Sunday, September 14, 2008

Thinking the unthinkable

The credit crunch has now become a full-blown systemic banking crisis. Financial institutions that were previously thought immune from failure are now crashing. Eighteen months ago, who would have thought that Bear Stearns and Northern Rock would be no more; that Freddie Mac and Fannie Mae would be nationalized and that Lehman brothers would be on the verge of total collapse. Moreover, you don’t have to look too far beyond Lehman to see other vulnerable institutions. The unthinkable has suddenly become the plausible.

There is worse to come. Other institutions are going to tumble and fail. Lehman, Freddie and Fannie are not the end; they are but the prelude. We have only just raised the curtain on this sorry opera.

How do we know this to be true? We have to start by understanding a rarely mentioned and shocking fact about the failures recorded so far. In the greater scheme of things, the sub prime shock was only a modest blip. Yet somehow, it finished off Bear Stearns, and Lehman. Default rates on US mortgages are still in single digits. Although US house prices have fallen by about 25 percent, even foreclosed properties still have some value. When you do the arithmetic; the losses are really not that great. Nevertheless, Freddie Mac and Fannie Mae found these losses too much to bear.

So why are financial institutions collapsing so quickly? It is a lack of bank capital. Every prudent bank should keep a buffer to absorb losses. Roughly speaking, this buffer is the difference between total bank assets, which are basically loans, and total liabilities, which are deposits and loans from other financial institutions. Banks on both sides of the Atlantic minimized this difference; their capital. They reduced their buffer because holding capital meant reduced profits. Banks reduced their safety zone down to the absolute minimum. When the sub prime losses began to arrive, bank balance sheets could not cope. The buffer was too slim.

This is one of the reasons why the Fed and the US treasury are finding it so hard to save Lehman. In principle, Lehman is on sale for $3.5 billion. Based on past valuations, this is a ridiculously low price. Yet why can’t Lehman find a buyer? Other banks simply don’t have the resources to pick up this bargain. True, Lehman has some potentially worthless mortgage debt on its books. However, these losses could be easily absorbed if the buyer had a sufficient capital buffer.

So if banks do not have sufficient capital to absorb modest losses, imagine what would happen if loan default rates really begin to rise. Unemployment on both sides of the Atlantic remains comparatively low. However, both economies are slowing and the unemployment rate is about to pick up. As it does, households default rates are going to begin to rise. However, the banks are already in the danger zone. They are having a hard time absorbing existing losses, and a further round of defaults will send many over the cliff.

Of course, this was all foreseeable. It was all completely understood by central banks, financial regulators and the commercial banks. Yet knowing something and acting on that information are two quite distinct things. People often prefer to ignore unpleasant facts that require distasteful policy responses. Invariably, it was easier to hope for the best. As US and UK banking systems slide into an ever deeper crisis, the unthinkable reality of bankruptcy was the highly plausible consequence of keeping too little capital. It was more a case of not thinking about some obvious dangers rather than imagining the unthinkable.


  1. Yet those of us who cried "ENOUGH!" four (and more) years ago were deemed laughable doom-mongers. Go figure, etc...

  2. Alice,

    I think you're wrong on the reason no-one's buying Lehman. It's the leverage. They've got a pile of assets on one side and a pile of commerical paper on the other side as the liability that funds it. The difference is a net positive of so many billion, which is their net assets. That the net assets aren't so high doesn't make it a bargain.

    The problem is the assets are tumbling in value while the CP is just the same as it always was. Therefore they have a negative net value, and it's likely to get much much worse for the sucker that takes on the book. So naturally nobody want's any piece of it. Lehman would be overpriced at £1

    I'm in a funny emotional position right now. (In my mind) my predictions from nearly a year ago have been spot on, as has my defensive measures. But I'm getting that sinking feeling that all hell is about to break loose and even the prepared are going to get caught in the crossfire. The Dow futures are down 300 right now.

    Thank god we've got Darling and Brown to navigate us through the storm, eh?


  3. Business bridge loans are an item that bears mentioning. A lot of business have an agreement with their bank for emergency contingency loans. The bank will issue say 100 of these agreements on the assumption that only 4 or 5 businesses will call to use them at any one point in time. When they all show up at the window at once, you have a serious if not impossible draw on reserves.

  4. Alice, Nick,

    Here's the gig. Asset deflation is upon us. There was WAY too much leverage in the system.

    Once everyone recognizes this fact, buying no longer makes sense. Even if you could borrow at 0.5% (as in Japan), falling assets values make that borrowing a losing proposition.

  5. yes, under-capitalised, the old old problem

    & the joke is that sound risk-management theory, if properly employed (properly enforced), easily identified the shortfall

    same as with Enron and the whole raft of 'energy merchants' that went under in their wake

    as I've said before, an interesting lesson from Enron was the protracted, slow-motion way in which the dominos fell: this one's bigger (much) and will thus take longer

    caught in the crossfire - yes, I am inclined to agree with other-Nick above (when you can't even be sure that cash is safe, you're in very murky waters - even with the best risk-management in the world: there needs to be a paradigm-case risk-free asset class)

  6. It's not clear anymore with which bank my savings are safest. Could there be another bank like Lehman in the UK?

    I want to invest more in HBOS but see the share price is very eratic which makes me suspicious. Currently losing nearly 20% of share value! I wonder if the investors know something I don't!

  7. Nick Drew,

    I'm 100% in hot cash, and have been for 12 months. I'd love to somewhere to diversify to but I don't see any risk-free options. Can't do international stocks cos decoupling is a hoax, can't do commodities cos that was obviously a bubble and will suffer in global recession, can't do gold cos all the fools are there already, can't short cos the SEC and FSA will just steal my money on a whim.

    That's what I'm worried about. So I'm in hot cash spread thinly around UK banks and I've got an offshore gold account ready if Brown and Darling try to pull a Paulson. But it's worrying.

    Thank god I'm not fully invested, or I'd be far going to Boots now to buy a tub of paracetemol and a few razor blades.


  8. Nice to see others confirm my view about cash. But yes, I worry about cash as well, which is why I'm glancing over at gold's standing. ND, you look quite right about the slow-motion crash, it's probably what has prevented a full-scale panic so far. And Alice, spot on as usual, it didn't require rocket science, just moral fibre.

    What will the authorities do when it gets too painful?

  9. yes, cash / NS&I, & a little gold

    (plus a few 'special situations')

    but pension etc is partially exposed, & the house ... difficult to go entirely bomb-proof, isn't it ?

    Sackers, you said it back in Feb: slow-motion = chance to act

  10. Nick,

    Razor blades are xheapest at Asda. Paracetamol too, I think. :)

    B. in C.

  11. """
    What will the authorities do when it gets too painful?

    Like gamblers, addicts and other fine folks their response will be: Still *More* of whatever it is that got them into the mess in the first place!!

    In this case: Lower interests, More bailouts, More regulation, Less enforcement of regulation, More currency intervention.

    People (and systems) only change behaviour *after* they are broken completely down.