OPINION:Charles R Morris traces the causes of the sub-prime and global credit crises and suggests exit strategies
George Magnus, senior economic adviser to the Swiss banking giant UBS, recently dubbed the ever-evolving global credit crunch a "trillion-dollar meltdown", joining a growing list of analysts with loss estimates in 13-digit territory.
There is a new recognition that the problem is much broader than dicey American sub-prime mortgages. There is a huge swathe of shaky debt in junk loans and bonds spawned by the private equity takeover craze, plus a trailing archipelago of red-tinged islets in commercial mortgages, auto loans and credit-card debt.
Although much-touted new risk-shedding technology was supposed to insulate deposit banks from undue credit risks, it has largely failed to do so, as Peter Fisher of Blackrock Inc, a big American asset manager, has pointed out. A fair guess is that about half of the projected writedowns, or some $500 billion (€327 billion), will eventually come home to roost on bank balance sheets.
Citigroup's annual regulatory filing spells out for the first time $356 billion (€233 billion) in "variable interests", in murky entities like CDOs (collateralised debt obligations) and SIVs (structured investment vehicles), many of them specialising in sub-prime mortgages and highly leveraged loans, that do not appear on its balance sheet. All of them have significant hooks into Citigroup, often in the form of liquidity or credit guarantees that could stick the bank with more losses.
Other big banks, of course, are in the same position.
So we can look for the string of horror story writedown announcements to clank on and on, like some endless Freddie Krueger movie. Citigroup, Lehman Brothers, Bear Stearns, UBS and Credit Suisse have already signalled sizeable new writedowns in their current quarters. Since banks can lend at about a 10:1 ratio to equity, the writedowns will ratchet the credit compression that much tighter. Hopeful sightings of a market bottom are mirages.
At my Jesuit high school some 50 years ago, the teachers made us distinguish "proximate" and "remote" causes. The immediate causes of the credit crunch can be pinpointed in shocking lapses in American monetary and regulatory policy. Its longer-run roots, however, lie in the radical transformation of financial services.
America's Toga Party
America slipped into a recession after the 2001 dot.com stock implosion and World Trade Center terrorist attacks. The recovery was built around consumers, which was sensible enough, given the excessive investment of the tech-bubble years. But there were two problems.
Americans buy clothes, home electronics, cars and car parts, even the wood in their homes, mostly from overseas, so big rises in consumption entailed big trade deficits. Worse, personal savings rates were at the lowest level since the Great Depression. Federal Reserve chairman Alan Greenspan dismissed worries about savings, since Americans had enormous value locked up in their home equity. His fellow board member, current chairman Ben S Bernanke, also pointed to a "global savings glut", concentrated among emerging powers like China, India and the oil producers, who looked happy to supply all the funds America could desire.
For a few years, the machinery worked like a watch. The consumer share of GDP jumped to 72 per cent in early 2007: possibly the highest rate ever, anywhere. The trade deficit jumped by a factor of almost seven. The total deficit from 2000 to 2007 was about $4 trillion (€2.62 trillion).
But as Bernanke expected, that money, like swallows at Capistrano, came flocking right back to America, mostly nesting in comfortable Treasury bonds.
The Fed did its part, rolling out its liquidity fire hose. For more than two-and-a-half years, the Fed funds rate was kept lower than the rate of inflation. For banks, that meant money was free. Trillions were cashed out through home-equity loans to finance the increase in consumption.
Risk-shedding devices like CDOs and SIVs - selling off sub-prime assets by re-jigging them into highly-rated bonds - allowed the banks to engage in ever more risky behaviour. Recent research shows that the loan portfolios banks sold to outside investors had much higher default rates than the apparently identical portfolios they kept. Weirdly, consumer prices stayed well-behaved. Growing scale efficiencies in India and China and an overvalued dollar all imposed competitive price ceilings.
Instead, all the inflationary pressures unleashed by the Fed flowed into assets. Housing and securities prices skyrocketed. By 2005 or so, house prices had jumped well past the financial reach of most families, no matter how cheap the mortgage. But instead of turning off their golden CDO and SIV machines, lenders muzzled up reality to make mortgages look cheaper and safer than they really were.
Ditto for the lords of private equity. When the billions flowing into takeover funds forced a doubling of takeover prices relative to company cash flows, dealmakers just pumped up their projections, much as they had during the 1980s LBO binge. In fact, many of the key players were the same people.
It is conceivable that, from early 2006 through mid-2007, every house purchased in America, every private-equity deal, every industrial building sold, was grossly overpriced. Those are the assets now lying across the balance sheets of banks and other investors.
Squeezing their stated values down to sustainable levels, without destroying the banking system, is the policy challenge for the rest of this year and probably 2009 as well.
But as we weather the crisis, the focus will shift to prevention. And that means looking more deeply into why it was so easy to create such a mess in the first place.
