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23 May 09
Philip RothmanAs an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers.
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23 Nov 08
fullness TimeAs an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers. What they told me was so interesting and insightful that I begged them to write their explanations down for a broader audience.
econ credit-crisis lehman aig financial-crisis 5 loans finance bear-stearns
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The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression.
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On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)
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On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.
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The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company.
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they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market.
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many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities
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They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
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once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.
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Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.
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as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.
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For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged.
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With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman.
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Lehman’s costs of borrowing rose and its share price fell.
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A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
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The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts;
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A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s.
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Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part.
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$160 billion in bonds
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There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.
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In March, Bear Stearns lost its access to credit in almost the same fashion as Lehman; yet Bear was rescued and Lehman was not.
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Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear.
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The second problem was that Bear’s counterparties in many transactions were not prepared for the sudden demise of Bear. A Bear bankruptcy might have triggered a wave of forced selling of collateral that Bear would have given its counterparties.
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the Fed argued that the rescue was a rare, perhaps once-in-a-generation, event.
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When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.
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Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or “collateral damage” effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.
Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system — or both.
It was not surprising that they drew the line at helping Lehman. Based on all the publicly available information, this was clearly the right thing to do.
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The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.
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the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise
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We have not seen this much stress in the financial system since the Great Depression
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This is going to slow growth.
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One is where to draw the line. A.I.G. was an insurance company, not a bank or a broker dealer, so the Fed had no special relationship with A.I.G. Presumably, if a very large airline or automaker had been involved in the C.D.S. market, the same reasoning that led to the rescue would apply.
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A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.
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Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?
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The inability to secure short-term funding fundamentally comes from having insufficient capital.
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One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.
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24 Sep 08
Scott Waltereconomics
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Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
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But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.
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Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.
This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.
Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.
A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
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23 Sep 08
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Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system — or both.
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As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.
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A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.
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20 Sep 08
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19 Sep 08
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The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.
As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.
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Jim HolincheckA great post on what has happened with the recent financial crisis and why. It also discusses the potential implications on the economy as a whole.
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Dennis Howlett"As an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means." Honesty in an economist is refreshing. A solid read.
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18 Sep 08
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