The First Crisis of Financial Globalization and Securitization. And the Coming Generalized Credit CrunchNouriel Roubini
Oct 22, 2007
SourceProject Syndicate has recently published a comment of mine on the "First Crisis of Financial Globalization and Securitization". And
I presented similar views at a seminar at the recent annual meetings of the IMF. A more extensive version of my thoughts is provided below.
The recent turmoil and volatility in U.S. and global financial markets and the sudden and unexpected liquidity and credit crunch suggest the following question: how did some defaulting sub-prime mortgages in California, Nevada, Arizona, Florida lead to a worldwide financial turmoil as far as Australia, France, Germany and parts of Asia? Or more formally, why did systemic risk increase rather than decrease in recent years?
Blame the turmoil on financial globalization and the related phenomenon of securitization. In the past banks that were originating loans and mortgage were keeping these assets on their books and thus holding the credit risk. Then, when a recession occurred – like the housing bust in the US in the late 1980s – many banks that were into mortgage lending (the Savings & Loans Associations) went belly up; this led to a banking-wide crisis and credit crunch and a US recession in 1990-91.
This systemic risk – a financial shock leading to a severe economic contagion and economic damage – was supposed to be reduced by the new phenomenon of securitization: in the new brave world of financial globalization banks now don’t hold such assets in their books but package them in asset backed securities (mortgage backed securities or MBSs for mortgages) and off-load them to investors in capital markets, at home and worldwide. This new “originate and distribute” model was supposed to reduce systemic risk as risks were taken out of the banking system and partly distributed worldwide to a larger set of investors, thus spreading risks previously concentrated in banks. But this summer’s financial turmoil shows that systemic risk has returned with a vengeance in spite of securitization. So what went wrong and what can be done about it?
First of all, notice that this was not just a subprime problem. The same reckless lending practices we observed in subprime – things such as no down-payments, no verification of incomes and assets, interest rate only mortgages, negative amortization, teaser rates – did occur for more than 50% of all mortgage originations in 2005-2007, including many near prime and prime mortgages.
Why then such reckless lending practices? Because the securitization model of “originate and distribute” meant that banks were not carrying the credit risk – they earned fees in the transaction – and thus did not care about the quality of the lending. There is now a whole chain of financial intermediaries there were earning such fees without bearing the credit risk: the mortgage broker was paid a fee and maximized its income by having a larger volume of mortgages; the originating bank was packaging the mortgages into MBS and getting a fee without bearing the credit risk; the investment banks were then re-packaging these MBS in various tranches of Collateralized Debt Obligations or CDOs (and sometimes into CDOs of CDOs, or CDOs of CDOs of CDOs, i.e. CDOs cubed) and getting a fee; the credit rating agencies had serious conflicts of interest - as were giving their blessing and misrating these MBSs and CDOs with higher ratings than warranted - as they were getting a fee from the managers of such instruments; the regulators were asleep at the wheel as the US regulatory philosophy was a free market laissez-faire fundamentalist ideology. Finally, the final investors who were buying these MBS and CDOs – the alleged guardian of market discipline - were greedy and believed the misleading ratings of the rating agencies. So everyone in this credit house of cards chain was getting a fee and not holding the credit risk; while the final investors were greedy and clueless as it was near to impossible to price these new complex exotic illiquid derivative instruments.
Similar reckless lending practices and dangerous levels of leverage were occurring in the LBO markets where private equity firms were taking over public firms and financing such deals with very high debt ratios; and in the leveraged loan market where banks were providing such financing to the private equity firms; and in the asset backed commercial paper market where banks were using off-balance sheet schemes (Structured Investment Vehicles – or SIVs - and conduits) to borrow very short term to invest in such risky MBS, CDOs and other asset backed securities. So no wonder that when the subprime carnage blew up the near prime and prime mortgage markets got a seizure, the CDO market froze, the LBO and leverage markets had a seizure, the asset backed commercial paper market went into a panic and even the interbank market (the market were banks lend to each other liquidity for short term periods) also froze. Since the size of losses was unknown and no one knew who was holding this toxic waste of securities no one trusted counterparties and wanted to hold on its liquidity at the same time that the roll-off of short term debts was leading to a severe liquidity crunch.
