Part 4 (1/2)
As panic spread in the spring and summer of 2007, the search for toxic a.s.sets began apace. Investors desperately tried to figure out who else was exposed to the subprime mess. Suspicion soon fell on the off-balance-sheet vehicles that investment banks and broker dealers had created during the rush to securitization. They came in two varieties: conduits and SIVs. Both had played essential roles in the securitization frenzy: conduits had served as a holding pen at the beginning of the process, and SIVs served as a dumping ground at the end. Together they held upwards of $800 billion in a.s.sets.
Here's how they worked. As investment banks a.s.sembled mortgages and other a.s.sets, they needed a place to park them. Rather than keeping them on their balance sheets-where they would force the banks to maintain higher levels of reserves relative to the value of the a.s.sets-the banks parked them in something called a conduit, a kind of shadowy legal ent.i.ty that had reserve ratios a tenth the size of ordinary banks'. There they would sit until they were turned into mortgage-backed securities, collateralized debt obligations, and other securities. Conduits depended on financing to keep this process humming along, for which they turned to money market funds, pension funds, and corporate treasurers, who gave the conduits short-term loans using a.s.set-backed commercial paper (ABCP).
Crucially, the loans were short-term, but once again the a.s.sets-the subprime mortgages and other forms of debt-were illiquid, long-term instruments. The same dynamic was in play at the other end of the securitization a.s.sembly line. Once the investment banks had created the securities, they inevitably encountered a bottleneck: they could not possibly shove all the new structured products down the throats of gullible investors right away. Rather than keep the a.s.sets on their balance sheets-and incur capital charges-the investment banks came up with the SIV. The purpose of this off-balance-sheet vehicle was to buy up these securities using money siphoned from the ABCP market. This was a bit like an automaker setting up a sh.e.l.l company to buy up unsold vehicles sitting on dealer lots.
Citigroup, which had some seven separate SIVs holding a.s.sets of $100 billion, was one of the first to falter. Just as trouble with one hedge fund sparked a panicky scrutiny of all hedge funds, trouble with one SIV sparked a more general rush for the exits by wary investors. It quickly turned into a rout: in the s.p.a.ce of four weeks, investors moved $200 billion out of the ACBP market, and the SIVs and conduits alike had to contend with much higher costs for borrowing money from this market. Even worse, some creditors of the SIVs and conduits refused to lend money at any cost, leaving them unable to continue in their current incarnation.
As things spiraled out of control, the banks that had sponsored the SIVs and conduits found themselves in a delicate position. Originally, in order to entice investors, many of them had promised to use the bank's own liquidity in the event of a crisis, and they had even guaranteed the interest rates and value of the instruments. That put the banks on the hook for any losses. After much kicking and screaming, the banks were forced to bring their SIV exposure back onto their balance sheets, sustaining ma.s.sive losses in the process.
The worst was yet to come. Beginning in August 2007, a much more severe shock-a full-blown liquidity and credit crunch-seized the financial markets, culminating in the collapse of Lehman Brothers and bringing the global financial system to the brink of collapse. During that time the remnants of the shadow banking system collapsed, and even the conventional banking system came under a.s.sault. The crisis was just beginning.
Fear of the Unknown.
Risk, Uncertainty, and Profit, first published in 1921, contains iconoclastic economist Frank H. Knight's now famous distinction between the concepts of risk and uncertainty. Risk, he argued, can be priced by financial markets because it depends on known distributions of events to which investors a.s.sign probabilities-and price things accordingly. Uncertainty, on the other hand, can't be priced: it relates to events, conditions, and possibilities that can't be predicted, measured, or modeled.
To understand this distinction, imagine two men playing a game of Russian roulette. They take a standard revolver with room for six bullets, put a bullet in the chamber, and spin it. Whoever pulls the trigger first has a one-in-six chance of blowing his brains out. That's risk. While the men playing this game may be suicidal idiots, they know the odds. Now imagine that the two men are handed a mystery gun prepared by someone else. The gun could have one bullet; it could have six; or it could have none. It may not even be a real gun; it could fire blanks instead of bullets. The players don't know. That's uncertainty: they have no idea how to a.s.sess the risk. The odds of dying are impossible to quantify.
The distinction between risk and uncertainty helps explain the financial markets from late summer 2007 onward. Until the crisis struck, risk could be reduced to the ratings slapped on various securities: some were riskier than others, and the risk could be quantified-or so it seemed. As the housing market crumbled, however, and uncertainty enveloped these securities, the financial system no longer seemed comprehensible, much less predictable. Bad things had already happened, but they paled next to what might happen next. As one journalist with the Financial Times put it that August during a radio interview, ”It is not the corpses at the surface that are scary; it is the unknown corpses below the surface that may pop up unexpectedly. n.o.body knows where the bodies are buried.”
