Cracks in the foundations

by John Quiggin on January 23, 2008

The decision of the US Federal Reserve to cut interest rates by 0.75 per cent is as clear a sign of panic on the part of the monetary authorities as we’ve seen since the 1987 stock market crash. It’s not entirely coincidental that it followed a dreadful week on Wall Street, and a couple of awful days on world stock markets while the US was closed for the long weekend.

Still, stock markets have fluctuated quite a bit in the last 20 years without producing this kind of reaction. The really alarming events have been happening in bond markets and, in retrospect, the most alarming happened just over a month ago.*

That’s when Standard and Poors cut the credit rating of ACA Financial Guaranty Corp from A (strong investment grade) to CCC (just about the worst kind of junk) in one move. This event showed the weakness of two of the most important defences against the kind of credit derivative meltdown that market bears have been worrying about for years.

First up, it’s yet more evidence that, when it comes to systemic risk, credit rating agencies like S&P are either asleep on the job or, worse, incapable of performing it. They are fine at the day-to-day job of comparing different assets of the same kind, for example, estimating which companies are more or less likely than others to default on their corporate bonds. But when it comes to assessing the risks of whole asset classes, particularly new and ‘innovative’ asset classes, they’ve proved themselves to be hopeless.

They were caught napping by the Asian financial crisis. In the dotcom boom, they failed to detect the bogus financial structures of firms like Enron and many of the big telecoms. And they have been centrally implicated in the crisis that began with the repacking of subprime loans into bundles of securities, many of which were given AAA ratings on the basis of dubious projections of default rates.

But the failure to detect problems with bond insurers like ACA is far more serious. As I said in the 2002 post I linked above,

The starting point [for a possible financial meltdown] is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) … refuse to pay up.

To protect themselves against such a risk, parties to these deals have insured themselves against the possibility of default with bond insurers like ACA. But what happens if the insurers themselves go broke? This looks very likely to happen. ACA is relatively small, and has just staved off liquidation for a month or so. But the bigger insurers like MBIA and Ambac are also in trouble – Fitch just downgraded Ambac to AA and if the other agencies follow suit, the company will be largely unable to write new policies. It’s hard to believe they can make it through the coming year without being rescued either by the big banks (themselves looking pretty sick now) or the US government.

Suddenly, there are a couple of trillions of dollars of bonds that are less secure, maybe much less secure, than their holders thought they were. If, as seems entirely possible, derivative contracts have been written with these bonds as part of the underlying assets, the amounts at stake could be much larger.

The subprime mortgage crisis, in isolation, seems likely to produce losses of a couple of hundred billion, possibly enough to generate a mild recession in the USA. But the possibility of large-scale failure in bond and credit derivative markets, now all too real, could bring an end to the long period of global economic expansion that began with the end of the last big global recession in the early 1990s.

Note:I’ve made various updates in response to helpful comments

{ 2 trackbacks }

Stephen Laniel’s Unspecified Bunker » “Noise Trader Risk In Financial Markets”
01.23.08 at 3:21 am
Pundit like it’s 1929. « The Edge of the American West
01.23.08 at 10:18 pm

{ 44 comments }

1

SG 01.23.08 at 1:04 am

John, would you say that organisations like Standard and Poors have been proven incapable of performing their job or unwilling to? Maybe they have as much of a stake in the fantasy of the eternal boom as the people they have been rating?

Does the US Federal Reserve meant to behave like the Australian reserve, matching rates to inflation? Or does it have a general role controlling the economy? Because if the latter, it doesn’t seem to have many bright ideas.

2

mkl 01.23.08 at 2:40 am

Directionally correct, but a few quibbles:

1. ACA was rated A, not AAA. It was the only financial guaranty insurer rated so low and, as such, never had much of a business until they figured they could whore their counterparty rating to the banks and dealers.

2. The dotcoms typically never had credit ratings. Equity was cheap and plentiful, upsides were boundless and most of the companies had no cash flow to service debt. The telecoms of the period were a different matter. As one bond manager of the time described it, “we gave money to 360 Netowrks and they buried it in the ground; we gave money to Global Crossing and they sank it to the bottom of the ocean; and we gave money to Globalstar and they blasted it into space.”

