risk, the Fed had less ability to restrain the growth of credit in the economy.
Wall Street in the past ten years has expanded its securitization process wherever it can. The mortgage-backed securities (MBS) market, which bundles thousands of individual mortgages into bonds investors can conveniently buy, exploded right along with the housing boom. You could say that the relationship between the housing boom, the government support provided by the GSEs, and the MBS market was symbiotic, each feeding off the other in a frenzy of double-digit annual growth.
But the MBS market didn’t really become the centerpiece of the mortgage business until 2004, when the GSE’s found themselves constrained from further business. Wall Street had a securitization process at hand ready to replace the GSEs, but what it didn’t have was an ability to control the credit risk of the mortgages being created. It’s not even clear Wall Street cared, or maybe the incentives of churning more and more mortgages through the system caused them to look blindly the other way. Either way, as soon as the MBS market went into high gear, credit standards collapsed. Mortgages that the GSEs would never have been able to accept now became the norm ”“ no proof of employment or income, no down payment, no principal payments required, and negative amortization all became standard features.
To sell the millions of mortgages that were now running through the system, Wall Street used derivatives products like Collateralized Loan Obligations and Collateralized Debt Obligations to slice and dice the cash flows from mortgages and sell them in tranches based on their default risks. The ratings agencies Moody’s and Standard & Poor’s modeled each of these securities transactions and invariably came up with very low default risk, based on what was known statistically about mortgage behavior. Unfortunately, nothing much was statistically known about the 2005 and 2006 mortgages being booked that had dramatically weaker credit standards, but that didn’t stop the ratings agencies from placing Aaa ratings on securities that included sub-prime mortgages in their cash flows.
When we say ”œWall Street banks” we don’t just mean the New York investment banks. The top 20 ”“ 30 commercial banks in the world morphed into investment banks in the 1990s, mostly to compete with the likes of Goldman Sachs and Merrill Lynch who were encroaching on the banks’ customer base, but also in response to pressure from the central banks who wanted the commercial banking industry to improve its risk-based capital practices. In the U.S., this merger of the two banking worlds was complete when the Glass-Steagall legal firewalls between the two industries were eliminated. This new world of overlapping functions has greatly complicated the role of the central banks when it comes to market crises.
One focal point in the current credit market meltdown is a sector of the market known as Asset-Backed Commercial Paper (ABCP). This paper is issued by legal entities called conduits or Structured Investment Vehicles (SIVs) set up by the largest banks to purchase mortgage securities, auto loans, credit card receivables and all sorts of other debt that these banks want to issue but do not want to keep on their own balance sheet. To finance these assets, the conduits issue short term commercial paper, and the investors who buy this ABCP know it is not an obligation of the bank, but only of the conduit. Theoretically, if the conduit fails the investors may lose all their investment, because they cannot turn to the bank for help.
Because of this legal independence, conduits have an array of credit protections, often including an emergency loan facility from the bank to provide liquidity if the conduit is having trouble selling its commercial paper. Investors cannot always be sure if the ABCP they are buying is going to be collateralized by mortgage assets, auto loans, etc., so in the current crisis many are assuming that sub-prime mortgages are involved and they are refusing to buy the paper. The conduits are now facing potentially dire circumstances because they survive only on the steady reissuance of their commercial paper. Many are beginning to turn to their bank sponsors to take down emergency loans from the bank. There is an estimated $1.2 trillion of ABCP currently in the market, so we are talking about multi-billions of dollars of emergency liquidity being required from the banks.
The ABCP business sprung up to help Wall Street move a growing number of mortgages from the balance sheets of the banks to the hands of investors through securitization. But this business also showed banks that the credit creation machine didn’t have to stop at mortgages, but could include other forms of retail debt. And if this could be done, why not apply the concept of securitization to corporate debt?
Why Stop Just at Mortgages?
By the 1990s the credit creation process was applied to corporate lending, particularly to the buyout business developed by private equity companies like Blackstone and Kohlberg Kravis and Roberts, which were eager to buy cash rich companies, take them private, polish them up with cost cuts, and then bring them back to the stock market a few years later at tremendous profit. To do this, these companies needed massive amounts of credit, and Wall Street converted its tried and tested securitization process to the task at hand. Securities were packaged and sold just as quickly as deals were announced, and not surprisingly, by 2007 credit standards on these transactions had deteriorated in the same way as mortgage loans had deteriorated.
The most eager buyers of all this paper were hedge funds, the secretive pools of investment capital that promised 20% to 30% annual returns, and extracted enormous fees and bonuses for their managers as compensation for such generous profits. To get these profits, however, the hedge funds had to leverage their equity, which means for $100 million of investor capital, they would often borrow $1.0 to $2.0 billion extra.