While the immediate manifestation of the market turmoil was a liquidity crunch this was not just a liquidity problem; rather a solvency problem. Solvent institutions can be illiquid if they have liabilities that can roll off (such as bank deposits in a bank run, commercial paper rolling off, redemptions from hedge funds) while their assets are illiquid. But the problem in the US today is not only illiquidity, as it was in 1998 in the case of the near collapse of LTCM; it is rather also a problem of solvency. Indeed, you have hundreds of thousands – possible as many as two million – households who are bankrupt and cannot afford their mortgage and will thus default and go into foreclosure; you have already sixty plus subprime lenders who have gone bankrupt; you have many home builders who are near bankrupt; you have many hedge funds and other highly leveraged institutions who have gone bankrupt; and even in the US corporate sector now default will rise as corporate bond spreads are now sharply higher. So this is not just a liquidity crisis. It is also a solvency crisis that easier monetary policy will not resolve. It will take years to clean up the mess of the busting housing bubble and its financial fallout.
The reasons for the market panic, volatility and turmoil have also to do with what economists refer to as unmeasurable “uncertainty” that leads to risk aversion and that is different from priceable “risk”. When phenomena and risks are known you can assign probabilities to them and price this risk correctly. But in this world of financial globalization and securitization we have unmeasurable uncertainty. Why? For two reasons.
First there is massive uncertainty about the size of the losses. Some say subprime alone will be $50 billion or $100 or $200. Nobody knows how much as it will in part depend on the fall in home prices where some estimate a 10% fall, others 20% of more. Moreover, it is real hard to price losses on exotic instruments that are illiquid (i.e. do not have a market price) and are marked-to-model (i.e. priced on a theoretical model based on faulty ratings rather than being priced-to-market value).
Second, no one knows who is holding this toxic waste of dangerous securities. It is like walking blind in a minefield where you have no idea of where the next mine is. In the last few years – thanks to securitization, private equity, hedge funds, over-the-counter markets rather than trading on official exchanges – financial markets have become more opaque with less transparency. And this opacity means that no one knows who is holding what, there is a lack of trust and confidence, there are doubts about your counterparties and, in situation, of market uncertainty, investors panic and become risk averse. Markets are based on trust but trust requires transparency; but in the brave world of financial globalization there is less transparency.
Add to all this investors’ greed, risk spreads that were too low for too long, search for yield and carry trades, high leverage ratios, and poor risk management and you get an explosive mix: when the repricing of risk finally occurred this summer - as the subprime carnage blew up - investors suddenly panicked and rushed to the exits in a liquidity run and a credit strike in an extensive range of financial markets.
This financial market turmoil also brought to the surface the issue of liquidity risk: this liquidity/rollover risk – as well know in emerging market crisis – occurs when there is a mismatch between the maturity of a financial institution assets and the maturity of its liabilities: liquid liability at risk of roll-off and illiquid assets are a dangerous combination. We saw it in the bank run on Northern Rock in the US, in the risk of redemption of hedge fund assets, in the serious liquidity problems of the SIVs and conduits once the asset backed commercial paper funding these assets started to roll-off.
Indeed the problem of the SIVs and conduits is the most serious manifestation of maturity mismatches and liquidity risk in the most recent market episode. And it is also the most serious manifestation of the banks’ gambling for redemption and moral hazard from the lender of last resort role of central banks.
