Thursday April 22, 2010
IPE Leiden

Agustin Mackinlay

Session 4. Financial Crisis
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Short comments on points raised in Session 3

. Interest rates & microcredit. The reality of very high interest rates unveiled (Neil MacFarquhar: "Banks Making Big Profits From Tiny Loans", The New York Times);

. Microcredit & the problem of scale. Cisco Systems (market capitalization: $155 billion) was established on a very tight budget. But founders Leonard Bosack and Sandra Lerner of Stanford University were able to mortgage their house in order to get the venture off the ground. This stands in sharp contrast to inhabitants of slums in developing economies, who cannot use their assets as collateral to get loans. They are thus forced to rely on credit from a limited number of sources, mostly friends and family.

. Judicial independence: supreme courts & precedents. One element of judicial independence is the role played by precedents as a check on arbitrary legal decisions (stare decisis is the principle according to which precedents are a formal source of law). In countries with high grades in terms of judicial independence, precedents are more important. (a) The Netherlands: “There is no stare decisis in Dutch law, as there is in common law [mostly English-speaking countries], although in practice the Supreme Court will not usually overrule its own previous decisions” (Sanne Taekama, ed. Understanding Dutch Law. Boon Juridische uitgevers, 2004); (b) The European Court of Justice: “Where a question referred to the Court for a preliminary ruling is identical to a question on which the Court has already ruled, where the answer to such question may be clearly deduced from existing case-law or where the answer to the question admits of no reasonable doubt, the Court may, after informing the court or tribunal which referred the question to it, give its decision by reasoned order in which, if appropriate, reference is made to its previous judgment or to the relevant case-law” (Hans Baade: “Stare Decisis in Civil Rights Countries: The Last Bastion”, in Peter Birks & Adrianna Pretto, eds. Themes in Comparative Law. In Honor of Bernard Rudden. Oxford: Oxford University Press, 2002); (c) Jonathan Miller: “Judicial Review and Constitutional Stability: A Sociology of the U.S. Model and Its Collapse in Argentina”, Hastings International and Comparative Law Journal, Vol. 77, No. 21, 1997 [this article discusses, among other things, the frequent changes in Argentina’s Supreme Court jurisprudence].

. On Russia’s “legal nihilism”. Olga Kudeshkina: “Tackling Russia’s Legal Nihilism”, OD Russia, 11 March 2010. See also the Hermitage Capital video.

. A new realism? NYT columnist Tom Friedman wonders whether the need for good governance means that “idealism is the new realism” (“Attention: Baby on Board”, The New York Times, April 13, 2010)

. Bolivia, lithium & the curse of raw materials. “Bolivia can become the Saudi Arabia of lithium”; half of the world’s lithium –needed to power the next generation of hybrid or electric cars– is in Bolivia. But what about the risks related to the performance of contracts? (Simon Romero: “In Bolivia, Untapped Bounty Meets Nationalism”, The New York Times, 2 February 2009)

. Venezuela & “onerous financing costs”. Oil development in the Orinoco Belt is in jeopardy: “Repeated delays in the bidding for rights to exploit the Orinoco Belt reflect investor concerns about political risk, onerous financing costs and the profitability of the projects” (Benedict Mander: “Chávez a problem for oil groups eyeing vast field”, Financial Times). Note that both Venezuela and Iran are usually the most aggressive OPEC member countries when it comes to reduce output …

. Montesquieu in Tehran: fear as the key feature of the government. Shirin Ebadi, winner of the 2003 Nobel Peace Prize, defines the Iranian regime as “ce régime de la peur”. Very interesting! This is exactly how Montesquieu defined despotic government – fear as its very essence. No wonder there is little credit available! (Josyane Savigneau: “Ce régime de la peur réduit les Iraniens au silence”, Le Monde, April 3, 2010).


Financial Crisis & Flight-to-Quality Episodes
The study of the recent financial crisis will greatly help us in our understanding of what is at stake in terms of financial diplomacy. Also, the dynamics of so-called flight-to-quality (or flight-to-safety) episodes will likely feature in the credit market exercise that I am preparing for you! Let me present the issue in two different parts. Part I deals with the specifics of the recent crisis; I trust that by 1:15 PM today you will have forgotten all about them. Part II deals with flight-to-quality episodes and credit markets. I hope will NOT forget this part any time soon!

Part I: Elements of the current financial crisis

. Lehman Brothers, a US broker-dealer, mediates (for a fee, of course) between those who supply loanable resources and those who demand credit. Imagine that the rest of us are US lower-to middle class American citizens ($12,000/year in income) with no property. Lehman Brothers sends out an army of brokers who (for a commission, of course) will offer us mortgages in pretty “generous” terms, both in terms of interest rates and in terms of collateral (100%, or even 120% of the value of the house). The contract are called sub-prime loans. Some contracts are awarded on a 2-28 basis, meaning 2 years at the known current interest rate, and 28 at a variable rate.

