FEBRUARY 27, 2008
The economic meltdown has just begun.
The financial markets are in a state of bewilderment, taken by surprise almost daily. We are, in short, in the midst of a crisis without precedent--a crisis of credit so fundamental to the working of the economy that it may take years to unwind.
Consider the almost unbelievable story of the 31-year-old junior trader at Societe Generale, one of France's largest banks. He bet nearly $75 billion of the bank's money, on an unhedged basis, that European and German stock indexes would rise. They did for a while, but, when they declined and payments were called for, the bank discovered the unauthorized trades. In the end, this one junior trader's bad bets will cost his bank the stupefying sum of $7.2 billion.
Questions: How could he have bet so much without senior management apparently knowing? How could his superiors fail to monitor properly the sophisticated trading techniques and the computerized analyses that underscored the bets? It is no wonder that the president of France described global finance as out of control.
THESE FAILURES are shared by many U.S. investment and commercial banks and compounded by the incredible leverage by which these institutions borrowed, often 80 percent to 90 percent of every dollar they invested. Merrill Lynch held subprime mortgages exceeding the net worth of the firm. Morgan Stanley lost $3.7 billion on a single trade--talk about risk assessment. Citigroup held $80 billion of subprime mortgages off its balance sheet in a so-called Structured Investment Vehicle (SIV)--in addition to the $43 billion of subprime paper on its balance sheet.
These and other banks invested heavily in all this paper because big profits come from borrowing inexpensively from banks and depositors in the short term and reaping higher returns from longer-term securities like subprime investments. Nice. But, just as profits are magnified by leverage, so are losses. If the price of the longer term securities grew by 5 percent when they were financed to the tune of 90 percent credit, the result was a 50 percent return on the equity. But, if the prices fall by 5 percent, there's a loss ten times greater in the value of the equity, or 50 percent. In many cases, the entire equity investment was lost as the drop in prices exceeded 10 percent. The way up is also the way down.
Compounding the mess was the fact that this credit bubble depended primarily on another bubble--the one in housing. The assumption had been that house prices would continue to rise as they had for the six years prior to 2007, enabling overextended borrowers to refinance the growing equity value in their homes. This was a bubble waiting to burst. Many risks were overlooked. Many of the borrowers had nominal equity on their homes, if any at all. Over 45 percent of recent home purchases were estimated to have less than 5 percent equity invested, without the income or net worth to support these mortgages. In one survey of borrowers who weren't required to provide documentation to their lender, 60 percent of them indicated they had exaggerated their income by 50 percent or more.
What was overlooked was that soaring house prices had caused the median priced house to become unaffordable for the vast majority of home buyers. But, when prices began to fall in 2007, mortgagees went into default. Bad enough--it was the first time house prices had fallen year over year in 40 years. Then the defaulters, like falling dominoes, took down with them the institutions that had invested in the subprime market by way of the bond-like securities they'd been bundled into (called collateralized debt obligations, or CDOs). The CDOs had been created on Wall Street in such a way as to make them look almost risk- free, and ratings agencies rushed to slap their shiniest seal of approval on them. The problem was that this bit of alchemy was no more successful than previous efforts. The CDOs were, at heart, still composed of incredibly risky assets--bits and pieces of subprime mortgages--and, when the subprime market tanked, they did, too.
The risk in these securities was supposed to have been reduced and dispersed by a variety of bond insurance mechanisms. But the rising tide of defaults in CDOs and corporate bonds has imposed heavy burdens on the insurers. A good chunk of the trillions they guaranteed is now worth much less than face value. If the insurer can't afford to make up these losses or goes bust, the "original" holders of the CDOs will be left holding the bag.
Alas, the bond insurers look pretty shaky themselves these days, as so many of the risks they were insuring against--e.g., steep declines in the value of a mortgage-backed security--have come to pass all at once. It's a little like being an auto insurer during a massive earthquake, when every car for miles around gets totaled all at once.
One reason the CDOs are cratering so abruptly is that their pricing was based on over-optimistic computer-based evaluation models or on untested historical patterns--especially during periods of acute market distress. They proved that computers can make fast, accurate mistakes: garbage in, garbage out. Even worse, the rating agencies too often relied on the information provided by the companies issuing these new securities. Now it is clear that this was a blunder recognized even by the rating companies themselves, as the president of Moody's rating service recently acknowledged.
