Baseline Scenario: Analysis, October 13, 2008
By Peter Boone and Simon Johnson, copyright
Published weekly, The Baseline Scenario is divided into two parts: analysis (this post) and policy (a separate post). In the analysis section, we first explain how we have updated (or not) our views, based on the major developments of last week. Then, we state our overall view of how the global economy got into its current situation and where this is likely heading. Readers who remember what we said last week can just look at the updates and then go to policy). The policy section reports our current view on policies in the US and elsewhere.
Please note that we do not currently publish our upside and downside risk scenarios in detail.
The most important recent development is the – at least partial – shift in European government attitudes during the past few days. Over the weekend Europe announced a bank recapitalization program, along national lines. As we prepare to publish, key details remain vague, but it appears they are trying to provide guarantees only at the margin (for new debt, etc). Presumably this is because the total balance sheets involved are too large for the governments to take on blanket guarantees.
Each country will have a different plan and how these will mesh together remains unclear. It is also unclear why these plans were not announced with and coordinated within the G7 on Friday, the communiqué of which was vague. Exactly what the European Central Bank will do also remains unclear. And surely there are unaddressed gaps between these country-based approaches.
There will also be an end of mark-to-market accounting in Europe, which seems unfortunate. Reducing transparency is not obvious as an exit strategy in this environment.
The continental European moves follow steps by the British last week towards recapitalization. These resulted in lower credit default swap spreads for British and European banks (i.e., lower probability of default, in the market view), but LIBOR actually increased (i.e., interbank lending problems did not get better). There were some signs that international trade credit was drying up on Friday, notwithstanding these policy moves.
The main result of these measures is that we can be somewhat more confident that a major financial panic causing the downfall of many European banks will not occur soon. However, although these moves mark a substantial change, it is not clear how this changes the (downward) trajectory of the real economy or turns around equity valuations in a sustained manner. Banks still need to deleverage in a major way and government equity injections will dilute existing shareholders. It is true that there should be more confidence in being a creditor to a European bank, but markets already thought they would get bailed out by European governments, so the gain in this regard is limited.
The grim reality is that most European nations cannot truly afford to bail out their banks if a serious recession occurs. For example, the assets of Royal Bank of Scotland are similar to the UK’s entire GDP. If the UK’s recession proves deep, markets will start to question whether the UK government can afford to finance these banks. It will be tempting to either default, or let inflation rise to erode the value of liabilities. The probability of default for sovereigns in Europe has risen significantly (although it still remains low) over the past 10 days.
America follows Europe
The US is also moving towards bank recapitalization, but more slowly, and it is unclear if a comprehensive program is the top priority. It is true that the number of financial institutions in the US adds a level of complexity, and that there are various ways to treat nonbank financial institutions, each with its own drawbacks. The treatment of insurance companies remains a particularly important unclear part of the overall puzzle.
However, the US strategy also seems hung up on the original mission of the Troubled Assets Relief Program, which was to buy mortgage-backed securities (MBS). As this program is due to start in about a month, it now seems neither here nor there.
The US already has Fannie Mae and Freddie Mac buying up distressed mortgage-backed securities, to the tune of about $40bn total per month. It is not clear why this has not been scaled up faster, particularly as it is much easier to run that the not-yet-designed TARP auctions. Fannie and Freddie are capable of restructuring quite a large volume of MBS, if this were to become their top priority.
The US strategy for Morgan Stanley and Goldman Sachs remains unclear. For Morgan Stanley, a sale to foreigners (Mitsubishi UFG) with backstop from the Fed seems to be signaled, although it is not clear how this will play politically. Something similar might happen with Goldman Sachs. If those don’t work, conservatorship is still possible. This is an important event to watch: if creditors are made whole, it will provide some badly needed additional confidence in bond markets. As of Friday, Morgan Stanley’s long-dated bonds were trading at 50-60 cents on the dollar.
