Understanding The Credit Crunch
This article is a successor to an article I wrote on October 11, 2007 in which I suggested that the credit crunch would be far worse than most people believed and that the impact on the stock market, the financial system, economic vitality and inflation could be significant. Now it is the week after Thanksgiving weekend and as I contemplate last week’s market sell-off and this week’s dramatic rally, I realize that the stresses have grown more evident and I can’t help but contemplate what might now be in store for next year domestic driveway bollards.
On the positive side we are almost six years into an expansion and the US economy continues to grow albeit at a slower pace. Unemployment remains low except in sectors related to housing but it is edging up. Corporate profits have been good this year but they declined a bit in the third quarter. Until the first full week of November the stock market indices were at or near all time highs, though of late trading has been increasingly volatile. The credit crisis of August now seems to be just a problem for the financial sector to manage. The Fed has lowered interest rates three times indicating it wants to protect the economy. On the surface things are looking OK.
But look under the surface and the picture changes. The credit crunch has lost its crisis atmosphere but many sectors of the credit markets remain paralyzed. This paralysis is now affecting businesses and consumers in areas other than real estate. Equity investors are nervous as evidenced by the stock market’s extreme volatility. The Dow was 1,000 points off its all time high and the S&P 500 was even down year-to-date, though both bounced back on interest rate cut hopes. The housing market is in a deep recession moving towards a depression. Declining home values are siphoning off vast amounts of consumer wealth while rising food and energy prices are eating into family budgets. Unemployment is edging up in many states and consumer confidence is at a two-year low. Consumer inflation is 3.6% year-to-date and edging higher. On top of it all, we are entering an election year and geopolitical events are more unstable and dangerous than they have been since WWII.
As consultants, business owners and senior executives our job is to be aware of what is happening in the world, anticipate how events might impact our clients or our businesses and stay ahead of the curve by taking action to mitigate identified risk. We can’t relax just because things are going well now. We have to look ahead at what might or might not be.
I see seven interrelated threats that business owners, senior executives and Boards of Directors should understand, anticipate and plan for in an effort to minimize the negative consequences should one or more of them become a reality. The principal threat is the growing credit crunch because depending on how it ultimately unravels it could lead to any one or more of the other six – depression, recession, inflation, stagflation, legislative action unfavorable to business and geopolitical crisis. This is a businessman’s effort to present the facts in a way that enables other interested parties to make sense of it all.
The Credit Markets
Perhaps the greatest risk to the economy and our businesses lies in the credit markets. While the credit markets have calmed down since the crisis atmosphere of August, the underlying problem still exists as evidenced by the lack of liquidity in the capital markets and the huge write downs being taken at public financial institutions. It is now understood that the ultimate severity of the credit crisis still remains to be seen, and people are beginning to recognize that depending on how it unfolds it could result in any or all of recession, inflation, stagflation and geopolitical upheaval.
It is now clear that the massive amount of debt underlying the world economic system is at risk of unwinding due to collateral defaults. At the heart of the matter are Collateralized Debt Obligations, or CDOs. CDOs are derivative securities, as in derived from another asset. Trillions of dollars of these instruments were created and sold over the past six years. According to Satyajit Das, one of the world’s leading experts in derivative securities for over 20 years, $1.00 of real capital supports $20.00 to $30.00 in loans. That means each dollar is leveraged 20 to 30 times! He estimates derivatives outstanding to be $485 trillion, or eight times global gross domestic product of $60 trillion. The scary thing is that no one really knows for sure who holds all this paper.
The problem is global and there is only a limited amount the Fed or other central banks can do to manage it. This is because much of the problem lies in the unregulated shadow banking system defined as the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures. The effect of securitization is that credit risk moved from regulated entities where it could be observed to places where it was unregulated and difficult to observe. Without regulators to keep tabs on cross-border flows and quality standards, investors didn’t really know what they were buying or what it was really worth.
U.S. ingenuity: In the post dot com bubble and 9/11 world of ultra low interest rates, US Banks saw their net interest margins shrink along with their loan volume which negatively impacted profits. So the banks developed ingenious ways of creating significant fee income by bundling volumes of consumer (many of them low income) and leveraged buy-out loans into what are called Asset Backed Securities (ABS) to be sold to institutional investors like “bonds”. The investors then use these ABSs as collateral for another high-yielding debt instrument called a Collateralized Debt Obligation. These CDOs were snapped up by Asia and Mid-East governments, hedge funds and pension funds looking for rated high-yield instruments in which to park their mountains of emerging markets cash. Financial engineers built towers of securitized debt with mathematical models that were fundamentally flawed, while managers overloaded on high-yield debt instruments they didn’t understand. All along the way the banks pocketed huge fees while shifting trillions of dollars of risk off their balance sheets and into the hands of investors. It is estimated that last year alone Wall Street bankers (including the money center commercial banks) generated $27.4 billion in fee income from the origination, securitization and sale of exotic Asset Backed Securities.
Because of low interest rates in the US and Japan most CDOs were bought with borrowed money. In other words, borrowed money bought borrowed money. Because of high credit ratings the CDOs could be used as collateral for more borrowing. These triple borrowed assets were then used as collateral for commercial paper purchased by risk adverse money market funds. When the assets underlying these securities begin to default in large numbers (sub-prime loans), the CDOs lose value and the institutions holding them incur losses. And because no one knows for sure who is holding this paper everyone is afraid of taking on new counterparty risk. The credit markets become illiquid and many financial institutions end up holding huge amounts of CDOs for which there is no or limited market.
Asset Backed Security basics: Let’s take collateralized mortgage obligations (CMOs) since they are the easiest to understand. In their simplest “pass through” form banks and other lenders originate loans, warehouse them for a brief time, package them into a bond, have the bond rated and sell the bond to investors. Instead of making money from the net interest margin over the life of the underlying loans, the originators earn origination fees and payments from servicing rights. Investors who buy CMOs are actually buying the future cash flow from the underlying loans’ principal and interest payments. Because the CMO is rated by the rating agencies the purchase price equals the future cash flow discounted to a yield consistent with the rating of the bond. The advantage of this system to the originator is that the fees are made up front, the servicing rights provide an ongoing source of fee income unless sold, the credit risk is transferred to the investor and the investment proceeds allow the originator to make still more loans. The investor gets a rated instrument with a yield appropriate to the rating.