Understanding The Financial Crisis

“Panic can cause a prudent person to do rational things that can contribute to the failure of an institution.” — William A. Ackman of the hedge fund Pershing Square Capital Management.

In 36 Hours of Alarm and Action as Crisis Spiraled by Joe Nocera, a gaggle of New York Times financial reporters have given us a valuable look at the panic that both Wall Street and Main Street recently experienced. Their behind-the-scenes story helps explain the urgency and scope of the bailout plan that Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson proposed. Here is a brief summary of that article.

Forget the picture of depositors anxiously lining up outside a bank’s door, waiting to get their money out as soon as the bank opened for business. Nowadays, it is hedge funds pulling their money out of investment banking firms such as Morgan Stanley and Goldman Sachs. There was also a run on money market funds, a fairly recent innovation, which most investors had assumed were as safe as bank accounts.

Investors large and small had been aware of the gathering problems and the ad hoc solutions to them. And while it is somewhat difficult to identify the actual tipping point in terms of a real financial panic, it’s widely accepted that the Lehman Brothers’ bankruptcy had serious consequences. The fear was that Morgan Stanley would be next. One thing led to another, events cascading with no one in control.

Here are some relevant quotes from the article.

Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.

It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.

Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope.

Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite the strong earnings it had disclosed late Tuesday, its stock continued to plummet. By noon, the Dow was down 330 points. It rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points.

And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks were refusing to lend to other banks, and spreads on credit default swaps on financial stocks — the price of insuring against bankruptcy — veered into uncharted waters.

Moreover, the drain on money funds continued. By the end of business on Wednesday, institutional investors had withdrawn more than $290 billion from money market funds. In what experts call a “flight to safety,” investors were taking money out of stocks and bonds and even money market funds and buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of.

In the stock market, Mr. Ehrlich of UBS was horrified by the plunge of Morgan Stanley’s shares, given the stellar earnings. “It felt like there was no ground beneath your feet,” he said. “I didn’t know where it was going to end.”

By Thursday morning, the need for dramatic action had grown even more urgent. In Asia, stocks had already closed lower. To quell fears before the opening of European markets, the Fed and other central banks announced they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs.

But it was to little avail.

For a number of reasons, the administration’s original bailout plan did not pass the House of Representatives. Last night, the U.S. Senate passed a somewhat different version of the bill; now the House gets another chance.

To be continued …

Criticism of the U.S. Bailout Plan, Part 2

“The Devil Is In The Details” – Proverb

Paul Krugman is a Princeton Economics professor and columnist for The New York Times. In his September 22nd column Cash for Trash, he claims that although Treasury Secretary Henry Paulson is “a smart guy” as far as his plan to bail out banks, “He’s making it up as he goes along, just like the rest of us.”

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?
Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

The Fannie Mae & Freddie Mac Takeover

 

“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.” – Treasury Secretary Henry Paulson, Jr.    

Last night’s Charlie Rose TV show had a panel discussion of the Federal Government’s takeover of U.S. mortgage giants, Fannie Mae and Freddie Mac. The panel included Nouriel Roubini of New York University, Mohamed El-Erian, co-CEO of PIMCO and Gretchen Morgenson and Floyd Norris, both of The New York Times. (I faithfully record the Charlie Rose show every night, knowing that, most of the time, he will have an enlightening, or at least interesting, program. Tonight, he will have Thomas Friedman, who will discuss his new book.)

Nouriel Roubini was, as expected, the most pessimistic about the future direction of the economy. He has been called, among other things, “Dr. Doom,” but the truth is that he has been prescient about the various crises we have seen. It is his belief that, because the government “subsidized” home ownership, we invested too much in housing, instead of more productive assets.

Things are so bad, Roubini said that “we have a subprime financial system, not a subprime mortgage market.” This has led to a systemic banking crisis.