Once Morgan Stanley and Goldman Sachs are put to bed, there will be plenty more finance-related firms to come. The market knows that GMAC, Ford, GE and several other quasi-financial companies are at risk. Very recently, there has been a concerning rise in credit default swaps of large insurance companies: Prudential Financial now prices in a nearly 60% chance of default within five years, and other major insurance companies are at risk.
The US government was early to provide fiscal stimulus to the economy. There is now talk of additional assistance: Congressional leadership seems interested in a lame duck session, in part to put through a modest fiscal package ($100-150bn).
Outside the US and Europe
The situation around Iceland and the default of its banks seems to point the way for emerging markets that previously relied heavily on capital inflows or commodity exports. Unless a country has a sufficient balance sheet and a very large amount of reserves, there will be selective defaults and large devaluations. It is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Some countries in Eastern Europe and Latin America are clearly showing signs of risk.
The Russian situation may indicate the future path for other emerging markets. The government’s assumption is that everything will be fine because oil will be at least $60 per barrel oil as planned in their 2009 budget. Up to now, there was widespread agreement that this was a conservative assumption. But it now looks like oil could fall a lot more, and the equity prices of global oil companies are already indicating this.
Russia is perceived as having a significant potential mismatch problem between very short term liabilities and longer term assets. This is complicated further by large private sector debt in foreign currency. The government may be moving toward deciding which companies they will save. Hopefully, for the companies they do not support, it will be possible to have an orderly workout. There is a real danger that the substantial reserves will be used now, to defend the exchange rate, rather than being saved for later, when they could be more use.
It is quite evident that foreign and domestic banks are changing their strategy in Russia, going for “quality rather than growth.” This will likely be the pattern much more generally, and points clearly to a major slowdown in growth across almost all markets.
Overview (includes material from previous editions, edited partly in the light of reader comments). Readers familiar with this material should skip to the latest policy implications.
In order to figure out how to combat the current economic crisis, it is important to understand what kind of crisis we are dealing with. The conventional wisdom is that we are dealing with a housing crisis (falling housing prices) magnified by excessive leverage. But this puts the emphasis in the wrong place, and fails to grasp the key dynamics of the crisis.
More than a housing crisis …
Problems in the U.S. housing market triggered a global crisis of confidence in global financial institutions, but the housing problems themselves were not big enough to generate the current financial collapse.
America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in the value of housing would generate a paper loss of $5.75 trillion – similar to the losses observed in the 2000-2002 decline in stock prices, and not far off the losses as a share of GDP due to the 1987 stock market crash. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion long-term reduction in total consumption – a modest amount compared to US GDP of $15 trillion. The resulting decline in the US dollar, which boosts exports, and the offsetting fiscal stimulus, would probably have reduced the overall shock by at least half. We should have seen a serious impact on consumption, but, there was no reason to a priori believe we were embarking on a crisis of the current scale or entering a deep recession.
… not just too much leverage
But, conventional wisdom continues, this fall in housing prices was magnified by leverage, causing financial institutions to collapse. But this is also not a compelling argument. There is no magical point at which an institution becomes too leveraged. The range of leverage at institutions varies enormously: typical commercial banks have assets which are 10-12 times their equity, while some investment banks recently had assets that were 30 times their equity. However, to the extent investment banks offer loans secured against underlying, liquid securities, those loans are more “secure” than typical commercial bank loans.
Credit in the economy, relative to the size of incomes, has been growing over the last 50 years, and it is hard to know when exactly the US had “too much” credit. Even if we assume that credit was overextended, today’s crisis was not a foregone conclusion. There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years.
The second path is more dangerous. If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices. These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to falls in their value.
Although leverage itself did not cause the current crisis, now we can see how leverage can be calamitous: all leveraged financial systems, regardless of the level of leverage, have the ability to collapse far more sharply than prior fundamentals would deem plausible.