Banks have had to take back tens of billions of dollars of lending onto their balance sheets--bonds that are declining in value, either in response to market expectations of more mortgage defaults as housing prices continue to decline, or because the insurers that once backed the bonds are being down- rated or going belly-up. (These bonds enjoyed the credit rating of the companies that insured them; when the insurer melts down, so do the bonds.)
Quite simply, a lot of smart people took a lot of foolish risks, many of them on securities that they didn't understand. The result has been a bursting of the credit bubble and a dramatic tightening of credit in the financial system.
NOBODY RUNS FASTER than a banker gripped by fear. Banks are calling in loans or boosting the amount of collateral required to secure financing and raising interest rates. Even inter-bank lending, the core of the financial system, has been hobbled; banks themselves, in some cases, have lost confidence in the finances of other banks. So, today, the credit system has been virtually frozen. Lending across the economy is plummeting, with the central banks almost powerless to control this contraction. Everybody fears more skeletons will emerge from the banks' closets.
Now comes the Federal Reserve cavalry providing both liquidity and dramatically lower interest rates. The problem is that lower interest rates promoted by the Federal Reserve Bank cannot fully counter the contraction created by these large losses, which force banks to reduce loans by a multiple of those losses to maintain their capital ratio standards. Lenders aren't particularly inclined to lend when credit markets are in turmoil. Many companies, especially small and mid-sized companies, will now find it much harder to borrow the money they need to fuel their businesses.
These ailments won't fade overnight. When other countries have experienced similar banking crises, it has taken an average of at least two years for growth to return to normal trend lines. It is hard to see how the U.S. economy will bounce back any more quickly.
The crisis has prompted the president and Congress to agree to a package of stimulants--a package that does next to nothing. What is a $150 billion stimulus compared to the trillions of dollars of reduced credit? It is like battling a pandemic by distributing cups of tea. The tax rebates won't be distributed until the summer and then are more likely to be used to pay off debt than spent in the marketplace. The additional depreciation allowances in the bill will help only at the margins, since lack of demand is the issue, not lack of capacity. Businesses won't develop more capacity until they know their customers are capable of purchasing their products.
The December unemployment rate hit 5 percent, a chilling harbinger, and January also witnessed a contraction in service sector employment. Now some 23 states are estimated to be in a recession, and seven more are on the verge of one. Quite simply, this financial crisis is the worst since the panic that led to the Great Depression. No one knows where the bottom lies.
THE FIRST pressing issue--and there is no time to lose--is to get more equity into the bond insurers before the rating agencies downgrade them or they go bust, which would dramatically reduce the value of security holdings they have insured. The prime official responsibility for swiftly initiating repairs falls on state insurance regulators. The New York state insurance superintendent, Eric Dinallo, has led the way in asking banks and big investors like Warren Buffett to inject fresh equity or start new accredited insurance companies. But, clearly, the crisis demands a national policy and the Fed's involvement.
A second pressing issue is the lack of confidence in the financial system. The Federal Reserve and Congress will have to increase scrutiny of financial industry activities (like default swaps) that migrated outside of normal regulatory review. Particular attention should be paid to the rating agencies, which have literally subsumed the Federal Reserve's role in controlling lending capacity by lending their imprimatur to securitized obligations.
What are the lessons to be gleaned? Remarkably, the largest and most conservative institutions have suffered the most--Citigroup, Morgan Stanley, UBS, Merrill Lynch, and Bank of China. By contrast, hedge funds, smaller and generally more highly leveraged, have escaped with fewer bruises. The hedge funds evinced greater flexibility and more easily cut their losses and redeployed their capital. Of course, there is a danger: The hedge funds reap vast rewards for winning bets; but, if the bets go wrong, they do not suffer the losses. This skewed incentive structure requires repair. But, in the meantime, it would seem that the banks and the regulators should carefully study how the hedge funds eluded damage.
Another lesson is the inadequacy of the regulators. None of the systematic protections have helped in this current crisis. It will be critical, therefore, to see how the presidential candidates respond to these complicated and difficult issues. It again highlights that our perilous times require expert knowledge and managerial abilities in addition to uplifting rhetoric.
By Mortimer B. Zuckerman; Mortimer B. Zuckerman is the editor-in-chief of U.S. News and World Report. This article originally ran in the February 27, 2008, issue of the magazine.