John Authers of the Financial Times thinks the markets got a lucky break this week, and deferred a so-called Minsky moment, which he discussed in a noteworthy piece earlier.
By way of background, economist Hyman Minsky observed that creditors become more lax about lending standards during times of stability. He divided borrowers into three types: the upstanding sort that can pay principal and interest; speculative borrowers (or “units”), who can pay interest but have to keep rolling the principal into new loans; and “Ponzi units” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender.
Minsky’s comment:
Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.
What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy,
….speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.
Ouch.
To Authers’ current article:
A Minsky Moment has been averted for now. Can it be postponed indefinitely?
Thursday saw credit markets recover slightly from their precipitous falls of the last week, while stock markets rallied. In New York, the Dow Jones Industrial Average closed at an all-time record as, more significantly, did the MSCI emerging markets index, Brazil’s Bovespa, and Korea’s Kospi.
So the sharp increase in the cost of credit has not yet brought down the stock market with it. Why not?
Enter Hyman Minsky. The late US economist offered a theory of the behaviour of lenders, which many have re-examined in recent weeks.
He said credit conditions became increasingly lax in times of good economic health. Then the credit supply would dry up (through such measures as the tightening of lending standards). Then liquidity dries up as lenders call in loans and borrowers sold liquid assets to comply. The final “moment” came when central banks cut rates to avert economic collapse.
The theory was drawn to fit a world where, as in 1929, the decision whether to extend credit rested with bankers. Now, it rests with the markets. But its potential relevance to current circumstances is clear.
George Magnus of UBS suggests reasons to believe a Minsky Moment can be deferred. First, housing problems take a while to unfold. Second, companies have cleaned their balance sheets and are not heavily leveraged. Third, there is still much liquidity in the world system. High energy and commodity prices suggest petro-dollars will not go away.
Finally, there is still no clear evidence of economic weakness, as the most recent data underscore, or of a significant return by inflationary pressures.
All these factors could change quickly. But even with credit valuations back to earth, markets believe Minsky’s Moment of reckoning can be deferred further.
The FT’s capital markets editor, Gillian Tett, provided evidence of Ponzi unit behavior in her story, “Have we really learnt our leverage lesson from LTCM?” in which she describes how prime brokers have been quite generous (one might say lax) with their hedge fund clients. And she highlights a key fact often overlooked by the financial press: while hedge funds appear less highly geared than LTCM, and by implication safer, unlike LTCM, many hold assets with high “embedded leverage.” As a result, no one knows how much leverage there truly is in the system.
From Tett:
When Long-Term Capital Management imploded back in 1998, there was much hand-wringing on Wall Street about the evils of excess leverage….Fast forward to 2007, and it feels like déja vu….
Once again, hefty levels of leverage have been provided. And – yet again – some big investment banks seem to have asked surprisingly few questions about how this money was being used.
For, just as at the time of LTCM, many institutions have recently been scrambling to break into the prime brokerage game – and willing to take shortcuts.
Indeed, I am told that at least one lender was so eager to grab market share that it provided finance to these funds on an uncollateralised basis. That is truly a sign of leverage gone mad.
But the really interesting question that arises from this tale is how widespread this pattern might be. In public, most investment banks insist it is not. And official data measuring hedge fund activity seems to back this up: for the industry as a whole, leverage levels do not look unusually high, relative to earlier decades.
Yet I have never met a senior policy maker who has much confidence in these measures, partly because the nature of leverage is changing as a result of financial shifts. Back in 1998 “leverage” was primarily measured in terms of loans made by prime brokers to hedge funds (and indeed, that is what official data still typically tracks.) But these days many financial instruments – such as collateralised debt obligations – have so-called “embedded leverage”, which essentially means they are highly sensitive to market swings.
Moreover, whatever the official data might say, there are some good macro-economic reasons for suspecting that leverage in the system is relatively high – and rising. For as inflation adjusted returns have shrunk around the globe, investors of many stripes have been leveraging themselves up to some degree, to improve returns (which, in turn, has had the pernicious impact of pushing overall returns even lower). The Bear Stearns saga, in other words, might be extreme – but, some echoes of this pattern can be seen in a mild form at any asset manager that holds a collateralised debt obligation, say.
That, in turn, poses a bigger question which is increasingly troubling policy makers: namely if conditions change in the coming years, can the system now “de-leverage” itself in a calm manner? The evidence from the Bear Stearns funds is hardly cheering. We will not learn until next Monday (or when these funds issue their results to investors) the full scale of losses at these groups. But it is already clear that they are finding it painfully hard to reduce leverage, without triggering a market shock.
An optimist might argue that this is a special case because these funds were trading illiquid instruments. When the Amaranth hedge fund was forced to cut its positions last year, by contrast, it exited its loan positions pretty smoothly.
However, the fact remains that in recent years, the most highly leveraged players in the financial world have been increasingly moved to illiquid areas, in a search for returns. And if many investors are suddenly forced to deliver in a hurry, this could potentially turn even relatively liquid markets into frozen fields.
So if any senior bankers heading for the beach this summer, they could do worse than re-read the old accounts of LTCM. Yes, Wall Street has a learnt some lessons since then (but not quite as much as they might claim.) But one point has not changed: namely that leverage remains key. Even – or especially – given that policy makers and investors still have precious little idea how much leverage is really afoot in the system today.