By late summer of 2007, the balance sheets of an extraordinary range of financial inst.i.tutions showed an unpleasant surprise: a diverse handful of hedge funds, banks, conduits, SIVs, and others had been forced to exhume ”bodies” by revealing a bewildering array of toxic a.s.sets. Where might others lie? And how many were there? No one could know; uncertainty reigned. Estimated losses on subprime mortgages now ranged from $50 billion to $500 billion and beyond.
This development didn't fit the standard expectations or measurements of risk. When two Goldman Sachs hedge funds lost more than a third of their value late that summer, the firm sought to calm investors by claiming that these losses were ”twenty-five standard deviation events.” This was statistical shorthand for claiming that what had happened should occur only once in a million years. In actuality, the models used to a.s.sess risk were flawed; they used preposterous a.s.sumptions-home values could only go up!-and relied on data that went back only a few years.
A deeper appreciation of history might have prepared market watchers for what happened next: uncertainty spread, suspicion grew, and long-time bonds of trust frayed. Bagehot captured this dynamic all the way back in 1873, noting that ”every day, as a panic grows, this floating suspicion becomes both more intense and more diffused; it attacks more persons; and attacks them all more virulently than at first.” When that happens, the money market-the arena where banks borrow and lend surplus cash-seizes up. In Bagehot's day the epicenter of the global money market was Lombard Street, where the most important banks in England had their headquarters.
In 2007 the seizure occurred in a more amorphous international network of financial inst.i.tutions-not only in London but in New York, Tokyo, and other financial centers. This was the interbank market, where banks and other financial inst.i.tutions lend their surplus cash to one another. It all takes place in cybers.p.a.ce, but in a testament to London's enduring place in financial history, the most important rate at which money is lent is known as the London Interbank Offered Rate (LIBOR).
In normal times, the overnight LIBOR-for loans made for the duration of a day-is only a few basis points above the overnight policy rates set by central banks around the world. The reason for this near convergence is simple: the perceived risk of lending between established banks is only marginally higher than the risk-free lending available from central banks. Similarly, longer-term interbank loans-three-month LIBOR contracts-rarely deviate from rates a.s.sociated with supersafe investments like three-month Treasury bills.
In August and September 2007 unease was rising. By that time the sub-prime crisis was in full swing, complete with rising delinquencies and foreclosures. The securitization pipeline clogged as ratings agencies downgraded mortgage lenders and a range of structured products. At the same time, the ABX Index revealed a marked deterioration of confidence in the value of various CDO tranches, while the unraveling of the commercial paper market continued apace. Other ominous portents appeared: stock markets became extraordinarily volatile, and hedge funds that used complicated mathematical strategies to make money off equities suffered enormous losses. Subprime mortgage lenders continued to go under, including giant American Home Mortgage. Credit spreads for corporate firms sharply rose. A run on some money market funds overseen by BNP Paribas only added to the sense that things were going horribly, terribly awry. So did ruptures in the ”carry trade,” where investors borrowed in low-interest-rate currencies and invested them in high-interest-rate currencies. The crisis was no longer an isolated problem; it was spreading into new and dangerous territory.
As a consequence, the interbank market tightened in August, and the spread between LIBOR and the rates charged by European central banks soared, from 10 basis points to about 70. This was extraordinary, signaling that liquidity in overnight money markets had largely dried up; banks that had previously done business confidently now looked suspiciously at one another's finances, fearful that untold numbers of ”bodies” might be lurking on or off the balance sheets. Every bank in Europe and the United States wanted to borrow cash, but no bank would lend it, except at extraordinarily high rates.
Predictably, central banks rode to the rescue-or tried to do so. On August 9 the European Central Bank lent 94.8 billion to some fifty banks; the next day it lent another 61 billion. The Federal Reserve joined the fire brigade as well, lending some $60 billion over the course of two days. Though these infusions helped close the LIBOR spread in the early fall, it widened once more in November and December as bank losses mounted, stock prices plummeted, and panic spread still further. The Federal Reserve cut its rates by 100 basis points that fall, but to no avail. The Fed also made it easier for banks to borrow from its discount window, but there was a stigma a.s.sociated with doing so. Any bank that needed to go to the Fed for funds might be perceived as weak and on the brink of collapse.
These events followed a familiar pattern. Hard evidence was growing that things were bad and getting worse by the day; it was not a matter of rumor or conjecture. According to the ABX Index, CDO values continued to erode, and even the AAA-rated supersenior tranches were losing value by the day. The ratings agencies, in a rush to compensate for their negligence during the boom years, downgraded the ratings of a range of securities. As for the securitization market, it was effectively frozen. Mortgages and other forms of debt that had served as ingredients in the sausage making of structured finance now acc.u.mulated, unused and unwanted.