The AAA monolines, eg. MBIA and Ambac are likely to fall into the broad space between not having enough capital to stay AAA and not enough capital to remain solvent. Their cost of capital may be so high that they can’t raise more, and will lose their AAA ratings, but there’s a long way (and a long time) from AAA to bust.

I’ve fixed points 1 and 2. On the final point, my reading is that once these firms lose their AAA status, they will rapidly lose their capacity to write new business. Just as with some of the mortgage companies, that doesn’t mean instant insolvency, but it seems likely to produce failure in some form within a year – maybe a low-value sellout a la Countrywide rather than a complete collapse, but still needing a rescuer.

3

Azael 01.23.08 at 4:14 am

One thing I would really love to see is an analysis of the financial deregulation that happened in the ’90’s and what effect that all had on the current mess.

4

Matthew Kuzma 01.23.08 at 4:40 am

“now all to real”

And when the economic downturn comes, people who can’t use homophones correctly will be the first with their backs against the wall!

5

John Quiggin 01.23.08 at 5:56 am

#4 On the contrary, the world will realise it can no longer afford the luxury of grammar snarks, and will implement the necessary, brutal and probably ungrammatical response.

6

Ragout 01.23.08 at 7:05 am

It sounds like the right policy response is a massive bailout of bond insurers? In the long run, presumably the answer is more regulation, but in the short run it seems a lot better to bail out the rich than to slide into a global depression.

7

The Oracle 01.23.08 at 8:47 am

I have the perfect economic stimulus package in mind:

IMPEACH Bush and Cheney NOW!!!

Not only would this provide a major boost to the U.S. economy, but to economies worldwide. Confidence would soar. Birds would begin singing again. Rainbows would brighten up world markets.

Hey, we should at least give it a try. A package deal. An economic stimulus package deal. Impeach Bush and Cheney at the same time. I just know it would stimulate our economy and avert a deep recession.

8

Ginger Yellow 01.23.08 at 11:02 am

“Just as with some of the mortgage companies, that doesn’t mean instant insolvency, but it seems likely to produce failure in some form within a year – maybe a low-value sellout a la Countrywide rather than a complete collapse, but still needing a rescuer.”

I’m not so sure about this. The big monolines have huge revenue streams from existing guarantees (around $1bn a year, I believe). They may still be able to do some secondary market business on a double default accounting basis, if not a risk transfer one. Nobody’s expecting significant losses in their municipal bond portfolios in the foreseeable future. Depending on the scale of losses in their structured finance portfolios, they should be able to continue making required payments, even without further capital. The crisis scenario will be if we get a vicious circle of downgraded monolines->tanking markets->reduced demand->deep recesssion->increased defaults->defaulting monolines. We’re already several steps along the way – it’s certainly not an implausible scenario, but it’s not inevitable either. The monolines are designed to be able to go into run-off without defaulting. But events might overtake them.

By the way, Ambac has already been downgraded by Fitch.

9

MFB 01.23.08 at 11:33 am

A nice, healthy correction, just what the capitalist system needs.

With breadlines, of course, and the cavalry charging the bonus-marchers, naturally, and perhaps a few brownshirts rounding up the minorities.

10

abb1 01.23.08 at 11:53 am

Don’t worry; even if the wheels really start falling off our Saudi royal brothers and our Communist Party of China brothers will certainly bail us out. We’re all on the same boat, though some in the first class, and others down in the engine room.

11

stuart 01.23.08 at 11:53 am

Isn’t part of the problem here the exaggerating effect of losses to financial instituions that lend money – if companies like Exxon lose $200b then that is a loss to the economy of $200b. If some group of banks, etc., with a reserve ratio of 10% (for the US) or 2-3% (UK/Euro), then the same asset loss of $200b can be expected to lead to a drop in lending of $2-5 Trillion (depending on which institutions lose what).

12

Ragout 01.23.08 at 1:42 pm

A nice, healthy correction, just what the capitalist system needs. With breadlines, of course, and the cavalry charging the bonus-marchers, naturally, and perhaps a few brownshirts rounding up the minorities.

That would suck, but I’m not too worried about a global depression. A crisis which can be averted by a trillion-dollar bailout of bondholders is a crisis that’s likely to be averted.

