JPRI Occasional Paper No. 37, October 2007
vs Uncertainty: The Cause of the Current Financial
By Marshall Auerback
During a widely anticipated speech in Jackson Hole, Wyoming, at the end of August, U.S. Federal Reserve Chairman Benjamin S. Bernanke discussed the ongoing problems in both the housing and asset-backed-commercial-paper (ABCP) markets - as well as the quickly spreading global credit crunch. A large proportion of the text also discussed the sub-prime markets in the broader context of the history of securitization - the evolution of mortgage lending from deposits to the financing mechanism of securitization -- all of which ultimately pointed to the growing opacity of financial markets and the corresponding ineffectiveness of rate cuts.
Of course, Bernanke himself would not dream of making such an explicit confession of the limits of Fed policy. But the environment he describes suggests securitization run amok: the banking system has become the small cousin of a gigantic array of non-bank, credit-generating institutions. In spite of its much touted benefits, the stability of this brave new world of finance has yet to be fully stress-tested. Unlike banks, these newer credit intermediaries operate outside of the reserve system with a minimum of disclosure, regulation and transparency. Given this, the question is whether central banks are truly well equipped to deal with the new financial Frankenstein - a monster they have inadvertently helped to bring into being through lax regulation and virtually non-existent oversight.
The champions of securitization have long argued that it carries many benefits for the financial system - most notably that it disperses risk across a much wider pool of investors. But this trend also carries at least one downside; it has added to the opacity of financial markets, leading to greater uncertainty. Here, uncertainty must be distinguished from the concept of "risk", even though the two are often used interchangeably. The distinction between the two was first drawn by the economist Frank H. Knight in his seminal work, Risk, Uncertainty and Profit (Hart , Schaffner & Marx; Houghton Mifflin Company, 1921). In an essential passage, Knight noted: "Risk is present when future events occur with measurable probability" while "Uncertainty," he elaborated, "is present when the likelihood of future events is indefinite or incalculable". This distinction helps us better understand what has transpired over the past several weeks and why the problems cannot be easily mitigated through a simple manipulation of the Fed Funds rate. Ultimately, if uncertainty, as Knight defined it, is to be resolved going forward, it will likely entail a substantial re-regulation of the financial services industry to eliminate the complex, opaque "financial weapons of mass destruction" (to paraphrase Warren Buffett) now at the heart of today's credit crisis.
The Sub-prime Debacle
Bernanke himself appears to have recognized that the sub-prime debacle was coming and (unlike his predecessor) implicitly recognized the risks posed by this evolution of credit intermediation. However, the Fed Chairman, like so many others, seems to have underestimated the impact that opaque structured products combined with a shift in risk attitudes would have on financing these vehicles and the threat it could pose to the broader economy. In particular, although recognizing that this episode appears to have been triggered largely by heightened concerns about sub-prime mortgages, Bernanke nonetheless expressed some surprise that global financial losses had far exceeded even the most pessimistic projections of credit losses on those loans and that investors had become more risk averse as a result.
But to acknowledge this point begs the question: What has caused the sudden increase in risk aversion? The difficulty is clearly not a lack of general liquidity, which the central banks (with the conspicuous exception of the Bank of England) have provided freely and generally without penalty (the liquidity injections by the European Central Bank have exceeded the sums provided in the aftermath of 9/11). Some would argue that, in the case of the Fed, with its half a percentage point cut in the discount rate, provision has been too cheap and, in the case of the European Central Bank, provision has been too free. But that merely illustrates the foregoing point that the lack of liquidity per se has not been the proximate cause of the credit crunch.
Nor is this a general crisis in lending. Credit spreads have not exploded for corporate or emerging market debt. They have merely become less unreasonable. Market volatility has increased, but not to extraordinary levels - in contrast to the period following the collapse of Long Term Capital Management in 1998 (with which the current period is most often compared).
In the current episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress. "Risk" and "uncertainty" are almost always viewed as synonymous, but as Knight argued, uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separated:
The term 'risk,' as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different... the essence of [the distinction] may be stated in a few words at this point. The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. There are other ambiguities in the term 'risk' as well, which will be pointed out; but this is the most important. It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term 'uncertainty' to cases of the non-quantitive type.
