Summer 2007: most executives went on holidays on a rosy economic and financial outlook. A few weeks later, credit had dried up, central banks were on high alert, England was facing its first bank run in decades, and a major crisis loomed on the horizon. What happened?
This financial crisis was originated by unexpected large-scale defaults on subprime mortgages in the United States. They can be attributed to three factors.
First, years of strong economic growth coupled with low interest rates convinced relatively poor households to get into debt to acquire a house. Lacking financial acumen, they often opted for variable rate loan payments, at a time of very low interest rates. The Fed had indeed reduced its base rate to forestall a recession following a number of financial crises, the latest being the bursting of the internet bubble in 2001. Intermediaries intent on doing business convinced these households that they could afford these mortgages. They were to be subsequently strangled by soaring interest rates.
Second, years of rising house prices entrenched the belief that real estate consistently delivers positive returns, fostered speculation and reckless collateralized lending. Since American households can borrow by pledging their assets, rising prices also increased their borrowing capacity. Conditions were in place for a mania: only a few months ago, advertisements promising wealth and success through real estate investment were omnipresent in the U.S..
Third, the financial architecture mitigated adequate monitoring of the credit worthiness of borrowers. Financial innovations such as CLOs (collateralized loan obligations, an instrument that yields the payoffs of given tranches of a portfolio of loans) or CDOs (collateralized debt obligations) allowed new and sometimes inexperienced investors to easily gain exposure to fixed income markets. These instruments offer diversification benefits, and enabled financial institutions to outsource risk by selling packaged portfolios of loans to other investors. Consequently, banks did not have to retain all their loans anymore. They merely originated them, sliced them up, bundled them, and sold them. Securitization allowed banks and other institutions to become intermediaries. Not restricted by their capital, they lent more freely. Not bearing any loss triggered by defaults, they were less concerned with credit quality, and did not screen borrowers as thoroughly. They collected fees based on the amount of loans originated. Lending standards dropped.
At the same time, confident investors looked in the rear view mirror, by gauging the riskiness of CLOs and similar instruments based on historical (very low) default figures – overlooking the fact that this new lending regime would be characterized by a different distribution of defaults... According to Martin Wolf of the Financial Times: “Intermediaries persuaded borrowers to borrow what they could not afford and persuaded investors to invest in what they did not understand.” Actually, most of these investors relied on credit ratings, as attributed by rating agencies, to price securities. But these agencies were also caught off-guard. When it turned out that products rated AAA were in fact more risky than expected, investors lost faith in the ratings. Left without a compass, they ran for the exits, and sold indiscriminately. Wild fluctuations in prices and low liquidity made the incriminated products appear even more risky to investors. Rating agencies defended themselves by clamoring that credit ratings neither measure volatility risk nor liquidity risk. This is true. And it was quite sufficient in the past, in stable market conditions. But during a financial crisis, volatility and liquidity risk are very relevant to investors.
Some commentators blamed a global liquidity glut, or the availability of massive amounts of money, for the financial crisis. This is misguided. In the world, rates of expected return adjust so that aggregate savings are equated to aggregate investments. Savings are not a given. They were high partly because expected returns were held artificially high by a dysfunctional Western financial system. The latter proposed to massively absorb savings, thus generating them. This inflow of capital widened the US current account deficit. So finance generated two problems: global imbalances and a financial crisis. Without this dysfunctional financial system, expected returns available would not have been this high, which would have had two consequences: there would have been more corporate investment (the bar being lower), and less savings. Instead, savings were invested in non-viable investments, which resulted in a dead-weight loss – a destruction of savings, when actual returns turned out to be negative.
All this action happened a few months ago. Why does it take so much time for this crisis to be resolved?
To begin with, investors must assess the true value of fixed-income products before they can create a market for them. Even if things are slowly improving, for a few months there was virtually no market for these products, for no one knew for sure what they were worth. Additionally, anyone entering the market is eyed with suspicion: “If he is so bold, he might know more than we do, which means we’re going to lose if we trade with him.” Asymmetric information, real or imagined, created a market breakdown.
Understandably, banks and investors have long been reluctant to realize their losses, fearing that their opaque products are trading at a discount. As a result, no one knew the extent of their losses, and trust could not be restored. It took a few months for financial institutions to come clean. This problem was compounded by the fact that many institutions set up off-balance sheet vehicles, such as ‘conduits’, to reduce the amount of capital they have to set aside for regulatory purposes. Once again, it is hard to know the exposure of a financial institution in these conditions.
Banks therefore distrust their counterparties, and doubt their creditworthiness. They also need capital to cover their own losses, and keep on their books debt they cannot distribute anymore. But because of their extremely convoluted positions combined with high market uncertainty, they often didn’t even know what their losses summed up to. In addition, just as their balance sheets were damaged, the value at risk of their portfolios increased, so that they needed to set aside more capital. In this context, it is not surprising for banks to hoard capital, shrink their balance sheets, and be reluctant to lend to each other or to other financial institutions. All the more that adverse selection is at play: with high interest rates, the only borrowers will be those who desperately need cash, i.e., the more risky ones...
