Did last week mark the beginning of the end of the credit crunch, or merely
the end of the beginning? The answer depends on another question, which was
much in the news over the weekend: will the Bank of England and the Federal
Reserve start lending against mortgages, essentially without penalty and
without limit, as the European Central Bank has done since last year? This
may seem an esoteric technical question, but it will determine whether the
credit crunch can be resolved merely by tweaking the traditional techniques
of central banking, or whether vast sums of public money will be required.
And the answer to this, in turn, depends on another even more
obscure-sounding debate: has the “liquidity crisis” that started last August
in the US mortgage market degenerated into a “solvency crisis” for the
global banking system as a whole?
The relationship between liquidity and solvency has become so important that a
brief recap is required. Liquidity is the ability of a bank or business to
convert its assets into ready cash. Solvency is the ability to pay off or
“dissolve” debts. This seemingly semantic distinction is important because a
liquidity crisis can always be resolved, at least in principle, by central
banks buying long-term assets, such as bonds and mortgages, from the banking
system in exchange for cash. This process does not involve any public
subsidies, because the central bank merely swaps £1million in cash for
£1million-worth of bonds. An insolvency, by contrast, forces creditors to
accept a permanent loss of economic value or for some third party, such as
the government, to pay a subsidy so that the insolvent business can settle
its debts. Either way, there is a permanent loss of economic value.
Deciding who should bear this sacrifice involves serious political and moral
dilemmas.
Most economic commentators are firmly convinced that last year's sub-prime
liquidity problem has become a much more serious solvency crisis. In my
view, the past few weeks' dramatic events suggest the opposite conclusion: a
localised solvency crisis in US housing finance has been transformed into a
global liquidity problem. This problem is worrying because of its global
nature, but it can be addressed fairly readily by central banks.
The evidence for this reassuring interpretation lies, ironically, in the
failure of Bear Stearns. Bear Stearns did not collapse, as it might have
done - and perhaps should have done - last August because the sub-prime
mortgages that it did so much to invent and promote became worthless. It
collapsed because of the plunging market value of ultra-safe assets, such as
the bonds issued by Fannie Mae and Freddie Mac, the US government-sponsored
enterprises (GSEs). These triple-A bonds have, until recently, been treated
as risk-free assets almost interchangeable with US government obligations.
Similarly, Peloton, Carlyle Capital and several other respected hedge funds
were undone by their ultra-safe asset holdings, not by their speculations in
risky sub-prime bonds.
These hedge funds used preposterous amounts of leverage to buy triple-A bond
portfolios, which offered slightly higher interest rates than the cheap
money they could borrow in the markets for short periods ranging from 24
hours to three months. When banks became less willing to roll over the
short-term loans taken out by these hedge funds, they were forced to dump
their triple-A bonds on to unreceptive markets, thereby pushing down their
prices even though there had been no increase in the underlying probability
of these bonds ever defaulting. Although the GSE bond prices fell by only a
few percentage points, the hedge funds' leverage multiplied their losses and
they quickly went bust. These bankruptcies caused even more GSE bonds to be
dumped on the markets and triggered a further slide in their prices. But
Bear was among the world's largest holders of GSE assets - and used them as
collateral to back up its own leveraged obligations to other banks. With the
market no longer willing to accept the unimpeachable value of Bear's
triple-A collateral, the firm exhausted its capital by last weekend.
In other words, the latest phase of the credit crisis had nothing to do with
escalating losses on sub-prime mortgages or other risky loans.
Indeed, Standard & Poors reported just before the Bear collapse that US
banks had recognised most of their sub-prime losses - and this was supported
by the modest first-quarter writedowns reported a few days later by leading
US investment banks. The latest crisis, far from being caused by the banks'
dodgy lending, was actually triggered by the fact that their highest-quality
assets suddenly became impossible to sell in the markets, even though their
default risks have not gone up at all.
The probability of the American GSEs defaulting remains essentially zero, as
it has always been. If anything, the willingness of the US Government to
stand behind these enterprises is even higher today than it was before the
financial crisis. The market value of these bonds has fallen simply because
they have turned out to be less liquid assets than previously believed - and
liquidity has been recognised as a much more important and valuable
characteristic than investors suspected until a few weeks ago.
Until last month, it was still widely assumed that the danger of illiquidity
affected only inherently risky assets, such as sub-prime mortgages, complex
derivatives and leveraged loans. But this assumption completely changed when
the US bond insurers started to be downgraded in January. Suddenly,
ultra-safe municipal bond prices plunged to levels normally associated with
the riskiest junk bonds. This was not because the Port Authority of New York
or the California Water Board suddenly looked like defaulting. It was simply
because municipal bonds became illiquid as investors were forced by
regulations to dump them into a market with no bids.
After the municipal meltdown, forced sellers of top-quality mortgages, and
even of government-backed GSE bonds, suddenly could find no buyers. It was
this disappearance of liquidity - not a growing risk of default by borrowers
in the non-financial economy - that caused the collapse of Bear Stearns.
By last week, the liquidity crisis had spread even to assets whose default
risk was literally zero. A widely quoted story on Bloomberg read: “The risk
of losses on US Treasury notes exceeded German bunds for the first time
ever, amid investor concern the sub-prime mortgage crisis is sapping govern-
ment reserves.” The evidence cited was a sale of credit-default swap (CDS)
insurance on US Treasuries, which implied a default probability of 0.16
percentage points, as against 0.15 points on German bonds. But what did
these “probabilities” actually show? After all, Washington can always print
the money with which it pays for its bonds - and, like all governments,
invariably does so. Moreover, in the vanishingly improbable event that the
US Treasury really did decide to stop printing dollars, would the
underwriters of CDS insurance still be in business and pay up? What court
would enforce a private CDS deal if contracts with the US Treasury were no
longer in force? And what currency would such a judgement be paid in, since
US dollars would no longer exist?
This extreme example illustrated a market reaching reductio ad absurdum.
Prices had become completely detached from the risks they were supposed to
reflect. Instead of measuring default risks, credit-market prices were
becoming a pure measure of liquidity. Traders were pricing assets purely on
their value as emergency collateral for raising cash, not as a source of
prospective profits and cashflows.
This liquidity distortion cannot be tolerated much longer, since it destroys
the main functions of financial markets - to send signals about potential
profits and to create long-term stores of value. Luckily, liquidity is a
quality that central banks can create at zero cost. All they have to do is
lend against the vast quantities of high-quality, but illiquid, assets held
by financial institutions - without limit and without penalty. The time has
come to enact the famous injunction of Walter Bagehot, the father of modern
central banking: “Lend freely, boldly, and so that the public may feel you
mean to go on.”
anatole.kaletsky@thetimes.co.uk
