30 May 2008

The End of the Beginning – Developments in the Credit Crisis

May 27, 2008

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Equity markets believe the worst is over. Banks also seem to have convinced themselves that the worst is behind us. An alternative and, arguably, better view of the current state of the financial crisis is that stated by Winston Churchill: “… this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Nuclear De-leveraging

There is acknowledgement that an extraordinary level of debt and leverage precipitated the problems. However, there is limited recognition of the massive de-leveraging of the global financial system that is under way. Leverage amplifies returns but also accelerates de-leveraging.

The Exhibit below shows how de-leveraging takes place in a highly levered world. Assume a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage 5 times, then the hedge fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Assume the asset falls $10 (10%) in value. The hedge fund leverage increases to 9 times ($10 of equity (the original amount less the loss) and $80 of debt supporting $90 of assets). If the permitted leverage stays constant at 5 times then the hedge fund must sell $50 of assets - 50% of its holdings ($10 of equity and $40 of debt funding $50 of the asset). If lenders (more realistically) reduce permissible leverage, say, to 3 times, then the hedge fund must then sell $70 of assets - 70% of its holdings ($10 of equity and $20 of debt funding $30 of the asset).

Impact of Losses on a Leveraged Investor

De-leveraging requires liquid markets and buyers with capital to purchase the assets. Ultimately, prices of risky assets must adjust to market clearing levels as the system reduces debt. The process described is now under way in the global economy.

The first phase of de-leveraging is focused on financial markets. Banks have suffered losses in excess of US$200 billion (with more possible). Approximately US$1 trillion of assets have returned onto bank balance sheets. This included “warehoused” assets that could not be securitised and assets previously “parked” in asset backed security commercial paper (“ABSCP”) conduits, structured investment vehicles (“SIVs”) and Collateralised Debt Obligations (“CDOs”). An additional unknown amount of assets will return onto bank balance sheets as hedge funds gradually de-leverage.

Banks require funding and capital to cover losses and returning assets (christened IAG (involuntary asset growth). High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

They have been raising money both via “helpful” central banks and in the market. Major financial institutions have issued substantial volumes of term debt at very high credit spreads. In one week in April 2008, financial institutions raised a record US$43.3 billion in debt at the highest credit spreads since 2001.

Banks will also need substantial new capital to cover losses and the regulatory capital required against returning assets as follows:

Losses: US$ 200 to 400 billion

Additional Capital: US$ 100 to 300 billion (calculated as 10% (the Basel minimum is 8% but few banks operate at that level) of returning assets)

For bank’s operating under Basel 2, probabilities of default in credit models will increase resulting in regulatory capital increases. This is the pro-cyclical nature of the capital ratios in the current regulatory model.

The capital required is around 15-25% of total global bank capital. Banks have raised in excess of US$ 200 billion in new capital. The pace of new equity raisings is accelerating.

It is not clear how this capital requirement will be meet. Initially new capital was supplied by sovereign wealth funds (“SWFs”) and Chinese banks. Given that most investors have (sometimes) significant losses on their investment, this source of capital is less likely to be available in the near term. Banks have resorted to “hybrid” capital issues such as perpetual preference shares. The major attraction for investors has been the high income. Investors, especially retail investors, may not understand the equity risk in these structures. Rating agencies have expressed concern about the increasing level of hybrid securities in the capital structure of many banks.

Other sources of capital include asset sales. The current state of asset markets makes this problematic. Asset sales will put further pressure on available liquidity and prices.

One bright spot is investment in emerging market banks; for example, investments in Chinese State banks. For those lucky enough to have made these investments, there are still significant unrealised gains. Many banks see disposition of these shareholdings as an attractive source of capital. The recent decline in the Chinese stock market, the large size of many stakes and the unknown liquidity of the underlying stock remain issues.

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system’s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

In recent years, off-balance sheet vehicles – ABS CP conduits, SIVs, CDOs and hedge funds (collectively known as the “shadow banking” system) – provided additional leverage. These vehicles relied extensively on bank funding or support. The withdrawal of this support means that these vehicles are also de-leveraging rapidly.

ABS CP conduits, SIVs and CDOs are being gradually dismantled and the assets returning onto bank balance sheets. Hedge funds have been forced to reduce leverage by between a third and a half times. Prime brokers and banks have significantly tightened credit, increasing the level of collateral needed even against high quality assets. Each 1 times leverage reduction in hedge fund leverage represents in excess of US$2 trillion of assets. This accelerates the de-leveraging process.

The next phase of de-leveraging will focus on the real economy. The availability of debt has contracted sharply. The cost of funding has increased. This will force de-leveraging of corporate and personal balance sheets.