13

paul 01.23.08 at 2:39 pm

So what skin does Moody’s have in the game? They don’t have any direct liability for misrating, and it’s not as if anyone else is going to be sucking up their market share anytime soon.

14

Ginger Yellow 01.23.08 at 3:32 pm

“They don’t have any direct liability for misrating”

I think you’ll see that challenged in the courts and maybe by politicians in the next couple of years. They’ve always claimed that their ratings are just opinions and protected under the first amendment, but it’s possible a court might not agree this time round.

15

Grand Moff Texan 01.23.08 at 3:35 pm

First up, it’s yet more evidence that, when it comes to systemic risk, credit rating agencies like S&P are either asleep on the job or, worse, incapable of performing it.

Now that the jig is up on cheap credit, it’s getting harder and harder for Americans to pretend that they still have a broad, healthy middle class that can afford things like cars and homes. Bailing out financial institutions will do nothing to address the underlying weakness of the American economy, which is the weakness of the American consumer.

Whodathunk that a generation of rigging the game in favor of those who don’t drive the economy would actually have, you know, like, consequences, ‘n stuff.
.

16

Peter 01.23.08 at 7:37 pm

I recommend you visit Calculated Risk.
That blog is run by a pair who have been in the mortgage business for a long time. Their UberNerd series is some pretty dense reading.

17

Ginger Yellow 01.23.08 at 8:33 pm

Seconded. Calculated Risk has had some of the best commentary I’ve read on the subprime crisis and its fallout, including in the specialist press.

18

David Kane 01.23.08 at 9:51 pm

Finally, a Crooked Timber thread that I am actually qualified to comment on! Although it does not address the systemic issues that John outlines above, this piece (pdf) by David Einhorn is the best short introduction to the credit market meltdown that I have seen.

John argues:

[I]t seems likely to produce failure in some form [for Ambac and MBIA] within a year – maybe a low-value sellout a la Countrywide rather than a complete collapse, but still needing a rescuer.

MBIA and Ambac were up huge (more than 100%) in the last two days. Dead cat bounce or time to cover those shorts? There is a lot of money to be made by those who know the answer . . .

19

Walt 01.23.08 at 10:01 pm

Ginger: Isn’t the issue with the monolines that if they get downgraded that every bond they ensure gets downgraded with them, forcing banks to raise their capital reserves, and some other regulated entities to sell the bonds en masse?

20

lemuel pitkin 01.23.08 at 10:09 pm

Another interesting point this brings up is the impossibility of private insurance against systemic risk.

I can’t be the only one who, after finishing Sherrill’s Irrational Exuberance, was amazed that after such sharp analysis of why financial markets go wrong the policy prescription was basically “let’s set up some new insurance markets to hedge that.”

21

lemuel pitkin 01.23.08 at 10:21 pm

I’d be very curious waht John Q or others think of the Einhorn article cited by David Kane. For whatever it’s worth, I read it and it’s kind of …. good.

22

Walt 01.23.08 at 10:47 pm

I’m not sure what you mean, Lemuel. The impossibility of hedging against systematic risk is widely understood. But if you have risks that are basically not spread out evenly, then you have people facing non-systematic risks. The blow-up here is happening because the banks were much more exposed to the risk of the housing bubble collapsing than anyone imagined. This happened because basically the banks were hoarding all of the fat profits from bearing that risk to announce spectacular profits.

23

lemuel pitkin 01.23.08 at 10:58 pm

Walt-

I’m not sure that’s right. What happened here is not that “banks were holding all that risk” but rather that they were securitizing it so it could be more broadly traded than previously. Relative to the “old” system, where banks made mortgages and then held them, risk is actually distributed much more evenly now.

What you’re describing is something like LTCM, but it doesn’t seem like that’s what we’re looking at now.

24

John Quiggin 01.24.08 at 12:29 am

David, thanks for the link to the Einhorn paper which is excellent. This is indeed an area where your comments are likely to produce light rather than heat.

On #22 and #23, the risks are both widely dispersed and concentrated in particular institutions. The problem is, nobody knows which institutions.

25

Walt 01.24.08 at 1:24 am

Lemuel: The theory was that it was widely traded, but the reality seems to be that it ended up surprisingly concentrated. That’s why banks are having to take such gigantic write-downs.

