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Wall Street's Day of Reckoning
By Mortimer Zuckerman
Posted September 19, 2008
Fear, panic, and uncertainty
pervade the world of finance. It's not
1929. We don't have speculators jumping from windows, but we see some
great financial
companies going splat—AIG, Lehman Brothers,
Countrywide, Bear Stearns, Merrill Lynch—and most spectacularly
and
most disgracefully, Fannie Mae and Freddie Mac, two
government-sponsored enterprises (GSEs) with a portfolio of
$5.5
trillion. What happened to make the heavens fall in?
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In the '20s, conventional banks took deposits
and made them work to
drive the economy; the rule was they could lend 9 dollars for every
dollar deposit. The process
is called leverage—the one dollar levers
nine. It was simple enough, except in panics, when every depositor
wanted
his money back at the same time and it wasn't there; the money
was out working, so thousands of banks went belly up and
the
Depression deepened.
What's new and scary is that the principal role in channeling funds
from savers to borrowers
now comes from nondepository institutions
such as investment banks, hedge funds, and private equity funds. They
invented
new ways to slice and dice loans, packaging them as
securities that could be sold to investors the world over. But who
knew
what they were really buying? The securitizers financed assets
with a growing volume of credit and with ever higher leverage.
In
short, the new but opaque pyramids of structured securities enabled
the new institutions to lend more against less.
The
world was awash not with cash but with credit. The global issuance
of credit instruments went from $250 billion to $3 trillion
a year.
Many of these securities were rated, but last year, the agencies
started downgrading billions of dollars of
debt they had once deemed
safe. Prices tumbled as investors stopped trusting the ratings and
stopped buying complex
instruments. Financial institutions began to
hoard cash and cut back on loans even to other banks. Witness the
sharp
rise in the London Interbank offered rate—the main measure of
banks lending to one another.
Bad timing. The
funding crisis meant financial firms were no longer
able to turn assets such as subprime mortgages into securities and
sell
them. These markets became illiquid, forcing securitizers to turn
to their banks for help. But that squeezed the balance
sheets of the
banks at the very moment when banks were facing their own losses on
debt securities.
Decisions
have been frozen, as no one knows whom to trust. Bank credit
has fallen at the fastest rates since the Federal Reserve
began
collecting weekly figures, as have total bank deposits and
money-supply numbers. Issues of collateral debt obligations
fell 94
percent between the first quarter of 2007 and the first quarter of
2008. This credit liquidation will continue
for a lot longer than most
people think, regardless of what the authorities do.
The investment banks, hedge funds,
and private equity funds that took
on the most risks are the ones facing the possibility of going under.
This is exacerbated
by the evaporation of trust. The word "credit"
derives from the Latin crederi, which means to believe. People stopped
believing
both in the borrowers and in the new credit instruments. Too
many of the investors had no idea of the risks they were exposed
to,
so now we have a postmodern version of a run on the banks. In the old
days, the depositors lined up outside the
closed bank doors; today,
the money leaves these financial institutions through electronic
transmissions. Cash is withdrawn,
credit lines are pulled,
counterparty risks are unwound, and the result is a freeze up of
credit and a downward spiral
of asset values, which paralleled what
happened during the great bank runs of the 1930s.
The Feds are doing their
best, orchestrating a series of ad hoc plans
to restore credit in these nondepository institutions. The Feds are
right
to keep the financial plumbing lubricated by providing liquidity
for different kinds of assets, for longer periods of time
and to more
borrowers, secured not just by fixed income securities but also by
equities. But this provision of more
aid to more borrowers than ever
before is an unprecedented expansion of the role of the Feds.
These steps may have
saved the system to date but have barely improved
financial conditions since the abrupt takeover of Bear Stearns by
JPMorgan
Chase in the spring. Now, there is fear of what economists
call an adverse feedback loop. Deleveraging puts downward pressures
on
the prices of securities, which in turn forces financial institutions
to deleverage more. The same thing happens
when home prices fall and
households are forced to cut back their spending or walk away from
their home mortgages.
The
speculation did not just begin yesterday. It began with the
technology stocks in the 1990s, turned to real estate, commodities,
and
private equity buyouts in this past decade, and then took over
many other financial markets. Now, a significant fraction
of the
speculative loans that banks made during the boom years are
underwater, and the risk of these losses will overwhelm
banks that
have limited capital to absorb them.
