Credit Crunch 2008
The Long Term Capital Management blowup of the late 90s and the ongoing credit crisis, have one major thing in common, they undermine the strict orthodoxy that markets are self regulating and need no government intervention to keep functioning. Differences between the two episodes are numerous, including the origin of the problem, the extent of the spillover into the real economy and the amount of intervention necessary to solve them. However, the similarities in the form of the excessive leverage employed, the belief in false mathematical precision and the unknown and difficult to quantify counterparty risk, are more alarming and suggest that there has been little systemic reform amongst financial institutions since the Long Term Management debacle.
In the Long Term Capital Management (LTCM) case, the undoing of the fund began with Russia's unexpected default on its debt obligations which sent global bond markets into panic and a flight to safety. The unsustainable current account deficits of many Asian "tiger" countries coupled with the panic set off by Russia's default was enough to push these countries into a state of financial panic. With capital fleeing those countries leading to a currency collapse, many financial institutions in the emerging Asian economies became insolvent overnight as they held debt denominated in US dollars. The financial tsunami that rolled throughout Asia setting off both economic and political collapse, led to further unrest in global credit and equity markets. The relationships between debt and equity instruments moved out of sync with historical norm, resulting in massive losses on LTCM's positions which relied on the convergence of markets to past correlations. Massive losses combined with the fund's derivative positions which implicated financial institutions all across Wall Street, led to a Fed orchestrated bailout and recapitalization of the fund by a syndicate of banks, stopping the panic at the cost wiping out the existing equity holders.
The current credit crisis has a different origin, but may have similar consequences, namely a significant reduction of value for equity holders in many financial institutions as weakened banks will need to be merged or recapitalized. The current crisis is a result of the "wealth effect" or in other words a failure to recognize that the availability of credit enhances the valuation of collateral. Historically low interest rates and high employment led to a real estate boom which allowed existing homeowners to withdraw equity from their houses and set of a speculative boom in residential construction. The notion that real estate prices can never fall and the initially good underwriting practices led to the development of sophisticated debt structures that could be tranched and leveraged, providing desired levels of returns. This allowed a whole class of new investors (pension funds, Norwegian insurers, school boards in Kansas) easy access to financial products offering yields significantly higher than those of government bonds. This new capital allowed the real estate boom to continue and further push housing prices out of sync with personal incomes. In 2007, when jobless people with hardly any assets could purchase several homes with little or no money down, this credit expansion has reached its outer limits. As mortgage defaults have risen, institutions have been forced to write-down the value of these new and esoteric credit structures. Given the leveraged nature of these structures, investors forced to mark-to-market their positions suffered significant losses as they needed to liquidate to meet margin requirements. Adding to the problem are close to $60 trillion dollars worth of credit default swaps (many times the notional value of the US mortgage market), many held by institutions that may not be good for their commitments. The ongoing crisis has forced Bear Sterns to accept a merger with JP Morgan at terms highly unfavorable to its shareholders, a deal like to foreshadow many others to come.
Citigroup, Merrill Lynch, Ambak, MBIA, Washington Mutual, Countrywide are just a few example of companies that have penalized shareholders by either cutting their dividend or being forced to dilute existing equity. Given the number of institutions affected, the current crisis is much wider and more difficult to solve than the problems of LTCM. Today, there is no single concentration of counterparty risk and no easy solution to the existing problems. In LTCM's case a rate cut and a syndicated investment of 14 banks ($3.625 billion) was enough to turn the tide and restore confidence in the financial system. In addition, LTCM's problems can be seen as a financial crisis with little or no affect on the economy (at least in the US). Today, there has been 300 bps of easing, coordinated liquidity injections by central banks around the world, new lending facilities for banks and prime brokers, a fiscal stimulus plan from Washington, a loosening of capital requirements for the GSE's and a taking on of credit risk by the Fed itself when it began to accept mortgage backed securities as collateral. None of this has yet to lead to an unblocking in the credit markets, suggesting that more drastic measures may be needed. One such option, dubbed the "nuclear" option by some commentators, is a creation of a financial institution or government agency that would issue government backed bonds and buy mortgage backed securities in the market, restoring liquidity and confidence. As losses on mortgages are likely to mount any shortfalls suffered by this new entity would have to be made up by the US treasury and the American tax payer. However, should tax payer money be used, the financial institutions would have to pay as well, either directly through having their equity holders wipedout or being heavily regulated ? a solution that neither the institutions nor regulators want.
While different on many counts, both LTCM and the current crisis show one important flaw in thinking about modern financial markets. Financial markets rarely have the means to correct excesses by themselves, and the ability of global markets to survive on their own has yet to be sufficiently proven. Free markets are seen as the best solution for the allocation of resources and as such are dubbed "self-regulating." In fact it has always been the intervention of financial authorities that has helped abate disaster, thus showing that the orthodox view, that free markets solve all problems, is a myth. It was deregulation and the relaxation of lending standards that led to the current state of affairs. While capitalism and globalization are beneficial to the world, they are not some sort of new panacea for the world economy and cannot survive without a certain degree of regulation. Accepting and admitting this are the first steps towards a solution.
- Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long Term Capital Management. Random House, 2000
- Wikipedia, http://en.wikipedia.org/wiki/Long-Term_Capital_Management, accessed: 30 March 2008
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