It is this true uncertainty, and not risk, that forms the basis of a valid framework for understanding today's credit implosion. The key distinction in the current context is that while "risk" can to some extent be priced by financial market participants, "uncertainty" cannot. The failure to distinguish between the two concepts is one reason the seizure of the credit system has been so rapid and has caught everybody off-guard, including the Federal Reserve . Despite a cut in the Fed discount rate on August 16, investor uncertainty increased significantly; the difficulty of evaluating the risks of structured products that were opaque or had minimal pricing transparency became more evident. The entire commercial paper market stopped functioning. Why? In the words of a market economist at Lehman: "We are in a minefield. No one knows where the mines are planted and we are just trying to stumble through it". Similarly, during a recent interview with National Public Radio, Gillian Tett of the Financial Times remarked: "It is not the corpses at the surface that are scary; it is the unknown corpses below the surface that may pop up unexpectedly. Nobody knows where the bodies are buried."
However morbid, Tett's metaphor is apt: If I witness a murder and see the victim quickly buried, I can readily determine cause, liability and the extent of the damage. I can therefore assess risk and plan accordingly. A Jack the Ripper type of murderer, killing scores of anonymous prostitutes in the nether regions of London's East End, creates a far greater problem. One neither knows the source of the problem, nor the extent of liability. The resultant fear creates uncertainty, making people averse to leaving their homes; taken to an extreme, "society" ceases to exist, given that its basis lies in day-to-day social interaction.
A similar phenomenon has been evident in the credit markets, particularly the commercial paper market, where the current market panic has to do with unpriceable uncertainty rather than measurable risk. To paraphrase former Defense Secretary Donald Rumsfeld's memorable phraseology: The known known was that there were losses in sub-prime mortgages and anything related; the known unknown was that everybody knew that they did not know the full extent of the problem; the unknown unknown was that there could be other problems that we didn't know about yet . What, for example, is the extent of the liabilities of the sub-prime problem: $50 billion, $100 billion, or $200 billion? The ultimate size of these losses is very much dependent on how deep and protracted the housing recession will be and the extent of declines in house prices. If home prices were to fall more than 10% in the next year or so, the sub-prime carnage will massively expand to near prime mortgages and prime mortgages.
There is already plenty of evidence that the delinquencies are not limited to sub-prime mortgages as a number of near prime and prime lenders are now bankrupt or in trouble (AHM and Countrywide, to cite two examples). The worse the housing recession, the worse will be these now uncertain losses. They could be as large as $500 billion if the U.S. enters a recession and we have a systemic banking and financial crisis. And the contagion has spread well beyond the mortgage market. In a matter of weeks, the entire asset backed commercial paper market has become virtually defunct. North of the border, the ABCP market remains frozen, despite a restructuring rescue organized by the Canadian banks and the Caisse des Depots, in which one-to-three month commercial paper was converted into five-year floating rate notes. The restructuring clearly did not address the underlying problem of unquantifiable risk, or uncertainty.
We also have no idea of the extent of the international exposure. Nearly all of the outstanding the sub-prime securities are U.S. domiciled. Historically, U.S. mortgages have generally been perceived as among the most rock-solid of investments, so some invariably trickle out to the wider world, with Europe being a popular investor. Therefore, when the German IKB Deutsche Industriebank announced July 30 that some of its sub-prime assets were hemorrhaging value, it set off a bit of a local panic. By August 2, the German government stepped in with a bailout package to calm things, but the damage to credibility was already done. Occasional reports by funds that their sub-prime exposure was minimal went unheeded, and European investors began pulling their money out of any investment they feared might be linked in any way to U.S. sub-prime mortgages. As the panic built August 7-8, the distinction between sub-prime and prime blurred. By August 9, investors' fears had spread from the specific risks of sub-prime itself to higher-risk products in general. Crowning the fear was the August 9 announcement by French bank BNP Paribas that it was suspending trading in $2 billion of funds on suspicion that sub-prime exposure meant they were not worth their listed value.
More recently, fears have emerged that the UK's biggest banks have heavier exposure to US sub-prime mortgage exposure after Alliance & Leicester (A&L) became the second bank to reveal that it has tens of millions of pounds invested in risky asset-backed securities. Britain's sixth-largest mortgage lender recently acknowledged that it had £175 million invested in CDOs containing US sub-prime mortgages. It is understood that the bank believes that its maximum potential loss on the exposure is £85 million to £90 million. The last week of August featured yet another European bank rescue: this time a €17.3bn ($23.3bn) bail-out of Sachsen LB. This was the second bail-out in three weeks of a German bank with structured credit market exposure and has raised fresh questions about the country's banking system. The German savings banks association assumed the whole of Sachsen LB's €17.3bn credit facility to a special investment fund, or conduit, that the Landesbank in the state of Saxony had supported and managed. The conduit, called Ormond Quay, was an asset-backed commercial paper (ABCP) conduit, which borrowed in the short-term commercial paper market and invested in longer-term asset-backed credit instruments. It was supported by a credit line from Sachsen LB. The rescue was triggered when commercial paper investors refused to refinance Ormond Quay and Sachsen LB was unable to provide the credit it had pledged.