And who was there to lend to the hedge funds? Wall Street investment banks, which dropped their usual reticence to putting loans on their balance sheets, and began to bloat their assets with the hedge fund loans they couldn’t readily sell to investors.
We should not forget the accounting conventions that helped churn these transactions at an ever-quicker pace. Loans held at banks have interest income, which is the difference between what the customer pays in interest and what the bank pays on its liability funding the loan. This interest income dribbles in over the life of the loan, is relatively unexciting, but does pay the bills over time for a well-run bank.
The securitization process accounts for transactions very differently. The securities, composed of thousands of loans, are marked-to-market, which means that at day one all the projected income over the life of the security is present valued and taken completely into income. This has the great advantage for the traders of creating a big pool of revenue for their bonuses, but unfortunately no further income can be assured in the future to cover the bills. So the traders have to book more and more securities to keep covering their costs, including the sizeable bonuses to which (no surprise here) they quickly become accustomed.
The Inverted Pyramid
As you think of this entire debt creation process, involving one securitization after another, and leverage pumping up the debt volumes much higher than pure business need would require, and mark-to-market accounting pressuring traders to do ever-greater amounts of business, remember that most of it was done outside of the banking system. To be sure, the very largest banks, like Citibank, Bank of America, and JP Morgan Chase, have become like investment banks and were very active in securitizing debt just as much as the investment banks. But even they kept as little of the securities and loans on their balance sheet as possible, making room for the volume of business that was sure to come next quarter.
This credit creation process was also replicated in many other countries, and housing booms were ignited in the U.K., Australia, Canada, New Zealand, China, and elsewhere. In each case, as with the U.S., an inverted pyramid of securities, derivatives, and loans was built upon a base of underlying mortgages or other basic credit transactions, and the base was becoming progressively weaker as credit standards were undermined.
In terms of the U.S. dollar components of the process, the deposit accounts receiving all the electronic credits for the loans being made showed up in M3, which explains why the growth rate in this money supply statistic kept increasing until it reached this year’s 12% annual rate. What was critical about all this growth is that it was largely outside of the banking system, and the Fed couldn’t stop it. Worse still, the Fed had no legal responsibility for any problems that might crop up, except in the specific case of the very largest commercial banks that were involved in securitization, and in the general sense of helping ameliorate a credit crisis.
Disillusion Sets In
It has long been recognized that the banking system rests on a grand illusion. Your deposit at the bank is not really there ”“ it has been lent out to someone else. You can only retrieve your deposit if just a few other depositors want their money out at the same time; otherwise you have a run on the bank.
The entire concept of paper and electronic money is an illusion as well. The dollars issued by the Federal Reserve only have meaning if the public puts implicit trust in the government to be able to honor all legal claims made in dollars, whether they are public or private, domestic or foreign. The Federal Reserve understands this well, and guards its public image as a repository of trust more carefully than anything else it does.
It is this confidence that girds the commercial banking system, allowing the public and corporations to trust not only that deposits will be safeguarded with insurance, but that bank failures on a large scale will be avoided. This means that the credit creation process will be monitored and controlled to prevent serious systemic abuses that could damage the economy.
When a parallel credit creation process arises it lacks the governmental underpinning that supports the credit created through commercial banks. Confidence is much harder to maintain, and it is much easier to disillusion the participants in the system. This is precisely what is now happening to Wall Street’s credit creation process. The process has been overloaded with security upon security, and the transactions at the base that are supposed to support these securities are themselves riddled with credit flaws. Wall Street’s securities have been sold all around the globe, and its process has been replicated in many countries. Each of these processes are linked by mark-to-market accounting standards that require daily prices for hundreds of thousands of securities, and if one security anywhere in the world is marked down by, say 30%, to the extent this is public information (and it is usually known to the brokers who intermediate in the process), then all such securities globally must be marked down 30%.
It doesn’t matter that only one sector of the market, like sub-prime mortgages, is actually experiencing dangerous customer defaults. Once confidence is lost in one sector of this parallel credit creation process, it is lost in the entirety of the process. This is why investors around the world have been selling all types of securities, leading to panic selling of higher-quality assets just to raise cash to meet collateral requirements under margin calls. Investors intuitively understand that defaults in this system could get out of control, because no central bank has been monitoring the process for credit weaknesses.