Investors including sovereign-wealth funds have put billions into
Citigroup,
Merrill , Lehman, and others, only to suffer mammoth losses
on these investments, which in turn is causing them to balk
at any
future flow of equity capital. This raises the prospect that other
banks, especially regional and community banks,
might fail.
We are into the second year of this credit crisis, triggered by the
subprime mortgage disaster. Why
hasn't the healing begun? The answer
lies in the way leverage works. Banks are not only providing loans to
customers,
they also use leverage themselves. When they make profits,
they borrow more money to make more loans and book still more
profits.
But for every dollar of bank wealth that they lose,
government-regulated commercial banks must eliminate $10
of lending,
and for investment banks, the figure may be as high as $30. If the
total losses across the credit markets
exceed $1 trillion—and some
think they will go to $2 trillion—then you have to put on a leverage
multiplier
of 10 or 15. This kind of gigantic number of more than $10
trillion poses a systemic risk that could drag many financial
institutions
down and take years to work through the system.
The problem is the financial markets and firms are interconnected with
increasingly
complicated securities such as credit default swaps and
money market instruments such as repos. The failure of one firm
can
send ripple effects through the whole system, but the market and
regulators have limited experience in how to handle
such a crisis.
Credit drought. Today, the challenge is to build a new sense of trust
in finance, as well as to rebuild
equity. That makes it hard to
predict when the credit crunch will end and how big the losses may be.
This crunch is
much more serious than in 1987, when the crash was
confined to the equity markets and over within a few weeks. This one
has
greater scope to harm the real economy: Without credit, business
dries up.
Lower economic growth in turn makes things
worse in the financial
markets. It is affecting not only housing but autos, credit cards,
commercial mortgages, commercial
and industrial activities, and the
leveraged buyout loan markets. Without credit, the domestic private
economy cannot
generate profits, and without solid profits the health
of lenders and the availability of credit will deteriorate even
further.
The
fear stalking the financial world is a counterpoint to the
downright greed that produced it. The corporate leadership of
Fannie
and Freddie clearly inflated the value of their equity base by
treating possible tax credits as assets, by extending
delinquent loans
from 90 days to two years so they wouldn't have to write down tens of
thousands of them, and by refusing
to mark some of their paper to
market but keeping it at par value. They did this to avoid falling
below the financial
regulatory requirements they should have met. The
result was to dramatically expand the exposure of the taxpayers to
their
losses. Management took on excessive and unnecessary risks
because it focused on profits and bonuses and failed to protect
adequately
against potential mortgage defaults. How else to explain
they had $65 of debt for every dollar of equity? How else to justify
taking
on $600 billion in subprime mortgages, or in securities backed
by those mortgages, over the past half dozen years? These
included
many 100 percent mortgages to borrowers whose incomes were
insufficient to cover the debt payments. Meantime
Fannie and Freddie
were dispensing vast rewards to their private management along the
way. Outrageous!
The investment
bankers took ungodly and unnecessary risks and then
really did not speak openly about them or address them soon enough
in
order to avoid the collapse of some of the firms. This was the case of
Lehman Brothers and its real estate holdings.
As Woody Brock of
Strategic Economic Decisions points out, mismanagement, along with
"greed, perverse incentives, poor
risk assessment . . . are deeply
rooted in human nature and thus cannot be changed." But too much
leverage, which amplifies
those human failings like ignorance and bad
judgment, can certainly be reformed and regulated.
What is to be done?
Both
presidential candidates recognize that in the post-securitization
world that has emerged in the past decade, a new system
of regulation
is inescapable. First, it will have to limit mortgages to viable
buyers, and it will require imposing
maximum loan-to-value mortgage
ratios. Secondly, we will have to change our monetary policy framework
to take explicit
account of asset prices whose escalation was what
blew up the bubble and finally burst it. Thirdly, a whole system of
regulation
(including limits on leverage) will have to apply to the
investment banking, hedge fund, and private equity world: When
firms
directly or indirectly have to rely on the federal government to bail
them out, they invite something similar
to the Federal Reserve policy
that was put into place in the 1930s toregulate banks and avoid
systemic risk. In the
short run some new federal agency may have to
buy at a discount illiquid assets in order to enable private financing
to
resume.
The world of finance will never escape the existence of fear and
greed. The appropriate degree of regulation
will clearly be needed to
prevent the kind of excesses that have now put at risk the entire
economy.
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