By the end of 2007, profound uncertainty prevailed. Which banks had bodies buried off their balance sheets? Which hedge funds had placed foolish bets? Who else had invested in subprime CDOs? Unfortunately, it was next to impossible to tell. The financial system was extraordinarily opaque, and much of its activity-credit default swaps, for example-took place outside the purview of regulated exchanges. Increasingly it resembled a vast minefield. A few of the mines had gone off, but most remained buried, waiting for the unsuspecting.
Illiquid and Insolvent.
In the late summer of 2007, when the Bank of England first threw a lifeline to British banks, Mervyn King, the governor of that inst.i.tution, had tough words for insolvent banks begging for a bailout. ”We are certainly not going to protect people from unwise lending decisions,” he grandly proclaimed.
The subtext was clear: if central banks were going to play their role as lenders of last resort, they would help only the deserving. He was speaking a language that Walter Bagehot would have appreciated. As Bagehot had counseled, ”Any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”
Now as then, the difficulty lies in distinguis.h.i.+ng between banks that are merely illiquid (the ”good” ones) versus those that are insolvent (the ”bad” ones). Or to put it another way, the challenge is to figure out which banks have more a.s.sets than liabilities, even if these a.s.sets can't readily be converted to cash; and which banks have more liabilities than a.s.sets, effectively wiping out the banks' capital and thereby driving them into insolvency.
The problem with teasing out this distinction in the midst of a panic is that financial inst.i.tutions can readily move from one state to another, depending on, say, the changing value of the a.s.sets they hold. This question of valuation was particularly complicated in the recent crisis. Take, for example, the CDOs held by banks and other financial inst.i.tutions. In the early months of the crisis, the ABX Index implied that the value of CDOs was declining. But that was not the actual market value: it was merely a reflection of the cost of insuring against future defaults. Early on, banks reasonably argued that these implied losses were theoretical, not real: the actual default rates on the underlying mortgages had not yet approached the levels implied by the index.
The thinking was that irrational panic was driving the markets. The banks blamed the losses on market psychology alone, be they the declines implied by the ABX Index or even the real declines in the prices of a.s.sets such as stocks. Once investors regained their sanity, it was thought, prices would return to their normal levels. The markets would become more liquid, and the threat of insolvency would subside. At least, that was the theory.
This thinking was naive. The crisis was never merely a function of illiquidity alone; plenty of insolvency was involved as well. That became apparent when the unthinkable happened: rates of delinquency and of defaults on mortgages started to soar, and the cash stream from these a.s.sets collapsed. Hypothetical losses on the ”safe” supersenior AAA tranches became real losses, and the value of those a.s.sets fell. The value of mortgage-backed securities, collateralized loan obligations, corporate bonds, and munic.i.p.al bonds fell too.
Even the banks' plain-vanilla a.s.sets hemorrhaged: that is, ordinary residential mortgages, commercial mortgages, credit card portfolios, auto loans, student loans, and other forms of consumer credit. Banks had also made commercial and industrial loans or helped finance leveraged buyouts of firms. All of these loans deteriorated, especially after the United States entered a recession at the end of 2007.
These developments highlighted that a bank's health is a fleeting, impermanent thing. As long as the prices of underlying a.s.sets continued to fall, banks in good standing saw their positions deteriorate, bringing them to the brink of insolvency. Of course, they could also collapse if they suffered a run on their liabilities. The shadow banks were clearly vulnerable on this point, given that they lacked deposit insurance. Conventional banks were not-or so the thinking went.
Nonetheless, once the run on the shadow banking system gathered steam, ordinary banks became targets of bank runs for the first time since the 1930s. One of the first to go was Countrywide Bank, the savings arm of Countrywide Financial, the nation's largest mortgage lender. Founded by Angelo Mozilo, the lender had been at the center of the subprime crisis. As conditions worsened, doubts about the firm rose and eventually spilled over to its banking division. In August 2007 depositors rushed branches of Countrywide Bank, clamoring for their money in a way not seen for decades. One retiree waiting in line outside a branch captured the spirit of the panic when he told a reporter, ”I'm at the age where I can't afford to take the risk. I'll gladly put it back as soon as I know the storm is over.”
Words like these were uttered during panics in Bagehot's time, but to hear them spoken in the twenty-first century was remarkable. Even more extraordinary, bank runs spread around the world. Northern Rock, a sizable British mortgage lender with a banking arm, suffered Countrywide's fate the following month. Like Countrywide, most of its funding came from sources other than ordinary depositors, but that didn't stop its ordinary depositors from lining up outside its branches in mid-September, under the glaring lights of the global media. The Bank of England intervened, offering emergency lines of liquidity, but still the run did not stop. ”I don't think the bank will collapse-but we just don't have the nerves,” explained one depositor. ”I'm taking the money out to get peace of mind.”