How a crisis of confidence spreads
We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets from Thailand to Korea to Russia to Brazil in 1997 and 1998. For countries then, read banks (or markets) today. In both sets of cases, a crisis of confidence among short-term creditors causes them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.
The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession. Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves. Their currencies fell sharply and their creditors suffered major losses.
From there, the contagion spread for no apparent reason to South Korea – which had little exposure to Southeast Asian currencies, and even participated in the IMF bailout of Thailand – and then to Russia. At the time, Russia was emerging from recession and had little exposure to Asia. However, Russia was funding deficits through short-term rouble bonds, many of which were held by foreign investors. When short-term creditors panicked, the best efforts of the government and the IMF could not prevent a devaluation (and a default on those rouble bonds). GDP fell 10% the following year, and creditors suffered in one of the largest single national defaults in history. After Russia, the story repeated itself in Brazil. In December 1998 Brazil let the currency float, leading to a sharp depreciation within one month.
In each case, creditors lost confidence that they could get their principal back and rushed to get out at the same time. In such an environment, leverage is not a necessary ingredient for a financial collapse; any institution that borrows short and lends long is vulnerable to such an attack. However, the contagion often spread despite little real economic links. The victims had one common trait: if credit were cut off they would be unable to find funding. The decision of credit markets became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.
How did we get here?
In this context, the evolution of America’s crisis seems remarkably similar to the emerging markets crisis of a decade ago.
America’s crisis started with creditors fleeing from sub-prime debt in summer 2007. Rapidly rising default rates made clear these were poor investments. Investment-grade debt – often collateralized debt obligations (CDOs) built out of sub-prime debt – faced large losses. The exodus of creditors caused mortgage finance and home building to collapse.
The second stage began with the Bear Stearns crisis in March 2008 and extended through the bailout of Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. In other words, they became like emerging market economies in 1997. And in a matter of days, despite no major news, Bear Stearns was dead.
However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole – a pattern they would follow with Fannie and Freddie. In effect, the government sent the message that creditors could safely keep their counterparty risk with large financial institutions – implicitly encouraging banks to continue lending to each other.
The third stage, beginning two weeks ago with the failure of Lehman and the “rescue” of AIG, marked a dramatic and damaging reversal of policy. Once Bear Stearns had fallen, it was natural that investors would focus on Lehman; and again, as confidence faded away, Lehman’s stock fell and its ability to borrow money evaporated. This time, however, the Fed let Lehman go bankrupt, largely wiping out creditors.
AIG was a less obvious candidate for a liquidity run. Despite large exposure to mortgage-backed securities through credit default swaps, no analysts seemed to think its solvency was truly in question. This changed almost overnight, not because of any fundamental changes, but simply because the markets decided that AIG might be at risk. As with Lehman, Treasury and the Fed sent the message that creditors would not be protected. The $85 billion loan was not only granted at the usurious rate of LIBOR plus 850 basis points but secured by AIG’s most valuable assets, leaving senior debt trading at a 40% loss.
This decisive change in policy probably reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear: RUN from all entities that might fail – even if they seem too big to fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needs access to the credit markets to survive might lose access at any time. The next targets were obvious: the previously invincible Morgan Stanley and Goldman Sachs, each with $1 trillion balance sheets and a assets-to-equity ratios of 24 and 30, respectively (in the second quarter), saw large jumps in their credit default swap rates. Citibank, with its $2 trillion balance sheet, also experienced a major fall in its share price.
As a result, creditors and uninsured depositors at all risky institutions are finding means to pull their funds – shifting deposits to Treasuries, moving prime brokerage accounts to the safest institutions (read JPMorgan), and cashing out of securities arranged with any risky institutions. The sudden rise of LIBOR (for interbank lending) matched by a fall in short-term US Treasury rates illustrates the shift of funds from banks to Treasuries. These sudden changes in liquidity invariably lead to stress: the collapse of one money market fund (traditionally seen as safe and attracting retail customers), and the pending collapse of more, sent the U.S. Treasury into crisis mode.