The Transformation of the Banks
Lending used to be the province of commercial banks, where the loans were controlled by credit guys - people with pursed lips and tight body language who liked to say no.
But the credit guys stumbled badly in the 1970s, especially on massive lending to "LDCs" [less-developed countries] like Brazil and Mexico. Within a few years, almost all the bigger banks were insolvent - an awkward fact that regulators concealed by pretending that LDC loans were actually performing.
Wall Street's investment bankers are traders, quick to get in and out of markets, and the weakened banks spelled opportunity. By the end of the 1980s, Wall Street was taking big, gouging bites out of the commercial bank franchises on almost every front.
The solution for the commercial bankers - who also had a bad case of bonus envy - was to become investment bankers themselves. Fiercely besieged by bank lobbyists, Congress steadily chipped away at the statutory wall separating commercial and investment banking, finally repealing almost all prohibitions in 1999.
Investment bankers traded for their own accounts. Three-quarters of Goldman Sachs' 2007 earnings were generated by "principal transactions", or bets the bank is making with its own money. Goldman is also highly leveraged, about 18:1, and steadily gins up its trading with more borrowing. The balance sheets of Citigroup, JP Morgan Chase, and other bank holding companies now look a lot like Goldman's, with in-house trading accounts almost as big as their loan books.
Trading is risky. Goldman had a blowout year because it made the right bet on housing late in 2006. Citigroup, Merrill, UBS and many others made the wrong bet, and got badly burnt. Hundreds of billions turned on just a few decisions.
The trading mentality has permeated much of what banks do. Northern Rock and its American equivalent, Countrywide Financial, operated like the old merchant bankers. They borrowed short term to buy assets and repackage them for sale; when they got caught in the middle - unable to sell their wares and with no cash to repay their lenders - they were effectively out of business.
The company takeover market ran aground last summer in much the same way. Banks had agreed to provide $400 billion (€262 billion) in takeover bridge loans, which they planned to sell off into CDOs and SIVs. But when those markets collapsed, the banks mostly walked away from their deals. They were, apparently, good loans to sell to customers, but not to take on to their own books.
Bankers are now moaning about the rigours of "marking to market" - adjusting balance sheet values to comport with trading prices.
But keeping score by market marks is what traders do, and bankers were happy to trumpet their prowess and cash their bonus cheques when markets were in their favour.
The market indices that banks most complain about are based on derivatives called credit default swaps - but the banks created those indices to facilitate their own trading. They derided the "ABX" index for lower-rated home mortgage CDOs when it plunged toward zero earlier this year. But the index turned out to be spot-on: those bonds really are worthless.
The London investment adviser Smithers & Co, in a fine analysis of the riskiness of American banks, points out that their "coverage ratio", or the ratio of reserves to non-current loans, is the lowest since 1993. But a recession was ending in 1993; now it's just getting under way. If the recession bites hard, as looks likely, the carnage on bank balance sheets will look like a Quentin Tarantino movie.
Digging Out
The first rule is to beware of dogmatists; no workable solutions will be reached except by fumbling. The short list below is offered in that spirit.
The Fed has to escape its thraldom to traders. A half per cent twitch in the overnight rate has little impact on most businesses. But if you're carrying hundreds of billions in bonds at 18:1 leverage, it can make or break your year. In the real economy, Bernanke's relentless rate cutting has only succeeded in trashing the dollar and possibly reigniting inflation.
The priority is to de-leverage - to push asset values down to sustainable levels, not prop them up, or hive them off on the taxpayer. De-leveraging will entail massive writedowns and capital impairments throughout the banking sector. The large-scale equity infusions required to recapitalise the banks can come from only two places: sovereign wealth funds or the federal government - ie, a choice of nationalisations, by the United States or by the Arabs and Chinese. I'd vote for America: non-voting shares deposited in the Social Security trust funds look like an excellent outcome on every count.
The merging of depositary banking and investment banking needs a complete rethink. We have allowed the public's interest in maintaining an orderly payments system to be perverted into the "Greenspan Put" - the notion that the Federal Reserve is always standing by to rescue banks from their trading blunders.
The recent experience of risk-transfer through securitisation has been a disaster. Earlier rounds in prime home mortgages and commercial mortgages, however, worked well over long periods of time. But they were built from good-quality assets and had simple structures that investors could look through.
The list goes on. Loan originators might be required to hold substantial first-loss positions before securitising. Trading in credit derivatives and structured instruments would be safer and more transparent in exchange environments, rather than over the counter. The rating agencies are a disgrace. Accountants should be much tougher in valuing liquidity and other put-back guarantees and much more sceptical of default protection offered by thinly capitalised entities such as hedge funds and bond insurers.
There is a decade's work at least; the sooner it starts, the better.
Charles R Morris is a lawyer, former investment banker and author. His latest book The Trillion Dolla Meltdown: Easy money, high rollers and the great credit crash will be published next month.