As the run continued, fears mounted that other well-regulated banks with deposit insurance might suffer runs as well, then spiral from illiquidity to insolvency. As irrational as these bank runs may have seemed, depositors actually did have reason to worry. Like Countrywide, Northern Rock offered deposit insurance only up to a certain point: $100,000 in the case of Countrywide, and 30,000 in the case of Northern Rock. Plenty of depositors had sums well in excess of these amounts, and should the bank become insolvent-with or without the support of a lender of last resort-they would lose their savings. In fact, in the United States in 2007, some 40 percent of conventional deposits were uninsured. Bank runs, in other words, were rather rational.
The cases of Countrywide and Northern Rock highlighted the difficulties of channeling aid only to ”good” banks as opposed to ”bad” ones. Banks were well on the road to insolvency, if not there already; by normal standards, they deserved neither lines of liquidity nor additional insurance for depositors. But what sounds good in theory is hard to put into practice during a crisis, when depositors storm banks and the financial system crumbles. The Bank of England's Mervyn King found himself in precisely this awkward position. A month after lecturing the market about letting bad banks fail, he reversed course, promising to insure all of Northern Rock's deposits and offering additional lines of liquidity to the beleaguered bank. That blanket deposit guarantee was soon extended to all banking inst.i.tutions throughout the United Kingdom. Most other countries eventually followed suit or, at the very least, raised the deposit insurance ceiling.
These interventions were just the beginning, but for a brief period in the winter of 2007 and 2008, some claimed that the crisis was over: the markets seemed to settle down. As any student of crisis economics should have known, this was an illusion. More often than not, crises wane before waxing anew; a period of calm may precede even worse outbreaks of panic and disorder.
The Eye of the Storm.
In May 1930 President Herbert Hoover confidently announced that ”we have been pa.s.sing through one of those great economic storms which periodically bring hards.h.i.+p and suffering upon our people. . . . I am convinced we have now pa.s.sed through the worst-and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us.” Another day in May seventy-eight years later, Treasury Secretary Henry Paulson confidently announced, ”The worst is likely to be behind us,” adding a week later that ”we are closer to the end of the market turmoil than the beginning.”
Both Hoover and Paulson were making the cla.s.sic error of those caught in a financial hurricane, mistaking the eye of the storm for the end of the crisis. They were hardly the only wise men to make such p.r.o.nouncements in the midst of a meltdown; every crisis has its share of optimists who at some point declare the worst is over. Interestingly, this kind of optimism is usually genuine; it's not an attempt to jawbone markets but generally reflects a real belief that the storm has pa.s.sed.
Unfortunately, financial crises usually ebb and flow in their severity; they rarely hit once and then subside. They resemble hurricanes in that they gather strength, weaken for a while, and then gain even more destructive power than before. This reflects the fact that the vulnerabilities that build up in advance of a major crisis are pervasive and systemic. They cannot be cured by the collapse or bailout of a single bank, or even the implosion of an entire swath of the financial sector.
Many crises follow this pattern. For example, in Britain the crisis of 1847 erupted in two distinct stages in April and October of that year; the crisis of 1873 was even more complicated, surfacing and subsiding in Vienna in April, reappearing with a vengeance in the United States that September, and then flattening much of Europe in November. The Great Depression was the most complicated of all, with a blowup on Wall Street, multiple bank runs interspersed with periods of relative calm, and different financial centers around the world erupting in panic at different times over the course of three years.
In the winter of 2007-8, surprisingly, a semblance of calm settled over the markets. As the fall turned to winter, write-downs and losses were reducing the capital of financial inst.i.tutions to new and dangerous lows. Many banks circled their wagons, lending less, increasing their lending standards, and limiting their exposure to risky a.s.sets. Nonetheless, the value of a.s.sets continued to fall, while liabilities rose. Regulators in both the United States and Europe suggested that banks raise more capital to b.u.t.tress their balance sheets.
Given that the entire financial system was in the same boat, the banks had few places to turn. Their solution was to go hat in hand to sovereign wealth funds, investment vehicles owned by foreign governments in the Middle East and Asia. The prospect of Saudi Arabian and Chinese investors controlling American and European banks was politically untenable, so the recapitalization of the troubled banks took the form of preferred shares. This meant in practice that sovereign wealth funds received only a minority stake, no board members.h.i.+p, and no voting rights.
Citigroup raised $7.5 billion from a fund in Abu Dhabi; UBS got $11 billion from Singapore's fund and a group of private investors from the Middle East. Singapore's fund sank $5 billion into Merrill Lynch, while China sank another $5 billion into Morgan Stanley. In a smaller-scale effort, American private equity firms pumped $3 billion into Was.h.i.+ngton Mutual and close to $7 billion into Wachovia.