The Worst Financial Crisis Since the Great Depression is Getting Worse…and the Need for Radical Policy Solutions to the Crisis
It is now clear that the US and global financial markets are experiencing their worst financial crisis since the Great Depression. And in spite of desperate and radical actions by the Fed this crisis is getting worse. A brief equity rally after the rescue of Bear Stearns, the 75bps Fed Funds and the announcement of new radical and unorthodox lending facilities (allowing non bank primary dealers access to the Fed discount window) has already completely fizzled today with US equities plunging over 2% while the severe crunch in money markets and credit market is becoming much worse.
Let me now flesh out how the crisis is becoming more severe and increasing the risk of the mother of all financial meltdowns…
First note that in spite of the most radical change in Fed policy since the Great Depression – i.e. the extension of the Fed’s lender of last resort support to non bank primary dealers and the announced swap of up to $400 bn of safe Treasuries for toxic agency and private label MBS again make available also to non bank primary dealers – the panic in money markets and interbank markets is now seriously worsening: today the yield on 3 month Treasuries plunged to 0.56, a level not seen since the 1950s; the TED spread (the difference between dollar Libor and 3 month T-bills) increased 32 basis points to 1.98 percentage points; swap spreads widened again; while the VIX spiked to a level close to 30; even off-the-run long dated Treasuries are becoming illiquid (as in the 1998 LTCM crisis). The situation in money markets is scary as there is a generalized flight to safety with investors avoiding everything but the most liquid and safe government bonds.
In the meanwhile the liquidity and credit crunch in the agency debt and MBS market is worsening in spite of all the Fed recent easing actions and in spite of the Fed decision to swap Treasuries for hundreds of billions of agency and private label MBS: the difference in yields for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes widened again both yesterday and today. So the radical decision of the Fed to prop the agency and non-agency MBS market with $400 bn of swaps has done very little to affect the liquidity and spreads of these markets. This is no wonder as Fannie and Freddie are – on a mark to market basis – effectively insolvent and the widening in their debt and MBS spreads reflect the worsening credit outlook for their assets, not just a situation of illiquidity.
These extreme dislocations in money markets and credit markets are slaughtering a variety of highly leveraged hedge funds and other funds that deluded themselves that high leverage could provide high returns: after the Carlyle Capital Corp, the Endeavour fund lost 25% of its value on wrong JBG “box trade” bets while the bond fund of Meriwether (of LTCM infamy) lost 24% on the crash in credit markets. Martin Wolf correctly pointed out today in his FT column that many hedge funds – run by mediocre managers – can make money for a while only following highly leveraged and risky strategies. These strategies are being smashed in this period of market turmoil and volatility. So, expect the bloodbath among hedge funds triggered by the market turmoil, the liquidity crunch and the forced deleveraging that margin calls trigger to worsen in the weeks ahead. And with spreads on even “safe” AAA agency and private label debt and MBS being so wide expect another round of massive writedowns that will lead to the bankruptcies of a wide range of leveraged institutions (hedge funds, broker dealers and other members of the shadow financial system).
Today we are facing a massive margin call on highly leveraged US capital markets and a massive de-leveraging of the financial system following fire sales of marked to market assets in vastly illiquid money markets, credit markets and derivatives markets. We are thus close to the last steps of my 12 Steps to a Financial Disaster. Each of these 12 steps is now underway and the only question is not whether such steps will take place but rather how severe they will be and how big the losses will be. We are now observing – with the Bear Stearns episode as well as with the collapse of the SIVs, the losses on money market funds and the collapse of hedge funds and highly leveraged funds – the beginning of a generalized run on the shadow financial system.
And – as discussed in my 12 Steps to a Financial Disaster – the financial losses are now spreading from subprime to near prime and prime mortgages, to commercial real estate loans, to consumer debt (credit cards, auto loans, student loans), to leveraged loans, to muni bonds and writedowns from the impairment of the monolines’ insurance, to corporate loans and bonds whose defaults will surge soon, to the massive losses in the CDS markets.
The Fed response to this run has been to provide the Bear Stearns bailout and provide both liquidity and swap of illiquid and toxic assets for safe Treasuries to the non-bank primary dealers. But these radical and risky actions of the Fed – as the collateral for this lending is now toxic – are not achieving their goals: in the short run the risk of a run on a Lehman may have been reduced; but what is happening in the money markets and in the agency markets shows that the Fed can only affect partially liquidity premia, not credit premia; and spreads are widening for a wide range of money markets and credit markets because of widening credit spreads driven by sharply rising counterparty risk.
The lack of trust of financial institutions in their counterparties is surging in spite of all the Fed actions as panic is setting in money markets and credit markets. Thus, providing access to a dozen broker dealers who are primary dealers does nothing to ease the credit risk and liquidity/rollover risk of thousands of US and global institutions that are part of the shadow financial system. In a mark to market world many of these highly leveraged institutions – including large broker dealers other than Bear Stearns – are effectively bankrupt and no Fed action can rescue them. And the run on the shadow financial system has barely started.
Thus the piecemeal approach to crisis management taken by the Fed, the Treasury and other financial authorities is going to fail miserably. A severe recession and a severe financial crisis cannot be avoided at this point. Only much more radical government action will limit the financial meltdown and start to put a floor on the financial markets collapse. This government intervention would not be aimed to prevent the necessary adjustment of asset prices; it would be aimed at ensuring that the necessary adjustment is not disorderly.