Roubini listed various simultaneous shocks to the U.S. economy:

• Consumers are “shopped” out
• Housing prices are falling and will continue to fall
• Stock prices have fallen
• Consumers are facing a large debt burden
• Banks are less willing to lend
• Consumers are dealing with rising oil and food prices

Roubini thinks that this is an unusual, if not unprecedented, confluence of events, as bad as we have seen since the Great Depression. He believes that the U.S. recession will get much worse and will last for 12 to 18 months, and that there is the strong possibility of a global recession and a “vicious circle.” He does not go so far, though, as to predict another Great Depression.

And to top things off, he commented that “Superpowers” should not be net debtors. Observing the huge and still growing U.S. deficit, Roubini said this could be indicative of the beginning of the decline of the “American Empire.” Whew! Heavy stuff.

Mohamed El-Erian’s analysis was somber, but not nearly as scary. He believes that the credit crunch had “morphed” into an economic crisis, which is in desperate need of crisis management. He sees the takeover of Fannie Mae and Freddie Mac as necessary, and as a bold attempt to change the “regime.” (Paradigm?) He believes that, in the next two years, the government will go from crisis management to an evaluation of the situation and, finally, to crisis prevention. He believes that a major reform effort will be required by 2010.

Speaking of reform, Gretchen Morgenson expressed her extreme disappointment at the failure of policy makers and regulators to address the problem earlier. Whether it was the SEC, the Federal Reserve Board, the U.S. Treasury or the bank regulators, she feels that there was a wholesale failure to recognize the problem. “Denial, upon denial, upon denial that there was a problem,” was how she described it. As a result, she sees a lack of credibility in the administration.

Morgenson commented that there was enough blame to go around, meaning banks, mortgage brokers, and consumers, in addition to the government, were at fault.

El-Erian “defended (!)” the regulators by saying that they knew that there was a problem, but they just didn’t know what the solution was, and they didn’t want to make things worse.

Somehow, this does not make me feel more confident.

Norris said that the takeover was necessary, to prevent the crisis from getting worse. He agreed with Roubini that the danger is a “negative loop,” where things just keep getting worse. He feels that we must do a much better job of regulation, especially in the “alternative financial system,” that has largely been unregulated. Norris was the only one to mention the fact that former Federal Reserve Bank Chairman, Alan Greenspan, was strongly against regulating financial markets, because he did not want to stifle innovation.

Norris highlighted the failure of top management of banks, who did not control risk. They may have thought they were making tons of money, but they weren’t, because they relied too heavily on models for reassurance that they were not taking on too much risk.

My interpretation is that they just did not think that we could have a nation-wide decline in housing prices. Bank management thought that the packaging of risky loans reduced the overall risk, through diversification. But, this could not be true if the underlying loans were extremely dicey, and in some instances, simply fraudulent. Everyone assumed that housing prices could go in only one direction – up — or if prices declined, it would be mild and temporary.

Take Home Message

One fear is that, if people are “underwater” or “upside down” with regard to their home mortgage (that is, their house is worth less than the outstanding balance of the mortgage) they will just walk away, leaving the bank to deal with a foreclosure and possibly a forced sale of the house. This is what the government is trying to avoid, or at least diminish the likelihood of it. It will not be an easy problem to solve. Roubini made the startling prediction that, of the people who have mortgages on their homes (and not everyone does, by the way), 40% will be “underwater.”

On the plus side, these recent actions by the Federal Government seem to have strengthened the confidence of foreign investors in the U.S. markets. El-Erian says that international investors view the U.S. markets favorably, because we have the deepest market in terms of liquidity, and we adhere to the rule of law. People living in the United States may take this for granted, but it is something to consider.

I would add that our dynamic, entrepreneurial “can-do” spirit is a huge advantage globally, so I am not quite ready to count the U.S. out, yet. We do have serious problems to address but, though long overdue, the Federal Government,seems, at last, to be on the case.

Postscript

For a fascinating portrait of Roubini, see this New York Times article.  In September of 2006, he was extremely pessimistic about the banking system, housing prices and the economy, and was mocked for his predictions. However, his critics dismiss his correct call because they point out that he was pessimistic about the economy back in 2004, as well. Read the article and judge for yourself whether it was “the broken clock being right twice a day” syndrome.