26

lemuel pitkin 01.24.08 at 5:25 am

Well, I admit a lack of real knowledge, so will defer to Walt, John Q., and even David Kane.

I did read a lot of Minsky once. Old Hyman would have something to say about this, wouldn’t he?

27

lemuel pitkin 01.24.08 at 5:32 am

Altho, Walt, if what you’re saying is true, the whole system was even crazier than it seemed.

Model A: Bank makes mortgage, holds it. Lack of diversification but incentives to be cautious issuing mortgages and make realistic assessment of their value & riskiness.

Model B: Bank makes mortgage, bundles it with mortgages from other banks, sells it to institutional investors. Less exposure to risks associated with particular real estate markets, but greater risk that mortgages will not get appropriate scrutiny.

So in principle either model could work with appropriate regulation, with different strengths and weaknesses.

But you’re saying what we actually had was Model C: bank makes mortgage, bundles it with mortgages from other banks, and then holds onto the package,.So they’re still exposed to real estate-specific risk but no longer are able to control the quality of mortgages they’re holding. Which seems to combine the worst of both worlds, no?

28

lemuel pitkin 01.24.08 at 5:50 am

Wow, sorry for the multiple comments, but this is really interesting.

Securitizing mortgages was supposed to be based on the idea of not putting all your eggs in one basket. But then, sometimes you do want ally our eggs in on basket, because then you can take really good care of that basket — that was the idea of the the old system.

But we got was a relatively small group of institutions holding each others baskets. Which would seem pointless — except that by laundering your mortgages through ABSs and CDOs and whatever, whose riskiness was systematically underestimated, and by pretending there was a big secondary market that didn’t really exist, you could pretend you had diversified away risk that you actually still faced. But that allowed institutions to make much more and riskier loans than otherwise would have been permitted (by regulators? by investors?) And when the music stopped — well, either the individuals involved figured they would personally do OK even if their institutions didn’t, or the government would bail them out, which it still may, or they just convinced themselves the music wasn’t going to stop at all.

Is that what we think was going on here?

29

Ragout 01.24.08 at 7:03 am

Why did big lenders like Citibank end owning such a large amount of mortgage-backed securities? Because they’re “warehouse lenders.” They buy mortgages from originators like Novastar, planning to hold them for a few months until they can be bundled up into securities to be sold to institutional investors. When the institutional investors soured on mortgage backed securities, Citibank et al got stuck with the loans.

The big lenders also got burned because a lot of the mortgages turned out to be basically fraudulent. The mortgage originators had promised to buy back loans that defaulted within a few months (a sign of fraud). But these promises proved worthless when Novastar and a couple hundred other mortgage originators went bankrupt earlier this year. Again, Citi and other big investment banks got stuck with trash.

One example of this kind of thing:

at the end of September, Citi had $2.7 billion in “CDO warehousing/unsold tranches of ABS CDOs.” In other words, that is stuff Citi was trying to sell when the music stopped. And how much is it worth now? They took a writeoff of $2.6 billion.

30

Ginger Yellow 01.24.08 at 10:48 am

Actually, the really big losses (what’s a couple of billion here and there?), didn’t come from warehouses – that risk was actually widely distributed. The big losses, and the ones that ended up paradoxically concentrated, came from huge super senior positions in CDOs backed by subprime RMBS. Because only a few banks dominated the CDO market, they ended up with huge residual positions that they had thought were completely safe (because they ranked senior to triple-A debt). As it turns out, they weren’t safe at all. In a way, that thinking wasn’t so stupid. What was stupid was having CDOs backed entirely by one highly correlated asset class – in that situation a super senior position isn’t much safer than a mezzanine position, whereas in a more diversified CDO it’s much safer.

“Ginger: Isn’t the issue with the monolines that if they get downgraded that every bond they ensure gets downgraded with them, forcing banks to raise their capital reserves, and some other regulated entities to sell the bonds en masse?”

In a nutshell, yes. A downgrade from AAA to AA, however, won’t require all that much of a capital increase (compared to what we’ve seen so far). The nightmare scenario is what happened with ACA happening to a bigger monoline, but nobody’s really expecting that and if it were to happen there would certainly be a bailout.