. Those mortgages are then collected into a bigger contract, a bond. In turn, many such bonds are bundled into a Collateral Debt Obligation (CDO), an instrument created by Lehman Brothers (for a fee, of course) for its clients. The CDO comprises 3 “tranches”. Tranche 1 absorbs all credit losses from the portfolio during the life of the CDO until they have reached 15% of the total principal. This is risky, because some defaults are to be expected. Tranche 2 absorbs all the losses in excess of 15%, while tranche 3 absorbs the rest (above 30%). Tranche 3 is less risky, because it is deemed highly unlikely that as much as 30% of the underlying bonds will default; it carries a Aaa rating, awarded by rating agencies (for a fee, of course). Thus, the pension fund or hedge fund that buys tranche 3 is supplying loanable resources to the subprime housing market through a high-quality contract made up of a bunch of not-so-good quality contracts!

. In a few years, the CDO market sees phenomenal growth: over $600 billion issued in 2007. That means a massive fee structure for many participants: mortgage brokers (commission), broker-dealers (fee for structuring CDO, up to $15 million each, depending on size), rating agencies (fee for rating the tranches), insurance companies (sellers of insurance policies covering credit risk).

. Sub-prime loans & CDOs: innovation or speculative tool? Alan Greenspan vs. Charles G. Leathers & J. Patrick Raines. Right until 2007, Alan Greenspan is decidedly optimistic about the subprime market: “By 2006, nearly 69% of [American] households owned their own home, up from 64% in 1994 and 44% in 1940. The gains were especially dramatic among Hispanics and blacks, as increasing affluence as well as government encouragement of subprime mortgage programs enabled many members of minority groups to become first-time home buyers” (NOT required reading! Alan Greenspan. The Age of Turbulence. Adventures in a New World. New York: Penguin, 2007, p. 230). The “magic” of financial innovation was such that rich people would be lending to Hispanics and blacks!

. In mid-2007 I discovered this excellent article [NOT required reading!] by Charles G. Leathers & J. Patrick Raines: “The Schumpeterian role of financial innovations in the New Economy's business cycle”, Cambridge Journal of Economics, 2004, No. 28, Vol. 5, pp. 667-681. While Mr. Greenspan reasoned in terms of Schumpeter’s ideas, Leathers & Raines went to the sources and concluded that CDOs and other such instruments were NOT “Schumpeterian” at all. The were not issued to finance innovation (remember Schumpeter’s 5 cases), but rather as instruments created by banks in order to speculate among themselves. Now, that’s what you can call a premonitory article!

. By 2007, CDO issuance had become an industry. More and more people were enticed to take on mortgages on a seemingly more attractive set of conditions. The incentives: fees & commissions! Broker-dealers like Lehman, but also Merrill Lynch and Citigroup were accumulating massive amounts of unsold CDO tranches, sometimes through critical regulatory loopholes. The so-called “bonus culture” appears to have aggravated matters, as investment banks pumped up CDOs …

. The were signs of regulatory loopholes. Lehman Brothers was able to hide as much as $50 billion in assets; these were booked off the balance sheet to avoid mandatory capital requirements against them. See also the recent fraud case filed by the Securities and Exchange Commission (SEC) against Goldman Sachs, for a CDO structure (insured by European investors who took a huge loss) whose underlying bond portfolio was allegedly selected by the same hedge fund that made a $1 billion profit on the insurance contract.

Part II: Flight-to-Quality!

This is the part of today’s session that will retain our attention. Each financial crisis has its own set of specific features, like CDOs in the most recent one. You will soon forget about CDOs. But what’s really important here is that all financial crisis appear to have an element in common: flight-to-quality episodes. And that is worth remembering! Already in his1848 Principles of Political Economy (“Of the Rate of Interest”), John Stuart Mill aptly described what happens in credit markets in all financial crisis:

[REQUIRED READING!]
Fluctuations in the rate of interest arise from variations either in the demand for loans or in the supply. The supply is liable to variation, though less so than the demand. The willingness to lend is greater than usual at the commencement of a period of speculation, and much less than usual during the revulsion which follows. In speculative times, money-lenders as well as other people are inclined to extend their business by stretching their credit; they lend more than usual (just as other classes of dealers and producers employ more than usual) of capital which does not belong to them. Accordingly, these are the times when the rate of interest is low; though for this too (as we shall hereafter see) there are other causes. During the revulsion, on the contrary, interest always rises inordinately, because, while there is a most pressing need on the part of many persons to borrow, there is a general disinclination to lend. This disinclination, when at its extreme point, is called a panic. It occurs when a succession of unexpected failures has created in the mercantile, and sometimes also in the non-mercantile public, a general distrust in each other's solvency; disposing every one not only to refuse fresh credit, except on very onerous terms, but to call in, if possible, all credit which he has already given. Deposits are withdrawn from banks; notes are returned on the issuers in exchange for specie; bankers raise their rate of discount, and withhold their customary advances; merchants refuse to renew mercantile bills.