Off-Balance Sheet Entities
Nor is it comforting that more and more banks are being forced to admit to having set up "special investment vehicles" or "conduits" off-balance sheet. For example, Singapore's DBS Group said last week that it had S$2.4bn of total CDO exposure, including S$1.1bn of CDOs held by a conduit, Red Orchid Secured Assets, which has been forced to seek funding recently. Likewise, it was reported that State Street has $22bn exposure to asset-backed commercial-paper conduits, accounting for 17% of total assets. By the same token, Citigroup owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is no mention of Centauri in its 2006 annual filing with the Securities and Exchange Commission. As Axel Weber, a member of the ECB council, admitted: "The institutions most affected currently are conduits and structured investment vehicles. ... Their ability to roll these short-term commercial papers is impaired by the events in the sub-prime segment of the US housing market."
This problem is affecting the wider banking system because these vehicles are now tapping other sources of finance -- mainly liquidity lines from banks. It appears that the prospect of receiving new liquidity demands has prompted banks to rush to raise funds -- and, above all, hoard any liquidity they hold. The high demand from banks to secure liquidity, coupled with their desire not to lend out what liquidity they have, makes it virtually impossible to execute trades -- even at the official prices quoted for such borrowing. That has created some extraordinary dislocations such as the fact that the cost of borrowing three-month money in the sterling Libor markets is higher than borrowing six-month or 12-month money.
Despite perpetuating great uncertainty (of Knight's variety), it is becoming increasingly apparent that such off-balance sheet entities have become commonplace in Western banking. Such dubious exercises have served two useful purposes for banks in recent years: First, it has allowed them to boost earnings on a ROE basis, in a further example of the way the formerly sensible concept of "ROE" has been used and abused on Wall Street, and those other markets slavishly following Wall Street's practices. Second, it has, presumably, allowed banks to park asset-backed securities they could otherwise not sell in such vehicles. In this sense the banks have not disintermediated the risk to the extent that the champions of securitization have long claimed.
For all of its rock solid financial surpluses, it appears that Asia has not remained immune from the contagion either. The FT's Alphaville reported about a letter from Kyle Bass of Hayman Capital in which Bass claimed:
I recently spent some time with a senior executive in the structured product marketing group (Collateralized Debt Obligations, Collateralized Loan Obligations, Etc.) of one of the largest brokerage firms in the world. ... This individual proceeded to tell me how and why the Sub-prime Mezzanine CDO business existed. Sub-prime Mezzanine CDOs are 10-20X levered vehicles that contain only the BBB and BBB- tranches of Sub-prime debt. He told me that the "real money" (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Sub-prime debt in late 2003 and that they needed a mechanism that could enable them to "mark up" these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! .... Interestingly enough, these buyers (mainland Chinese Banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, UK banks) possess the "excess" pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the US in USD, 2) petrodollar recyclers.
These two pools of excess capital are US dollar denominated and have had a virtually insatiable demand for US dollar denominated debt...until now. They have had orders on the various desks of Wall St. to buy any US debt rated "AAA" by the rating agencies in the US. How do BBB and BBB-tranches become AAA? Through the alchemy of Mezzanine-CDOs. With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB- tranches and repackage them with a cascading cash waterfall so that the top tiers are paid out first on all the tranches - thus allowing them to be rated AAA. ... This will go down as one of the biggest financial illusions the world has EVER seen. These institutions have these investments marked at PAR or 100 cents on the dollar for the most part. Now that the underlying collateral has begun to be downgraded, it is only a matter of time (weeks, days, or maybe just hours) before the ratings agencies (or what is left of them) downgrade the actual tranches of these various CDO structures.
This is an extraordinary assertion - and one at odds with the relatively limited exposure of China to US mortgages reported in the US data (the Bank of China acknowledged it held $9.65 billion in sub-prime asset-backed securities and collateralized debt obligations, or CDOs. Industrial & Commercial Bank of China, China's biggest lender, said that its sub-prime mortgage-backed securities were valued at $1.23 billion by the end of June, accounting for only 0.3 percent of its total securities investment.). Why the discrepancy?
