Plate Tectonics – Continued
This is Part 2 of my review of Roubini’s Crisis Economics, and I take over from where Part 1 ended, which was describing the causes of the Global Financial Crisis. The following parts of this book review will describe the perfect storm that followed the Lehman Brothers Collapse and the spread of the crisis to the rest of the world. The reactions of the US government and especially the Federal Reserve were spectacular, but the transfer of the risks and liabilities from the private to the public sector has considerable repercussions. Roubini shows how the haste of quelling the crisis made policy makers miss a unique opportunity to reform the system, and explains how the system we are in at the moment has become riskier than the one which was prevalent before the crisis. We essentially moved from a network of institutions that were too big to fail to one of institutions too big to be saved. Do not read this note if you are about to go to bed unless you are ready for some insomnia.
An action which suffers from moral hazard is the action of an individual who takes on excessive risks due to the fact that the consequences on him of a negative outcome of his bet are smaller in comparison with the size of the risk taken. The way the remuneration was structured before the financial crisis gave huge incentives for moral hazard to the most influential actors involved: the ratio of bonus to base pay in the financial industry skyrocketed, and most of the players found themselves having two potential outcomes if they take excessive risk: either their bet fails and they at worst lost their job, or their bet succeeds and they make a bonus a few multiples times their annual base pay. When the bonus becomes considerably larger than the base pay, risk is suddenly more appealing.
Some financial products can also potentially be an incentive for moral hazard, and perhaps the best example of those are Credit Default Swaps (CDS). A CDS is an insurance a lender can purchase from a third party which yields a payment if the borrower defaults. One funny twist to CDS is that you do not have to be a lender to purchase a CDS on a loan. If you think a loan is highly likely to default, and you want to bet on it, all you have to do is buy a CDS and do everything you can to make the lender default. AIG is among the insurance groups who found a very easy way to make money by selling CDS on mortgages which they perceived as safe (housing prices only go up, remember?). They had no idea that a large number of these CDS could all be activated together if home prices suddenly plummeted.
Moral hazard before the crisis has a few other sources, one of which is the Federal Reserve’s acting as a lender of last resort beyond the realm of regularized commercial banks, to any institution whose collapse was considered as potentially detrimental to the system. The larger the institution was, the more confident it felt that if it were to run into trouble, it would be saved by the FED. Can you imagine what could have happened if AIG, one of the world’s biggest insurance groups whose insurance of millions of people and pension funds depend on, was allowed to fail?
Policy Makers and the Limits of Democracy – After Me the Deluge
Alan Greenspan finished his term at the head of the US Federal Reserve in 2006 as the hero of the Great Moderation. His mandate was typically characterized by heavy interventionism in the markets when bubble went bust, and laissez-faire policy when they were growing. While it could be debatable that spotting a bubble is not easy, it is also questionable whether Greenspan and his administration really wanted to do anything about it if they saw one. After all, as a famous saying beautifully sums it up: “you have to dance while the music is on.” Even though it was clear that there was not enough chairs for everybody, Greenspan most probably didn’t want to be the one turning off the music and being remembered as the chairman under whose term one of the largest financial crisis in history unravelled.
The Shadow Banking System
The shadow banking system is a thrilling term to describe institutions which make loans and investments like banks, but are not regulated like banks. Banks have short term liabilities (depositors can turn up to their counters and claim for their money instantly) and long term assets (borrowers only pay back their loans from the banks progressively). This is how regulated banks make money: from the spread between the lower interest rates they give to their depositors and the higher rates their charge to their borrowers. Also, in the fractional reserve banking system we are in, banks make more loans than they have deposits. Say a bank has $10 of deposit, with a required reserve ratio of 10%, it can lend up to $100, all under the assumption that not all depositors will claim their money at the same time. And if they do so out of panic for whatever reason, and since we are talking about a regulated bank, the Federal Reserve would step in as a lender of last resort and provide the necessary liquidities.
The 1980’s and 90’s witnessed the burgeoning of a whole lot of financial institution which decided to let go of the Federal Reserve’s support in case of a run, act like banks and “yield higher returns as long as they were willing to walk the banking tightrope without the safely net underneath.” In comes the hedge funds, private equities, investment banks, broker dealers, structured investment vehicles, money market funds and so on. This whole network was left to grow un-regularized and unprotected, and its size was at its peak comparable to that of the regular banking system. When fear struck and investors ran to pull their money off these institutions, the network soon turned into a minefield.
The Ultimate Devil: Debt
While all the reasons described above heavily contributed to the crisis, the most important reason which is apparent in all financial crises throughout history remains excessive leverage or more simply: debt. Roubini argues that years of excessive liquidity preceded the crisis. This excessive cash floating in the system had two main sources: the liquidities injected after the dot com bubble of the early 2000’s by the Federal Reserve, and which were not mopped off early enough to avoid a bubble, and surplus savings in Germany, Japan and emerging markets, which needed to be invested and found a safe haven in US mortgage backed securities.
In addition, the years of low volatility and deep optimism which followed the dot com bubble, from 2000 to 2006, were characterized by extremely high levels of borrowing. Investors in the private sector were optimistic about the future and their ability to pay their debt, and went on to borrow as much as they could. What is striking in any cycle of leverage is its self reinforcing power. Imagine an investors borrows $1M from a bank and invests it in a fund of funds. Imagine then that the fund of fund borrows $4M, adds it to the $1M, and invests the total in a hedge fund. The hedge fund then takes the $5M and goes on to borrow $5M. The initial $1M loan, by the effect of leverage, has now become $10M. When all goes well and the value of the underlying securities goes up, leverage is very profitable. A 10% increase on the $10M is $1M, which is a 100% increase on the initial $1M invested. However, when things go wrong and the underlying assets fall, an equivalent 10% decrease on the $10M is equivalent to the initial $1M disappearing from the system. The initial investor then gets a margin call, and has to pump in another $1M to compensate for the loss. In order to do so, he might have to sell other assets he owns. And if everybody else is selling at the same time and assets prices are going down, illiquidity can turn into insolvency and the chain of defaults unravels.
To be continued