No Exit: Will "A Short Financial Crisis Become a Long One"?

By happenstance, three articles in the Financial Times provide useful, if disheartening, triangulation on the credit crisis. In sum, the markets are a mess, policymakers don’t agree on what to do, and there may be nothing they can do except make matters worse.

Last week was by any standards a bad week, with the Fed’s new liquidity measures an apparent reaction to a continuing deterioration in the market for Freddie Mac and Fannie Mae debt issues, which is a sign of how much confidence has fallen. Even though, as Brad Setser pointed out, push comes to shove, the Federal government would have to support the agencies, investors are instead taking a dim view of the GSEs’ not very pretty balance sheets.

The FT points out today in “Credit derivatives turmoil strikes,” that the less well publicized, but very large credit derivatives market (over $45 trillion in notional value; estimates of its economic value vary widely) is in a state of near meltdown due to hedge fund failures and credit unwindings, Worse, the sharp in swap prices leads to higher borrowing costs. And we warned of counterparty risk months ago; it’s now a widespread concern.

From the FT:

Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.

The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.

In Europe, the cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe index surged to a new high of 156bp, before closing at 146bp on Friday. A move above 150bp would spark the unwinding of structured trades, according to BNP Paribas…

Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction.

“There is potential for some wild and possibly inexplicable price movements as the unwinds get bigger,” said Mehernosh Engineer, credit strategist at BNP…

Tim Bond, head of global asset allocation at Barclays Capital, said: “It’s inflicting heavy losses on the banking system, eroding their capital and reducing their ability to lend. The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit.”

Some structured credit vehicles have in-built triggers that force them to be liquidated.

Bank of America estimates that if the cost of US investment grade credit insurance rises above 200bp, the unwinding of structures could trigger a jump towards 220bp.

Jim Sarni, portfolio manager at Payden & Rygel, an investment management firm, said: “The market is very concerned about counterparty risk and how stable positions are as they are marked to market as prices keep falling.”

Clive Crook in “In the grip of implacable subprime forces,” gives a good summary of current and projected defaults for US homeowners, and also notes the disconnect between Bernanke and Paulson on what to do about it. Crook argues that less intervention is the course of valor:

The line that “falling house prices are good for the economy – they help clear the market” is no doubt correct, but it will be difficult to sustain if anything like that worst-case scenario begins to unfold. Then the challenge will be to confine political action to measures that do relatively little harm, and to avoid palliatives that will only amplify the cycle of recklessness and remorse next time round.

This seemingly obvious point is widely ignored in Washington. The US already has what must be the world’s most generous fiscal dispensation for mortgage borrowers – uncapped tax relief for owner-occupiers, plus colossal “government sponsored entities” to guarantee loans, implicitly subsidise mortgage rates and promote securitisation. This fiscal regime created an environment in which you felt a fool unless you borrowed to the hilt – not just to buy your house but to keep your equity in it to a minimum, so as to liberate cash for other purposes. This is the very root of the problem. Yet favoured responses to the subprime crisis on Capitol Hill include extensions of tax relief to poorer households (at present, it goes only to taxpayers who itemise their deductions), further vast expansions of the remit of, and resources potentially available to, the GSEs, and assorted new outright subsidies.

Adjusting the bankruptcy laws to encourage writedowns and make repossession more difficult may do little to help right now, but it does at least have the virtue of making no new demands on taxpayers. If it makes lenders think twice in future about extending 100 per cent mortgages to borrowers with no income or assets, so much the better – although “jingle mail” may prove even more salutary in that regard. The medium-term goal for policy should be less subsidy of every sort for borrowing, and stricter regulation of lenders. The short-term goal should be to avoid actions that militate against the medium-term goal. That sounds timid, I know, but at times like this being timid is a lot to ask.

Wolgang Munchau, in “Central bankers cannot stop this contagion,” is on the same page as Crook, but for largely different reasons. He argues that a central bank’s tools for dealing with crises can address only illiquidity, not the sort of solvency crises we are seeing now. Thus, central bank action can give us the worst of all possible worlds: impotent in bringing relief to the markets but inflationary.

From Munchau:

Since the start of the global financial crisis last August, monetary policy has been remarkably ineffective. The US Federal Reserve has cut short-term rates by a cumulative 225 basis points since then. Yet, borrowing costs for US consumers and companies have actually gone up….

For as long as this financial crisis persists, interest rates will be determined by toxic market conditions, not central bankers. Among the various channels through which monetary policy affects the real economy, the credit channel is one of the most important. If real-world interest rates are determined independent of a central bank’s monetary policy, the effect of monetary policy on economic growth is correspondingly reduced.

But that does not mean monetary policy is irrelevant. On the contrary. It remains hugely important in steering inflationary expectations in the long run. I am not at all surprised by last week’s upward revision of the ECB’s own inflation forecast, a de facto acknowledgement that European interest rates have been too low for too long. Nor am I surprised by the falling yields of US Treasury inflation-protected securities, or TIPS. The difference in yields between ordinary US Treasuries and TIPS serve as an indicator – albeit imperfect – of future inflationary expectations, which are rising in the US as well.

We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run. What drives inflationary expectations up is not the current prices of oil or wheat, persistent though they may have been. What spooks investors is the loud and clear signal from central banks that they are not prepared to stabilise inflation in adverse circumstances.

This credit crisis is first and foremost a financial solvency crisis. When you are insolvent, the rate of interest is irrelevant because no one will lend you money in any case. And if someone did, the interest rate would still be irrelevant, since you are not going to pay them back. If you face only a liquidity problem, the rate of interest matters a great deal, since it determines the price you pay to regain liquidity.

This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market.

A good example of how contagion works in practice came last week when Carlyle Capital defaulted on a margin call from its banks. What is happening here is known in financial jargon as “haircut contagion”.

In its September 2007 global stability report, the International Monetary Fund provided a useful hypothetical example of how a small fall in asset prices can easily wipe out an investor. Say, a fund invests $100 in a portfolio of risky securities. The margin requirement from the lender is 15 per cent. So on that basis, the fund borrows $85 from the bank. The rest is the fund’s equity. Assume the portfolio drops 5 per cent in value, and is now worth only $95. At that point, the fund faces a margin call. To meet it, it is forced to sell securities. When the bank decides to raise the margin requirement, or the “haircut”, more forced selling becomes necessary. At some point, the fund’s investors start to panic and get out. And the fund is forced to sell again. In this hypothetical IMF example, forced selling turned a portfolio of $100 into one of $36.

Interest rates do not even enter into the picture. Central banks could cut their short-term rates as much as they liked and they still would not be able to stop this kind of contagion. I cannot offer an effective solution either, and believe that this crisis will slowly spread from segment to segment of the credit market. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem. I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.

But monetary policy itself cannot be an effective part of the solution of this credit crisis. This means that we are no longer living in the New Keynesian textbook world where the short-term interest rate is the variable through which central bankers can simultaneously control the economic cycle and maintain price stability in an optimal way.

A monetary policy overreaction would not solve any existing crises, but would create new ones. Nominal interest rates would rise sharply, bond prices would crash and a short financial crisis would become a long one.