Citigroup alone accounted for 25% of all SIV assets ($400 billion) given its $100 billion (now down to $80 billion given a partial disposal of assets) in seven SIVs. Such banks played a dangerous game of regulatory arbitrage by creating risky off-balance sheet SIVs, loaded with risky assets and funded with the most short term asset backed CP in order to avoid the Basel capital charges for similar on balance sheet assets. The whole point of bank capital regulation is that banks that get the lender of last resort support of the central banks need to have enough capital to avoid the gamble for redemption games of playing at a casino with the money of depositors. But banks first avoided those capital charges by creating the off-balance sheet SIVs with lower capital charges and then, when the roll-off of the liabilities of such SIVs occurred amply relied on the Fed’s lender of last resort lending – and on explicit Fed bending of strict rules on how much the banks could re-lend to their affiliated and SIVs – to avoid the losses that they would have incurred by their reckless creation of illiquid SIVs. Specifically, the Fed played a major role in this SIV mess by providing regulatory forbearance to Citigroup and other banks by allowing them to breach the rule on how much they could relend to their broker dealer and SIV affiliates of the funds lent by the Fed during the August and September liquidity crunch. Formally, Fed's decide to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America, Citigroup, and JPMorgan Chase, Wachovia to make large loans to their broker dealer units. As Chris Whalen clearly put it:
Section 23A is one of the most important parts of the Federal Reserve Act. It prohibits "covered transactions" with any one affiliate of a Fed member bank in excess of 10% of the bank's capital and surplus, and up to 20% in aggregate for all bank affiliates. The purpose of the section is to protect the capital of the bank, even if that means allowing non-bank units or the parent holding company to be decapitalized or even fail in a "market resolution."…. The Fed's August 20, 2007 letter to BAC [Bank of America] allows the lead bank to extend up to $25 billion in collateralized loans to affiliates, an amount equal to 30% of the bank's regulatory capital. The "securities financing transaction" will effectively allow the securities affiliate of BAC to "serve only as a conduit" for the bank to lend to "unaffiliated third parties." The letter notes at the bottom of Page 3 that any such loans will be eligible for excemption from the automatic stay in the US Bankruptcy Code, a comforting legal distinction that may have little impact on the increasing rancid economics of financing CDOs.This is moral hazard of the first order: avoid capital regulations via off balance sheet dangerous schemes characterized by serious maturity mismatches, high liquidity risk and gambling for redemption by investing in toxic waste securities; and then get free lender of last resort support when the liquidity roll-off occurs.
Such SIVs share in the first place many elements with the Enron-style of off-balance special purpose vehicles; and the attempt to avoid the losses from the toxic impaired assets held by such SIVs via a super-conduit is bound to fail. As I more extensively discussed in my “Super-conduit or super-bailout shell game?”:
“…it is not clear what will be the quality of the assets of the new super-conduit. If, as allegedly argued, the new super-conduit would avoid the toxic waste of subprime MBS and CDOs, the better acquired assets would have to be purchased at current market value: and, since those market value today of even better assets are below par because of credit risk and liquidity premium, if Citi and other banks were to dispose of the SIVs assets into the super-conduit at current market values, they would still suffer the same losses as in the case of selling now in the secondary markets the same illiquid assets; thus, their objective of avoiding such losses would not be achieved. Also, if only better assets were to be sold to the super-conduit, the SIVs would be left with only the bad assets (the toxic subprime MBS, CDOs, etc.) and thus the roll-off of the commercial paper backing those assets would accelerate rather than be reduced. It is like stripping a bank that has a run from its best assets and keeping only the bad assets on its balance sheet; the run would accelerate. So, this scheme of shedding only the best assets of the SIVs cannot work. And if the assets to be shed were the lousy ones, of course no one would want to fund such super-conduit as this conduit would be made out of only toxic waste radioactive assets…
The right solution would have been to punish the banks that created these dangerous schemes in the first place by forcing them to take the losses on their illiquid and/or impaired asset; or to bring such asset on balance sheet and take the capital charges or liquidity charges required to do that. Forcing the banks to sell the asset and take the losses would have helped to create secondary markets for these illiquid assets; thus, while losses would have occurred this would have reliquified a frozen market. The super-conduit scheme, instead, is a shell game to prevent the losses to be recognized and, as a by product, it will keep the SIVs asset off the market for a long time and thus avoid the losses to be recognized and the secondary market for such assets to be created and made liquid. But the Fed, instead of letting the market mechanism work, first flooded the banks with liquidity to allow them to have enough liquid assets to deal will roll-off of liabilities and then allowed banks – in an arbitrary regulatory forbearance - to relend such funds to their off-balance sheet affiliates. So the banks avoided the capital charges, avoided the liquidity crunch and got a nice bailout in exchange for their reckless behavior. But since the size of the bailout funds is not sufficient to dispose of all the SIVs liabilities that are being rolled off the current super-conduit scheme can work only if the Fed will provide enough liquidity that banks and creditors can put into this new shell game. Otherwise, as discussed above, the scheme does not add up and does not work. And with lots of SIVs debt coming due in November – for the relatively more thinly capitalized Citigroup but also for other U.S. banks – the urgency of creating this super-conduit becomes clear.”