Such radical policy action includes a government plan to purchase – at a significant discount to minimize its fiscal cost – hundreds of billions of dollars – possibly trillions – of mortgages, effectively a nationalization of mortgages. Once purchased by the governments at a significantly discounted price these mortgages could be restructured to reduce their face value, reduce the interest rate on the mortgage and allow distressed but solvent borrowers to avoid foreclosure. To limit borrowers’ moral hazard only truly distressed borrowers would qualify: i.e. no condo flippers, no second home borrowers, no early default borrowers; only borrowers that were likely to be subject to deceptive and/or predatory lending practices. Only this formal nationalization of mortgages will start to stop the foreclosure disaster and jingle mail tsunami ahead of us. The fiscal costs and lenders’ moral hazard risks of such a plan can be significantly reduced if action is taken early and if the price at which the government buys mortgages from lenders is low enough.
This plan also include a formal nationalization Fannie and Freddie as the ongoing farce of pretending that these insolvent institutions are private sector firms is being revealed: at market value these institutions are effectively insolvent and government decision to increase limits for non-conforming loans, to increase caps on their portfolios and to reduce their “excess” capital are now revealing that these are not private institutions: they are rather effectively public institutions that are – in spite of their massive problems – being used to bail out the mortgage markets. So lets end the farce of deluding ourselves that these are private firms: if these bankrupt institutions need to be used for public policy purposes – as they may need to – let us formally nationalize Fannie and Freddie – and put transparently on the public sector balance sheet the costs of bailing out the mortgage market.
This plan would also include the closing and/or nationalization of banks and other systemically important financial institutions that will fail in droves during the current financial crisis (they can then be privatized again after proper restructuring as many countries did after their banking crises). Again moral hazard distortions can be minimized by wiping out 100% the shareholders in these institutions and firing – with no sweet severance packages – all the reckless senior management that created this mess.
Claiming the Bear Stearns was not bailed out because the current shareholders got only $2 per share is disingenuous: this was a massive bailout as the Fed put $30 billion of cheap credits in the pot: without this massive financial support not only the shareholders would have been wiped out 100% as they deserved to (rather than keeping the option value that the government support will recover in due time the value of their shares); but also many of the creditors of Bear Stearns would have experienced massive losses as Bear was insolvent and unable to pay such creditors with its impaired assets. Instead the $30 bn Fed support represents a major subsidy for JPMorgan and a major bailout of Bear’s creditors. Effectively the Fed has taken on its balance sheet the entire credit risk of $30 of toxic securities held by Bear Stearns. So, this Fed bail out is an explicit case of using the disastrous Japanese model of a “convoy system” (healthier banks taking over zombie banks with the help of lots of public money) that led to a decade of economic and financial stagnation.
A market solution to this crisis does not exist; those who believe in such markets solutions are deluding themselves as markets left alone will melt down and enter into the mother of all meltdowns, margin calls, cascading collapse of asset prices, massive credit crunch and liquidity seizure and severe economic recession.
Of course the price adjustment in overpriced asset prices should not and cannot be avoided: home prices will have to fall at least 30%; equities will need to sharply correct in a bear market; risk spreads will have to widen sharply; many institutions will go bankrupt as they should. But what we risk today is a systemic financial meltdown where negative feedback loops lead asset prices to collapse much more than justified even by the much lower fundamental value of such assets.
So government intervention is necessary not to avoid the unavoidable massive losses and bankruptcies and the unavoidable fundamental adjustment in asset prices. It is rather necessary to avoid a financial meltdown where asset prices fall much more than justified by economic fundamentals and the credit crunch and de-leveraging of the financial system is much more severe than the necessary one that will occur regardless of any public intervention.
Alternative solutions that allow a private sector restructuring of mortgages and rely on greater market mechanism should not be ruled out but they will be complementary to government action rather than replacing it altogether: changing bankruptcy rules to allow judges to cramdown a reduction in the face value of the mortgage is useful and empirical evidence suggest that this change will not significantly affect mortgage rates (in the same way that introducing collective action clauses in sovereign bonds did not affect at all sovereign bond spreads). Also, using negative equity certificates for banks that accept a reduction in the face value of mortgages so that they get option value of a potential long term increase in the value of the underlying home is a sensible idea.
These and other proposals that are “market-oriented” can complement government action but – for a variety of reasons – they cannot fully replace it: the collapse in the mortgage market, even the agency one is severe; there is no large deep-pocketed private sector agent that can buy and restructure such large amount of mortgages and reliquify the frozen mortgage and MBS marktes; delays in restructuring will only further impair the value of the assets and lead to bigger deadweight losses (such as socially wasteful foreclosures costs) down the line; risk of litigation in case servicers restructure mortgages and collective action problems among the final investors holding the claims on such mortgages (different tranches of CDOs creditors) may slow down or block the necessary debt restructuring; and other collective action problems and externalities are likely to slow down any private solution.
We are facing now the risk of the mother of all financial crises and meltdowns. Moral hazard can be realistically address by wiping out reckless investors and lenders, having the government buying assets that need to be restructured at low prices closer to their fundamental value and limiting the mortgage debt reduction to truly deserving borrowers who were victims of predatory lending practices. But radical and coherent policy action needs to be taken urgently and without further delay as there is now the risk that the US will experience its most severe recession in decades and that the US and global financial system may melt down.
I will flesh out in more detail in the near future the logic and specific elements of this radical plan to resolve this most severe and dangerous financial crisis.