High quality corporations with maturing debt face face higher borrowing costs. For companies with less than stellar business outlook and credit quality, refinancing may prove difficult. Some US$150 billion + of leveraged loans comes due in 2008. A similar amount also must be refinanced in 2009.

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor’s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

Personal balance sheets will also de-leverage. Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of “easy” credit will force de-leveraging.

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt. Higher food and energy cost, especially over a sustained period, may affect the degree of de-leveraging if income levels do not adjust.

An economic slowdown will exacerbate the de-leveraging. A fall in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt.

In the US economy, the household, housing and financial sectors constitute over half of all economic activity. A (perhaps protracted) slowdown may be difficult to avoid. US demand is a significant driver of global activity. Recent reductions in global growth forecasts reflect these concerns.

Reduction in corporate cash flows as revenues slow down reduces the ability of companies to sustain leverage. Loan covenants (debt and interest coverage) will reinforce the de-leveraging.

There has been a systemic “financialisation” of corporate balance sheets. Changes in financial markets will have a significant impact on many companies that now rely on “financial engineering” rather than “real engineering”. The problems of GE may not be isolated.

For personal borrowers reduced personal income and unemployment will sharply accelerate the de-leveraging. Uncertainty about the future and market volatility will also accelerate the de-leveraging as companies and consumers reduce debt and aggressively save.

De-leveraging in the real economy may result in increasing defaults. Firms and individuals with unsustainable borrowings will fail. This will result in further losses to financial institutions setting off negative feedback loops as both asset prices and the level of aggregate leverage adjusts.

Central banks and governments actions have been directed at maintaining liquidity and (increasingly) directly supporting the financial sector. In the US and Spain, direct fiscal stimulus is already being administered.

These actions are designed to prevent a catastrophic collapse in the financial sector. They are also designed to help maintain a normal supply of credit to creditworthy business and individuals. These actions are designed to help the real economy from slowing down to a degree that the de-leveraging accelerates further. At best, these actions will smooth the inevitable de-leveraging and adjustment to financial asset prices.

What is to be Done?

The current focus is on reforming the financial system. This is like discussing lifestyle changes with a patient admitted to ER in full cardiac arrest. What is needed is the defibrillator paddles!

While the system will need to de-leverage over time, it is imperative that immediate steps be taken to restore functioning of banks and the supply of credit.

The first step is to establish certainty - the holdings and values of risky assets held by banks and investment banks must be accurately determined. The need for greater certainty of values applies to sub-prime securities and leveraged loans as well as other risky assets. Without certainty about what is held by whom and their values, it will be difficult to restore confidence in financial markets.

Risky assets must be valued on a hold-to-maturity basis (in absence of clear trading intent) at 100% (the security will pay back) or 0% (the security will not pay back). Mark-to-market accounting should be suspended reducing volatility in asset values, earnings and capital.

In the aftermath of the 1997-1998 Asian crisis, unfashionable insolvency practitioners, employed by the IMF, established asset values for distressed Asian banks in this precise way.

Market values (based on increasingly unreliable or meaningless indices or quotes) or model based prices (to 16 decimal places) should be abandoned. There is no market for many risky assets currently. The models have not performed and are what got us here in the first place.

The manifest problems of valuation can be easily illustrated. Bank holdings of Level 3 assets have increased in recent months. These are assets or liabilities that cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions – also referred to as “mark-to-make-believe”. There is concern about the accuracy of these valuations.

The increase in Level 3 assets may reflect a re-classification of assets previously classified as Level 2 assets. These are instruments that are valued using observable inputs that can be put through an accepted model to establish values (i.e. mark-to-model). This reclassification is consistent with deteriorating market conditions and unavailability of market prices.

Market values may be distorted. In recent months, investment banks have sold leveraged loans on the basis that the bank lends the buyers 75-80% of the price at below market rates. In this way, the sellers were able to avoid marking down its positions.

There is also significant disagreement between banks as to the values. A comparison between some US and European banks shows substantial differences in where similar assets are valued.

Even central banks, it seems, can’t agree on the current price of difficult to value assets. For example, market sources indicate that under its special term lending arrangements the Bank of England is placing a market value of 75 to 90% per cent on highly-rated non-government collateral, depending on type and the availability of prices. In contrast, the Fed is placing market values of 80 per cent to 98 per cent for similar securities. Greater certainty regarding positions and values are essential.

Once the true positions are known, then the capital levels that banks must hold against these assets can be set.

Capital levels should be set on a bank-by-bank basis by regulators rather than based on an inflexible formula that is frequently gamed by banks. Capital requirements should be eased, where appropriate. A “desired” long-term capital ratio for banks should be set. Banks should be allowed to transition to these levels over time. If all asset positions are known with clarity and confidence, banks can operate with lower than the normal capital requirements for a period.