31

Ragout 01.24.08 at 12:37 pm

ginger yellow writes: “The big losses…came from huge super senior positions in CDOs backed by subprime RMBS. Because only a few banks dominated the CDO market, they ended up with huge residual positions that they had thought were completely safe”

I may well be misunderstanding here, but that makes no sense to me. How can the same debt be both “super senior” and “residual” ? A residual position is the bottom tranche that’s left after the senior tranches are bundled up and sold, no?

32

Ginger Yellow 01.24.08 at 12:40 pm

There’s different kinds of residual. The most common sense means the first loss exposure as you described, often retained by the originator of an RMBS. In the case of a CDO, however, the first loss piece is almost always sold. Super senior positions, however, are usually either retained by the underwriter or taken by monolines – hence the big losses at major CDO arrangers and monoline insurers. Actually, in Citigroup’s case, a lot of the exposure was initially placed with investors, but contained a put option that brought it back on balance sheet right as the crisis broke. Bad move. Have a look at their Q3 earnings call for details.

33

Ragout 01.24.08 at 1:14 pm

I have looked at Citigroup’s most recent quarterly earning report, and it’s full of the same kind of seemingly-paradoxical claims. Apparently, Citigroup owned $8.3 billion of CDOs that were simultaneously “super senior” (paid first, I assume) and “mezzanine” (paid second, I assume). They’ve since decided that these super-senior mezzanine CDO positions are worth only $3.1 billion, of course.

But anyway, ginger yellow writes, “in Citigroup’s case, a lot of the exposure was initially placed with investors, but contained a put option that brought it back on balance sheet right as the crisis broke.” Isn’t this just what I said initially? Citigroup bought mortgages (or some other kind of loan) and bundled them up, hoping to sell them to institutional investors. But in the current crisis they were unable to sell them (or were forced to buy them back when investors exercised their put options). Maybe there’s some technical difference between what Citi was doing and warehouse lending, but it seems pretty similar to me.

34

Ginger Yellow 01.24.08 at 1:41 pm

“Apparently, Citigroup owned $8.3 billion of CDOs that were simultaneously “super senior” (paid first, I assume) and “mezzanine” (paid second, I assume).”

They were super senior positions in CDOs of mezzanine securities. In other words the actual tranches held by Citigroup were paid first in the CDOs, but the tranches underlying the CDOs were not. Highly correlated mezzanine CDOs are the worst of all worlds – it only takes a relatively small but widespread amount of losses to wipe out the entire CDO, whereas a super senior position in a “high grade” CDO can withstand much higher industry-wide losses.

“Maybe there’s some technical difference between what Citi was doing and warehouse lending, but it seems pretty similar to me.”

The difference is that a warehouse traditionally involves mortgages (or other assets) themselves, and is provided to a mortgage lender. The CDO positions came from packaging securities backed by mortgages and selling them on. In some cases this may be through providing a securities warehouse to a CDO manager, but in most cases they were just buying (or structuring) the securities themselves.

35

lemuel pitkin 01.24.08 at 3:09 pm

Ragout, Ginger Yellow-

Please keep posting. I, anyway, am learning a lot.

36

Ginger Yellow 01.24.08 at 3:16 pm

Any specific questions? I can help on the structured finance side – I know very little about equity markets.

37

mq 01.24.08 at 3:41 pm

The David Einhorn link in 19 is interesting, but he is a short-seller who has been pushing a line on this for years and has aligned his investment strategy to it for some time. Not to say he’s not right, but it would be nice to see stuff from someone with more distance.

38

GreatZamfir 01.24.08 at 4:27 pm

The Einhorn guy is interesting, in that regard. Let’s for the moment assume he is purely cynical, and is only saying stuff to make stocks drop and profit from that.

He has apparently been saying similar things (about a specific company) for years, and has written a book on the topic. In the case he is purely playing the market, the writing of the book is a signal,or a bluff: see, I believe it enough to spend time on bookwriting. Now he hopes enough people believe him to make the stocks drop, so he can profit. This only works if the drop in stocks is large enough, and his position short enough, to make up for the time he spend writing the book. I suppose hedge fund manager hourly pay is high enough to make this an expensive book.