First, and most obviously, the US survey data is now a year out of date. It misses $400 billion in Chinese reserve growth (roughly $370 billion when adjusted for valuation effects) and an additional $63.6 billion in private Chinese debt purchases in the second half of 2006 that shows up in the Chinese balance of payments data (some of those private purchases may have been reversed in the first half of 2007). The acceleration in Chinese reserve growth over the past year coincided with an increase in China's risk appetite. The purchase of debt securities by China's banks also picked up in the course of 2006 - and a lot of these purchases were financed using funds borrowed from the PBoC through foreign exchange swaps.
China and US Mortgage Debt
As a result, China -- both the banks and the government -- probably added substantially to their holdings of US mortgage debt over the past year. This does not bode well for China, given that the underlying quality of these instruments has shown a marked deterioration in the past 12 months. A good number of these mortgages were taken out by people who likely exaggerated the extent of their net worth and assets in order to qualify for a loan to buy a home that they expected to rise in value, aided by mortgage-brokers looking for another commission. As an example, consider the case of Casey Serin, a 24-year old web designer from Sacramento, who bought seven houses in five months with US$2.2 million in debt. He lied about his income on "no document" loans. He had no deposit. In 2007, three of his houses were repossessed. The others face foreclosure. Serin's website - www. Iamfacingforeclosure.com - has become the symbol of the excesses of the sub-prime mortgage market.
In addition, as economist Brad Setser has noted, after looking at the data on the reported holders of US MBS in the middle of 2006, it is probable that the US data has not picked up the ultimate owners of a lot of MBS. Here is Setser on August 28 in a blog commentary called "Just How Large is China's Subprime Exposure":
Two stand out: the single biggest holder of MBS was the Cayman Islands ($72.4b of $340.9b total) and the Caymans, Bermuda and Jersey combine to account for about 30% of total foreign holdings. It is probable is that a lot of CDOs are legally set up as Cayman island funds, as was the case in Bear Stearns's ill-fated fund that was recently closed down. Any purchases of US debt made by these sorts of vehicles show up as purchases from the Caymans. But the CDO then sells tranches - effectively its own bonds - to investors globally, many of which have likely found their way to Europe and Asia. Those sales would not be reflected in the US data.
Another $120b of MBS were held in the UK, the Netherlands, Luxembourg, Belgium and Ireland. Some of those MBS were held by conduits set up by European firms - and US banks who prefer to show profits (and perhaps now losses) in Europe for tax reasons. But perhaps some CDOs are also managed out of these locations - all of which offer relatively favorable tax treatment for offshore investors.
China's $9.5b in recorded holdings of MBS - and Japan's $19.8b in
recorded holdings - seems a bit low. China and Japan have
large current account surpluses to invest in global markets. The
Caymans - and for that matter Europe - does not.
Pricing opacity, then, is mirrored by a lack of statistical transparency, which breeds even greater uncertainty.
Risk can be measured and priced because it depends on know distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to supposedly "once in a lifetime" extreme events that cannot be easily predicted or measured. David Viniar, CFO of Goldman Sachs, recently justified the massive - 30% plus - losses of the two Goldman Sachs hedge funds by arguing that these were unpredictable "25 standard deviation events" that should occur only once in a million years. Responding to this, John Dizard of the FT sardonically remarked: "For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here."
If anything the history of the past twenty years illustrates that these "non-standard deviation" events do occur more often than our brilliant quant theoreticians allow for in their mathematical models: the real estate bubble and bust and S&L crisis of the late 1980s; the boom and bust of the tech stocks in 2000-2001; the 1987 stock market crash; the 1998 LTCM debacle; the variety of asset bubbles that ended up into busts from Japan (1980s) to East Asia (1997-98). So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, mis-rated, mis-priced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price and you have the perfect financial storm. These events point to another one of the flaws of contemporary economic analysis noted by Knight:
Economics, or more properly theoretical economics, is the only one of the social sciences which has aspired to the distinction of an exact science. To the extent that it is an exact science it must accept the limitations as well as share the dignity thereto pertaining, and it thus becomes like physics or mathematics in being necessarily somewhat abstract and unreal. In fact it is different from physics in degree, since, though it cannot well be made so exact, yet for special reasons it secures a moderate degree of exactness only at the cost of much greater unreality... It is never possible to deal in this way with a very large proportion, numerically speaking, of the vast complexity of factors entering into a normal real situation such as we must cope with in practical life. The value of the method depends on the fact that in large groups of problem situations certain elements are common and are not merely present in each single case, but in addition are both few in number and important enough largely to dominate the situations. The laws of these few elements, therefore, enable us to reach an approximation to the law of the situation as a whole. They give us statements of what 'tends' to hold true or 'would' hold true under 'ideal' conditions, meaning merely in a situation where the numerous and variable but less important 'other things' which our laws do not take into account were entirely absent.