Given the analysis above, it is clear that severe US and liquidity and credit crunch will get worse rather than better and it will lead to a generalized credit crunch that will trigger – together with a worsening housing recession and a US consumer that is now on the ropes – a severe economic recession in the US in 2008. Expect credit market conditions to tighten sharply over the next few months: the collapse of subprime lending has now led to a severe credit crunch in near prime and prime lending; the increase in credit cards and auto loans delinquencies will then spread the credit crunch to consumer debt; commercial real estate that had excesses similar to housing will be hit next; corporate default rates will start rising as higher junk bond yields and a weakening economy will take a toll on corporate earnings and balance sheets; the current deleveraging of the financial system and the reintermediation into the banking system of off-balances sheet SIV and of mortgages, MBS and leveraged loans will exacerbate the credit crunch in the banking system as banks’ capital is limited and banks’ liquidity also in short supply as banks are hoarding all the central banks’ liquidity injection; the subprime mortgage market is now dead; the CDO issuance market is effectively dead; the CLO and LBO markets are near frozen; the SIVs are unraveling and will be completely collapse and be unwound in a disorderly fashion that will lead to a disorderly sale of illiquid and impaired asset as the Super-conduit shell game will flow; and the liquidity crunch will persist in money markets and interbank markets as everyone is worried about counterparty risk and may need liquidity as the crunch will get worse. In due time even equity markets will realize that the Fed and central bank cannot resolve severe credit problems via liquidity injections: the event of last week prove that a slew of lousy economic news (a worsening housing recession, serious renewed credit problems, fall-off in corporate earnings) will take their toll on equity markets. The conditions described above are thus the factors that will trigger a generalized credit crunch and severe financial and real distress in the US and across the globe.
So what will have to be done – policy-wise and regulation-wise - to avoid the pitfalls of financial globalization after the necessary recession will lead to significant financial damage? Should we reverse financial globalization or try to restrict securitization? The genie of financial liberalization is out of the bottle and it will be hard and not even desirable to reverse it as financial innovation has many benefits. But in order to enjoy its benefits and controls its potential negative side effects – including the vulnerability to greater systemic risk - a series of policy reforms need to be adopted.
First, we need more information and transparency about such complex assets and who is holding them. Second, such complex instruments should be traded on exchanges rather than over the counter markets and be standardized so that liquid secondary markets in such instruments are able to grow. Third, we need better supervision and regulation of the financial system, including some regulation of non-regulated opaque or highly-leveraged financial institutions such as hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies in ratings – and even in Basle II banks’ regulation – needs to be rethought and more regulation and competition introduced in this market. Fifth, liquidity risk should be properly assessed in risk management models and both banks and other financial institutions should better price and manage such liquidity risk; most financial crises are triggered by maturity mismatches. Finally, Enron-style schemes of off-balance sheet SIVs and conduits that avoid ex-ante regulation and receive ex-post bailout should be strictly forbidden. These crucial issues should be put on the agenda of the G7 finance ministries – starting with their meeting on October 19th - to prevent a serious backlash against financial globalization and the risk that financial turmoil will lead to serious economic damage.