Now the fun thing is that the drop in stock prices will be stronger if people believe his book, and people will be more likely to believe him if they think he has little to gain by them believing it.

So, option one: The guy is truly concerned about the system, and wrote a book to warn other people. Because he is also a smart hedgie, he is short on the companies involved because he believes they will drop, but that’s separate from his concern.

Option 2: he truly believes the systems has flaws and those companies will eventually fail, but doens’t care about other people. He just wrote the, honest, book to convince others that he’s right and thus accelarate the fall in stocks .

Option 3 is the cynical case above: he doesn’t believe there is a flaw in the system, or not to the extend he claims he believes it. He just wants other people to believe it and profit from the temporary drop in stock prices.

Of course reality can be mix of it all, plus he could have the book written by a ghostwriter, so that it appears he is concerned enough to write book, but really just pays the ghostwriter a fee. I like the mess…

39

John Rynne 01.24.08 at 4:56 pm

#11. May I suggest that steerage is a more appropriate metaphor for where the bulk of the Chinese are currently labouring?

40

SamChevre 01.24.08 at 5:33 pm

Lemuel,

It’s important to remember all the risks.

The big risk-reduction with MBS is in the interest risk side, not the exposure to housing side–until now, the exposure to housing side has been fairly safe. A disaster concentrates the mind wonderfully. The last mortgage related disaster happened when banks had mortgages outstanding at 6%, and inflation jumped–so they had to pay 10% interest to depositors. Selling MBS spread that risk around quite well.

41

Dr Zen 01.26.08 at 3:28 am

It’s rather pointless defending rating agencies against the misinformed but two points are worth considering:

1/ Rating agencies don’t have magic spying powers that allow them to see the truth about a company’s finances.
2/ Big downgrades are not evidence of being asleep at the wheel. Your A rating is gained by paying your debts and seeming to have enough money to pay the ones you still have. A big change that happens quickly can leave you in a very different position. The level of defaults in mortgages is *unprecedented*, and ACA wrapped a lot of bad bonds. How is S&P supposed to know that the mortgages were that bad? It doesn’t get to interview the people who took them out. It always gets a hiding when it is lied to, but it is defenceless against liars, just as you are when you make investments based on companies’ accounts and financial reports.

42

shteve 01.26.08 at 10:06 pm

Yes, Dr Zen – but the people who “misled” the rating agencies are the people who furnish the rating agencies with swanky profits. A spectacular conflict of interest that suggests the markets are … rigged.

43

Peter 01.27.08 at 7:14 pm

The level of defaults in mortgages is unprecedented

It was not unprecedented at all. Everyone knew there was a bubble going on, and they didn’t care as long as they had a seat when the music stopped. Or that they could sell it to some greater sucker who came along. Claiming it was “unprecedented” is a case of selective amnesia.

44

Tom Grey 01.28.08 at 6:02 pm

Very nice thread.
Shareholders need to have a new Investment Insurance Agency, not just a “ratings” agency — one that prices risk and their “rating” becomes the price.

Neither the market nor any regulating entity can tell what the likelihood of mortgage default is after a new innovation, just like junk bonds in the 80s or the dot.com bubble in the 90s.

One HUGE moral hazard is to allow the rich early movers to skim the revenue side of the risky behaviour without paying the cost side when the risk comes up.

Regulators can only stop new mechanisms — but in the case of the subprime mortgages, there was a big increase in the number of homes constructed, thanks to the money available to borrow from the sub-prime borrowers.

What is the default rate??? 10%? 50%? 90%? I heard before that usual rates were about 10%, and it’s now up to 15%. Whatever the higher than expected default rate, it’s important to remember that those NON-defaulters are enjoying newer/ bigger/ better houses than they would have without the easy money available.

A big cut in the interest rate, helping the risky rich reduce their losses while helping the homeowners reduce defualt, seems a reasonable balance. Thanks to Friedman’s monetarism, it’s known how to avoid a depression … more money/ lower rates from the central bank.

I’m glad Citi lost big — I wish there was a way for the gov’t to “claw back” undeserved prior profit-sharing of those who got big buck bonuses on risky revenue that was more risky than expected. (sigh, wishful thinking for more justice)

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