The Alchemy of Modern Financial Engineering
The alchemy of modern day financial engineering has largely failed to make its nature and limitations explicit and clear. As Knight recognized in a different context, the quants' models posit what would happen under "perfect competition," virtually refusing to allow that these are mere mathematical abstractions. In the words of Knight, "Much remains to be done to establish a systematic and coherent view of what is necessary to perfect competition, just how far and in what ways its conditions deviate from those of real life and what 'corrections' have accordingly to be made in applying its conclusions to actual situations. " This plea for humility would serve Wall Street's financial engineers well. All their models have "created" is a financial maelstrom that has led to uncertainty, panic, market seizure, liquidity crunches, credit seizures, systemic risk and, a likely future economic hard landing. The last two asset and credit bubbles in the US - the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s - ended up in painful recessions. The latest credit bubble - housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging - is much bigger, and its resolution is likely to be far more problematic and painful.
Bill Gross, the Chief Investment Officer of PIMCO, the world's largest bond fund manager, was recently quoted in the New York Times that "our current system of levered finance and its related structures may be critically flawed. Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment." Our system of levered finance is indeed critically flawed, but everything within it allows for the hedging of liquidity risk and that, ironically, is the source of the problem: a profusion of attempts to hedge liquidity risks via portfolio "insurance", or "structured finance" instruments, such as securitized products or derivatives.
Too many of these innovations have taken place in the shadows of increasingly opaque and unregulated financial markets: much of North America's financial system now lies outside of the official monetary system. Non-bank players have grown rapidly in recent decades and securitization of loans and mortgages has boomed. Therefore, the powers of the "lender of last resort"--a central bank--during a period of liquidity crisis are greatly diminished, which is what has caught the Fed chairman off-guard.
Today, the member commercial banks of the 12 reserve districts of the US central monetary system represent only a small portion of total credit assets (now well less than a third.) Most credit, therefore, is manufactured outside of the banking system and is not subject to fractional reserve constraints. It is only banks that have access to the credit-window of the Federal Reserve System. Meanwhile, thousands of hedge funds operate in the absence of any kind of supervision and therefore possess huge discretion over the pricing of unlisted securities. There is an increasing avoidance of corporate governance via the expansion of private equity LBOs, and a shift away from regulated exchanges to unregulated over-the-counter trading in derivative instruments. There are complex financial instruments whose correct pricing and rating is increasingly difficult, coupled with a mis-rating of these new instruments by credit rating agencies saddled with severe conflicts of interest. (Not only were the agencies vouching for the securities' credit soundness, they were being paid large fees by the issuers of the securities to do so. They were also deeply involved in setting up the structures these companies had to conform to in the first place. In fact, almost half of the revenues of Nationally Recognized Statistical Rating Organizations come from rating companies that functionally do not exist until the ratings agencies bless them.) There is a laissez faire attitude among US supervisors and regulators that allowed reckless lending to foster, long sanctioned by the Federal Reserve itself (notably under the Greenspan years). All of this creates greater uncertainty and a far greater degree of financial fragility than in years past.
If the sub-prime bust is the catalyst, the real story remains the exposure of the whole structured finance industry as a collective endeavor to disguise risky credits as safe credits under the guise of "rational" mathematical modeling, supposedly there to refine and improve the operation of the free markets. This revelation should expose the Western financial-services industry to heavy regulation of this formerly super-profitable area. Short of allowing these institutions to go bust (something we have not allowed since the 1930s), far greater regulation and transparency seems to the only way to dealing with the financial dislocation that invariably arises when uncertainty collides with opaque financial recklessness.
Marshall Auerback writes regularly for JPRI on international finance. His most recent report is JPRI Working Paper No. 111, (February 2007), China's
Dollars Versus America's Guns."