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VIDEOThe Global Debt Crisis in Nine Slides
By
Peter Atwater
Feb 02, 2010 8:15 am
The more time we spend blaming it on the earliest failures, the less likely we'll be able to address what's yet to come.
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Remember that? That's how the media first portrayed our current financial crisis. But in announcing the “Volcker Rule," President Obama suggested that the root cause of the financial crisis was “proprietary trading.”
So who's correct? Neither. What I believe both groups fail to understand is the fundamental difference between cause and effect.
For over a year, when invited to discuss the financial crisis, I've used a series of simple slides to explain the progression of events both from a historical perspective as well as what I see ahead. Admittedly, my slides probably oversimplify things. But as a kid, my dad always said, if you can’t put it on a 3 by 5 filing card, you're making it too complicated.
But given all of the time being spent in Washington and elsewhere trying to lay blame, let me offer a different, albeit humble, take on the crisis.
Of course it did.
Measured on basic leverage and income quality, subprime borrowers were the worst. (And there's another reason subprime borrowers started to default first: They were also the last to the party. And there's a “LIFO” rule to credit. Over the course of a credit cycle, underwriting standards naturally deteriorate, so it makes sense that the “Last In” would be the “First Out.")
But what the regulators and most market participants missed was that the same quality characteristics of subprime borrowers were present elsewhere in the financial system.
Measured on inherent asset quality as well as capital structure quality, it should have been no surprise that the first financial services firms to be affected would be non-deposit-taking entities closest to mortgage lending: Countrywide, Lehman, and Bear Stearns. And given the ambiguous support arrangement between the Federal Government and the Agencies, along with truly excessive leverage, Fannie Mae (FNM) and Freddie Mac (FRE) met the same criteria.
But there was another factor at play, at least for Lehman and Bear Stearns, and that was mark-to-market accounting. What few grasped going into this crisis, was the speed at which mark-to-market accounting would play havoc on capital.
Generally speaking, there are two types of financial assets -- loans and securities. Loans, typically held by banks, are accounted for using accrual accounting (essentially the holder of the loan reviews the portfolio and estimates losses and accrues for those losses by establishing reserves).
Securities, typically held by brokers and investment banks, are most often accounted for using mark-to-market accounting, where every day, the holder must adjust the price up or down depending on where the specific (or a similar) security is trading in the market.
In rapidly falling markets, like we saw in 2008, mark-to-market accounting accelerates the speed at which financial services firms recognize loss. Conversely, in rapidly rising markets, like we saw after early March 2009, mark-to-market accounting accelerates the speed at which firms recognize gains.
Over the past 30 years, with the dramatic rise in “securitized” assets, a significant portion of total global financial assets shifted from loan accounting to mark-to-market accounting. And I think it's fair to say that, globally, banking regulators failed to see how this change reduced the “response time” from months to days, if not hours. Further, the elimination of the securitization markets during the crisis exacerbated the capital and liquidity demands on the banks, as loan assets which would otherwise have been sold or securitized were held in loan portfolios.
It's here that I disagree with the Obama Administration on proprietary trading. If one were to create a chart of specific banking activities such as the ones that I've presented for the mortgage borrowers and financial services firms above, one would put prop trading squarely in the lower left red box. But the “cause," as it were, wasn't the activity itself so much as the failure of both management and the regulators to understand the underlying asset quality, leverage, and funding (not to mention accounting). Having said that, I suspect that with appropriate capital and risk management, regulators, managers, and shareholders would all quickly conclude that the returns on proprietary trading are insufficient.
What I think is truly remarkable about this crisis, is how my simple analysis works on a global basis as well.
Admittedly, I'm no expert on government finances -- and how best to calculate public sector leverage and income quality -- but I think it's fair to say that having “failed” first, Iceland belongs in the red box. And Iceland, too, had the same characteristic of a subprime borrower, only exacerbated by “hot money” foreign deposits.
But fast-forward, to see what's happened over time, as the economy in the US and elsewhere has slowed.
So given this simple framework across mortgage borrowers, financial services firms and countries, let’s fast forward to see what's happened over time as the economy in the US and elsewhere slowed.
In the mortgage space, it should come as no surprise that Alt-A borrowers would begin to fail next. Whether for income or liquidity reasons, they were already in a weakened condition.
And we've seen the same pattern of failure among financial services firms.
Here I'd note that I've split Merrill Lynch (BAC), AIG (AIG) and CIT (CIT) from Wachovia, Wamu and IndyMac based on the latter three’s status as bank holding companies and their deposit-taking activity. But I think it's worth highlighting the role that mark-to-market accounting also played in the sequence of firm failure.
For what it’s worth, I believe that going into this crisis, both regulators and managers failed to grasp the systemic toxicity that results from a combination of non-deposit funding and mark-to-market accounting. And I think it's woefully premature to assume that this risk has been adequately addressed.
Again, I'm not an expert on government entities and my positioning of specific countries in the yellow boxes may be incorrect. Further, others may feel that more/different names should be included, such as Dubai, Portugal, Italy, etc. Hopefully, though you get the message -- the characteristics and thus the progression of default are similar across borrower types.
Here's where it gets interesting, at least to me.
At the risk of a gross generalization, I'd note that for most consumer (if not commercial) credit, it's less the depth of a recession that matters than it is the length of the recession. (And as an analogy, I'd encourage you to consider this: It's not much harder to hold your breath for a minute whether you are one foot underwater versus five feet underwater; but it's a lot harder to holder your breath for five minutes than it is for one minute, no matter how deep you are. Further, despite appearances, you only know who's really in shape after you see everyone in the pool.)
Even so, with 10% plus unemployment, we're seeing a dramatic increase in delinquency and default rates among “prime” mortgage borrowers. And I'd offer that it's the deterioration in the credit quality of prime mortgage borrowers, due to our high unemployment levels, that was behind many of the Obama Administration’s modification programs.
But if the Obama Administration’s focus on loan modifications was being directed at “temporarily” impaired prime mortgage borrowers, I think the Bush Administration’s focus on TARP was aimed at what it saw as “temporarily” impaired financial services firms.
But please appreciate that the longer we experience 10%-plus unemployment, the more credit defaults we'll experience and the more likely it is that the credit quality of our “prime” banks will deteriorate.
Which brings me to my final slide.
To date, the financial markets have taken great comfort in the ability of governments around the world to provide unprecedented fiscal and monetary stimulus. But given sovereign outlays to date, we now have several historically “green” countries also under stress.
While it's understandably tempting to attribute the cause of this crisis to a single, identifiable factor, be it subprime mortgages or proprietary trading, I'm not sure it's very useful given the similarities across borrower types (and for what it’s worth, I think one could easily prepare similar slides for corporate credits, commercial real estate, as well as municipal finance. For example, note the failure of Stuyvesant Town this week, arguably by both terms and timing, the subprime of the commercial mortgage sector.)
But that's truly the problem. The fact that the pattern is so easily replicated I think also makes it apparent that we're in the midst of a global credit crisis in which the debt excess cuts across all categories and geographies.And, unfortunately, all we have truly seen to date are the failures of those borrowers in the red and yellow boxes. The longer this crisis continues, the more certain it is that substantial losses will arise from the green boxes.
Finally, the longer this crisis continues, the more financially difficult it will be for those who have already come to the rescue of others to help.
No positions in stocks mentioned.
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