This is also why intervention by central banks now, such as this week’s 50 basis point cut in the Federal Reserve’s discount rate, may only prove to be temporarily ameliorative. The Fed earlier in the week had said it would intervene in the markets only if a ”œcalamity” occurred, and a few days later the discount rate cut suggested that something calamitous had happened. Based on the fact that the discount window can now be accessed for 30 day loans rather than just overnight money, and that the Fed also will now accept mortgage securities as collateral, we can assume one of the calamities involved Countrywide Bank. This commercial bank is a member of the Federal Reserve System and has access to the discount window. It is owned by Countrywide Financial, the country’s largest mortgage lender, and a company which a Merrill Lynch analyst said earlier in the week was possibly heading for bankruptcy. This led to an old-fashioned run on the bank, in which depositors were beginning to line up to get their money out. Nothing instills primal fear in a central banker like a run on a bank, which brings back all sorts of images from the 1930s Depression. This discount rate cut is first and foremost designed to stop the bank run in its tracks by giving Countrywide Bank whatever cash it needs.
The second likely calamity involved the ABCP market. Many conduits are simply unable to roll over their commercial paper, and they are turning to their commercial bank sponsors for emergency liquidity. This is very serious stuff because of the potential that hundreds of billions of dollars of loans now may need to be booked by the banks themselves, in effect bringing all this off-balance-sheet business right back on to their balance sheet. This could dramatically weaken their capital ratios, and certainly will put strain on their own financing activity. Hence not only did the Fed open the discount window to these banks, it specifically said that to borrow from the Fed was no longer to be considered an embarrassment and sign of failure, but a sign of ”œstrength.” Discount window borrowing has always be shunned by the banks, and as of last week the amount borrowed was a paltry $11 million. Now it is the Fed itself that is trafficking in illusions, trying to convince the market that nothing is wrong if discount window borrowings balloon by billions of dollars.
The Fed’s action will help some of the large U.S. commercial banks that are deeply mired in the securitization process, and it may help these banks lend to investment banks facing much deeper problems. But it does not necessarily force U.S. commercial banks to make loans to investment banks, hedge funds, or other players who now may be facing bankruptcy. Also, it does nothing to change the true weakness staring everyone in the face ”“ this credit creation process has been out of control, and it has been run on deteriorating if not deplorable credit standards for years. Liquidity cannot solve these problems; only the bankruptcy courts can.
It All Comes Down to Cash
As we watch the pyramid being dismantled, as hedge funds reduce their holdings and try to pay down debt (or are forced to do so because of margin calls), as ABCP conduits discover they don’t have the ability to replace their commercial paper borrowings, and as the mark-to-market process works its inexorable damage now that prices are going down, we discover how little actual cash was in the system in the first place. The participants in this credit creation process had created their own, fatal illusion: that debt is liquidity, just like cash. ”œThe world is awash in liquidity” has been repeated so many times in recent years, but the truth is that debt is not liquidity and it certainly isn’t cash.
The demand for cash to meet margin calls, or handle investor redemptions, or replace funding that has now dried up, is so strong that pressure has been building on short term bank deposit rates, forcing central banks to inject huge amounts of liquidity into the banking system to restore these rates to levels seen just a week ago. What this tells us is that the entire parallel credit creation process has frozen up, leaving the world dependent on the traditional commercial bank/central bank credit creation process.
This traditional process is not only way too small to handle all the credit needs that Wall Street created, it has also atrophied over the years. Bank credit departments, where analysts once numbered in the hundreds at big banks, have shrunk as banks have determined they don’t want to hold on to loans anymore. Banks simply don’t have the means even to analyze the risk, because increasingly they are relying on Moody’s and Standard & Poor’s to do this for them. Unfortunately, these ratings agencies have been found wanting, and may wind up being taken over by the government before this crisis is completely cleaned up.
The global economy cannot survive for long on the traditional credit creation process, and unless Wall Street can revive confidence in its securitization process almost immediately, a global recession starting later this year is a high likelihood. Wall Street might have a chance if it could make public very soon the nature and extent of the problems with its credit creation process. But this is one of the key differences between the two processes ”“ problems in the commercial banking system are quicker to surface, and there are regulators ready to intervene. Not so with the complex, sprawling, opaque, and unmanaged Wall Street process, whose raison d’etre seemed to be to generate fat bonuses for many involved, with little thought to the systemic and economic risks being created.
We shall see what good the Fed and other regulators can do with interest rate cuts and any other interventions they can think of, but the problems are so large and unwieldy that no one should hold out much hope. The implosion of the Wall Street credit creation process is unprecedented in its depth and international scope, and the global economy will be fortunate indeed to avoid severe and prolonged damage.