Like a decade ago, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates and EURIBOR rates shot up, and banks from Bradford & Bingley to Fortis were nationalized. Further afield, Russia and Brazil each saw major disruptions in their interbank markets and Hong Kong experienced a (small) bank run.
There is general fear around the world that any leveraged institution might fail. Capital and solvency don’t matter, just whether the company can survive if short-term credit is cut off or borrowing rates sharply rise. JPMorgan obviously thought Bear Stearns was not insolvent when they paid $10 per share in the fire sale; Lehman fell when it still had a reported book value per share of $27.29; and the fall of AIG seems clearly due to a liquidity run. The problem is simple: there are just too few entities with a large enough balance sheet to stop liquidity runs. Once a liquidity run succeeds, liquidation destroys a large portion of the value, and creditors lose out. Self-fulfilling collapses can dominate credit markets during these periods of extreme lack of confidence.
There is a second aspect of these collapses. When companies fall, the survivors benefit: JPMorgan obtained Bear Stearns and Washington Mutual at fire-sale prices; Bank of America hauled in Merrill Lynch; Barclays and Nomura divided Lehman’s assets; Warren Buffett negotiated a sharp deal with Goldman Sachs; Mitsubishi-UFG is doing the same with Morgan Stanley; and it looks like Wells Fargo will win the bulk of Wachovia. While the conventional wisdom views this as healthy, in reality this leads to predatory behavior by health companies. The acquirers have an incentive to wait, let a company fall, and then scoop up the assets, with the blessing of Treasury and the Fed. This is standard market behavior, without any collusion or conspiracy.
In this context, there are two critical questions. First, what happens next? And second, what can we do about it?
The events of the last few months could be setting the stage for a major global recession. In the face of uncertainty and higher credit costs, many spending and investment decisions will be put on hold. We will surely see US and European consumption decline along with housing prices. With credit default swap rates and interest rates rising around the world, companies will prefer to pay down debt and reduce spending and investment plans. State and municipal governments will see lower tax revenues and so cut spending. In the United States, we can no longer rely on exports to provide much cushion, as growth and spending around the world have been affected by the flight from credit.
There are two ways to end a crisis in confidence in credit markets. The first is to let events unfold until so much deleveraging and so many defaults have occurred that entities no longer rely on external finance. The economy then effectively operates in a “financially autonomous” manner in which non-financial firms do not need credit. This is the path most emerging markets took in 1997-1998. Shunned by the world investment community, it took many years for credit markets to regenerate confidence in their worthiness as counterparties. Today, the U.S. is still far from such a scenario.
The second is to put a large balance sheet behind each entity that appears to be at risk, making it clear to creditors that they can once again safely lend to those counterparties without risk. This should restore confidence and soften the coming economic recession.
The policy makers of the world’s financial powers have chosen the second route, as evidenced by the statements made at this weekend’s G7 and IMF meetings. However, so far they have failed to act swiftly and decisively enough to stem the panic. The original Paulson plan (to purchase mortgage-backed securities) was not enough. $700bn is a relatively small fraction of the amounts in question. More than a week after passage, many details remain unclear.
The consensus seems to be shifting toward more drastic steps, including explicit bank recapitalization (since discovered in the Paulson plan) and guarantees of bank obligations. The coming week will see the announcement of many specifics, and will reveal whether these are able to restore confidence in the credit markets.
As the wealthiest nations protect their banking sectors, damage will spread to emerging market economies. Iceland is already facing default, either by its banking sector or by its government. Capital flight to the safety of the G7 will trigger major deleveraging in overextended countries around the world. Falling commodity prices due to the coming recession will also hurt many exporting countries.
Additional decisive, well-timed measures will be needed to restore confidence, and these should be thought out and prepared in advance. See our policy proposals for details.