The gap between the interbank rate (Euribor for the euro, Libor for the dollar) and the base rate measures the price of mistrust. In the U.S., it more than quadrupled in August, and is still around 200 basis points – against around 50 basis points in normal market conditions. The subprime crisis turned into a crisis of liquidity: credit was largely unavailable, credit spreads widened, with potentially disastrous economic and financial consequences.
Using marking-to-market accounting to value positions injected some transparency in the system. But it also aggravated the problem as banks’ balance sheets were further weakened by virtual losses generated by temporarily dysfunctional markets. If markets overshoot following fire sales, should banks necessarily record a loss, even if they intend to hold on to this asset for a while? Marking-to-market could also coordinate players on a bad equilibrium: fire sales from a distressed agent momentarily depress prices, which puts other financial institutions in a precarious position, thereby triggering more fire sales… In this situation, an agent with deep pockets and for whom capital requirements are not binding could find bargains and stabilize markets.
With expensive credit and scarce capital, investors often had to cut their positions in other asset classes. Volatility and correlations increased, and equity markets suffered – except for emerging markets, which surprisingly emerged as a safe haven. Similarly, speculators reduced or cut their carry trade positions (the carry trade typically consists in borrowing in yens at low interest rates to invest at high interest rates elsewhere): they bought back the yen, and sold other currencies, including the dollar. Hence the strength of the yen, and the weakness of the dollar – which is also driven by other factors, including a concomitant global rebalancing.
Simultaneously, the subprime mortgages crisis also prompted long-overdue broader reckoning, which progressively resulted in corporate debt market collapsing, as investors progressively became aware of the hidden dangers of allegedly “fixed” income: in January 2008, corporate U.S. debt recently issued was on average trading at 8% below par. Investors’ beliefs on the distribution of future operating free cash flows by and large did not change. But they realized that more levered financial structures and less thorough screening of borrowers resulted in higher probabilities of defaults. This lowered the value of debt on secondary markets, and raised its cost on primary markets. Defaults did not materialize yet on covenant-lite deals. That’s because borrowers could until Summer 2007 obtain very generous terms, including repaying their lenders at maturity only, without any interim obligation. Even struggling companies can survive unnoticed for a few years in these circumstances.
All these developments contributed to a gloomy outlook for the coming year. Stock prices, which are most sensitive to a change in economic conditions, tumbled in January 2008. Investors realized that the financial mess would have relatively severe and long lasting consequences.
As in any good movie, there is a providential savior. This role is endorsed by Central Banks, featuring Jean-Claude Trichet and Ben Bernanke. Their success at taming inflation brought them a credibility that reinforces their capacity for stabilizing interventions. Called to the rescue, they cut short-term interest rates, and repeatedly injected massive amounts of liquidity. At first to supplement a temporarily failing interbank market, and later on to avert a recession. But surging inflation, propelled by rising commodity prices and a collapse in the dollar exchange rate in the U.S., limits their ability to support the financial system and the economy. Hence the fear of stagflation.
However, the financial crisis will ultimately be resolved when institutions know how to value their positions, when all players agree on the pricing of complex fixed-income instruments, when financial institutions record their losses accurately, when defaults occur, capital is reallocated and companies are financially restructured, and when instruments as well as accounts are transparent. Regaining confidence may take time, and be painful. The latter is necessary for investors to learn from their mistakes.
In the meantime, bailing out failing institutions without penalties amplifies moral hazard, and encourages future reckless behavior. Banks have to suffer the consequences of their unwise decisions: most took liquidity as given, and did not monitor credit risk adequately. Even providing liquidity in a crisis is fraught with perverse incentives. For Raghuram Rajan in the Financial Times, “First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it.” In the same newspaper, the economist Lawrence Summers disagreed, and warned against the “moral hazard fundamentalists” who do not tackle crises. This is a classic dilemma: should authorities stick to preventing crises ex-ante with appropriate incentives and controls, or also attempt to resolve any crisis ex-post with interventions that undermine these very incentives and “sow the seeds of the next crisis”?
This time, Central Banks seem to have taken the middle road. Following an initial tough stance, the Bank of England had to make a humiliating U-turn after a bank run on Northern Rock, a mortgage lender reliant on money markets for its funding. By contrast, the ECB was praised for its management of the crisis. Finally, governments don’t seem inclined to intervene heavily. In the U.S., they only take action to stimulate economic activity. This is good news: there is not much good they can do here, but much harm. Let’s hope they can control themselves and not overreact – for once.
PS: This article was written at the end of 2007.
Editeurs : Pierre Pâris, Bruno Lannes, Pierre Chaigneau.