Proposals to accelerate Basel II or increase bank capital are ill considered in the present market conditions. The banking system needs significant amounts of capital to cover losses. It also needs additional capital to cover assets returning onto balance sheet. Increased capital ratios would accelerate the de-leveraging already under way worsening the contraction in economic activity.

The final step is a government guarantee of all major bank liabilities. The step is not as radical as it appears. The Federal Reserve (for example, in the case of Bear Stearns), the Bank of England (Northern Rock and the Special Liquidity Scheme (“SLS”)) and Germany (the Landesbanks) have de facto already done this.

The extent of central bank support is significant.(1). For example, the US Federal Reserves 7 May 2008 statement shows that it holds $537 billion of US Treasury bonds out of a total of US$795 billion in securities. This amount to 68%, a fall from 98% a year ago. Closer scrutiny reveal that the US$537 billion includes US $143 billion of Treasury bonds lent to dealers under the liquidity support schemes. The US$143 billion is “fully collateralized by……. highly-rated non-agency mortgage-backed securities”. In effect, the Federal Reserve has provided over US$400 billion (around 3% of US GDP) in funding to banks and (now) investment banks. This funding is at subsidised, negative real interest rates.

Term lending through the support facilities means that the central bank is doing more than providing liquidity. The central banks are underwriting the solvency of banks. If at maturity, the bank can not repay the advance, the central bank will be forced to continue to fund the borrowing bank to avoid triggering default. Bank’s generally fail due to liquidity risk. It is sobering to consider that Bear Stearns was technically solvent when a withdrawal of liquidity brought it to the brink of a bankruptcy.

An explicit guarantee has many advantages. It avoids inflationary money supply expansion and the need for money market sterilisation operations. It would directly help restore confidence in banks and in the inter-bank market.

The Central Bank would charge explicitly for the guarantee based on the underlying risk. In this way, the taxpayer is properly compensated for the risk assumed. Central banks currently are providing a similar underwriting of financial risk at money market rates. This contrasts with the high costs being paid by banks on their equity capital raisings. For example, banks are paying 7% to 11% on hybrid capital raisings. Similarly, bank equity offerings are at substantial discounts to already low stock prices.

Support of the global banking system will be difficult to avoid. The originate-to-distribute and risk transfer models did not, as we now know, distribute risk through the financial markets. Instead, it linked the financial solvency of all financial market participants in a complex web. Government underwriting of the banking system is now critical to resuscitating normal financial activity.

The proposed actions are contrary to free market orthodoxy and raise familiar concerns about moral hazard and rewarding greed. There seems to be no choice. There will be a high price to be paid but that will come later. As Charles Kindleberger noted in his history of financial crisis: “today wins over tomorrow”.

Credit markets have become dysfunctional. As Walter Bagehot observed: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his argument, in fact his credit is gone”. The outlined actions would help restart the credit heartbeat in the US and global economy. Vital life signs need restoration before longer-term lifestyle changes are contemplated.

Implementation of the three steps outlined above allows monetary policy, interest rates and fiscal policy to be directed to ameliorate any economic slowdown. As noted above, falls in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt. Initiatives in the US mortgage market to help those with salvageable debt positions to avoid foreclosure are also valuable in this regard. Attempts by governments in the USA and England to maintain supply of “normal” housing finance are also targeted at this objective.

The defibrillator shocks must be accompanied by far reaching and fundamental changes in financial architecture and global capital flows. Regulation of banks, capital regimes, risk transfer, asset valuation, risk management, use of collateral, counterparty risk, model risk, rating agencies and financial accounting need radical surgery. Fundamental economic imbalances - excessive reliance on US consumption and excessive savings by other nations – must be addressed.

Present proposals by various bodies are tepid and do not address the fundamental problems. Many of the suggestions, such as derivatives clearing houses, have been doing the rounds for 20 years. Giuseppe di Lampedusa (author of “The Leopard”) would have seen the proposals for what they are: “everything must change so that everything can stay the same”.

Failure to address the major structural problems of financial architecture and global economic imbalances may mean that any improvement is short-lived. It will also sow the seeds of future, perhaps more serious, financial crises. The present problems and government steps already are creating problems in commodity and emerging markets.

Resolution of the crisis requires brave and decisive steps that transcend geography, jurisdiction, regulatory silos, nationalism and rigid economic formalism. John Maynard Keynes knew the problem well: “the difficulty lies not so much in developing new ideas as in escaping from old ones”. But as John Kenneth Galbraith observed: “faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”

[1] I am grateful to Charles Morris for drawing this to my attention.

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