A “general disinclination to lend”. Indeed!

Let’s look at Lehman’s case in mid-September 2008. Since late 2006, the health of the US housing market had been deteriorating steadily. As defaults started accumulating in 2007, the value of the assets held by Lehman Brothers (notably the more risky CDO tranches) rapidly fell. The extent of the damage was not clear to regulators; fee income seemed to increase, while various accounting techniques enabled the firm to disguise the true situation of its balance sheet. While lending long-term, Lehman was borrowing short-term. Its total debt level had surpassed $600 billion. Some money-market funds (companies that mediate between lenders and borrowers for short-term funds) were lending heavily to Lehman.

When Lehman declared bankruptcy on September 15, one money-market fund that had lent as much as $785 million to Lehman declared that it was unable to pay the full amount of its liabilities. It was the first time that such an event took place! Investors promptly took $40 billion out of that fund. NOW EVERY PARTICIPANT IN THE CREDIT MARKET STARTS TO FEAR ABOUT THE SOLVENCY OF EVERYBODY ELSE!!! WHO HAS LENT TO LEHMAN? WHO HAS LARGE HOLDINGS OF SUBPRIME MORTGAGE DEBT & CDOs? WHO HAS INSURED THOSE WHO HAVE LENT? ETC. ETC. ETC.

This feeling of general distrust sets in motion a flight-to-quality episode in credit markets. Let us see how that works. Imagine one Ms. De Souza, a 37-year old hospital manager in Sao Paulo, Brazil. A mother of two, she wants to send her children to a US college. She needs to very cautious about her $400.000 nest egg! She watches the Lehman news on TV; she reads the newspapers. She starts to worry. “What if my investments in loans to companies both in Brazil and the US decline in value as banks refuse to lend to private companies? What if my investments in loans to emerging market states decline in value as global economic trade and growth falls, forcing some states to default on their debt?” She makes up her mind and calls her broker in Sao Paulo, with three very precise instructions:

1. Cease all lending to entrepreneurs, wherever they are located;
2. Cease all lending to sovereign issuers from emerging markets countries
3. Invest all the available resources into loans to the US Federal government, or to the German government.

The behavior of our hypothetical Ms. De Souza is replicated worldwide. Many investors react exactly like her: in Russia, in Thailand, in the Netherlands, everywhere! Now remember the paper from Horace Brock (Session 2): INTEREST RATES CHANGE WHENEVER NEW INFORMATION ALTERS THE BEHAVIOR OF EITHER/OR THOSE WHO SUPPLY LOANABLE RESOURCES AND THOSE WHO DEMAND CREDIT. The Lehman Brothers bankruptcy IS INDEED NEW INFORMATION! Interest rates are bound to change. But how?

Let us look at two different kinds of credit markets: (a) risk-free credit markets; (b) risky credit markets.

(a) “Risk-free” credit markets. Although no loan can ever be entirely without risk, some sovereign issuers of debt are called “risk-free”. These countries feature: [1] an institutional framework that protects the performance of contracts (rule of law, stable property rights, judicial independence); [2] well-developed credit markets.

(b) Risky credit markets. They include … all the rest! We can divide issuers of risky debt into two categories; (b1) sovereign issuers, mostly emerging-market countries where the performance of contracts carries risk, and where financial markets are underdeveloped; (b2) entrepreneurs, wherever they are located (in both developed and less-developed countries). Unlike sovereign issuers, private companies are unable to impose taxes; their solvency is at risk whenever the economy goes into a prolonged recession.

Note that the definition of “risk-free” is not set in stone. The USA were very risky issuers of debt between 1776 and 1783! Nowadays, some emerging-market countries have made phenomenal progress in terms of property rights protection and credit market sophistication (Brazil, Singapore and South Korea come to mind here).

[DIAGRAMS. WE PLOT CHANGES IN THREE CREDIT MARKETS]

(a) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE ENTREPRENEURS CREDIT MARKET: THE INTEREST RATE GOES UP!

(b) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE CREDIT MARKET FOR RISKY SOVEREIGN BORROWERS: THE INTEREST RATE GOES UP!

(c) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY MORE IN THE CREDIT MARKET FOR RISK-FREE SOVEREIGN BORROWERS: THE INTEREST RATE GOES DOWN!

A FLIGHT-TO-QUALITY EPISODE OCCURS WHENENVER EVENTS (a), (b) and (c) take place.

Credit spreads

Credit spreads are important financial and economic indicators. Credit spreads are simply the difference between two interest rates, one from a risk-free credit market and the other from a risky credit market

. credit spread between entrepreneurs’ and risk-free credit markets. Example. In the USA, the so-called “junk bonds” are credit contracts issued by entrepreneurs (see here). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for entrepreneurs is 7.54% and the interest rate for US Treasury debt is 3.82%, then the credit spread is 7.54% minus 3.82% = 3.72% [Note: these rates change every day, every hour, every minute!]

. credit spread between sovereign emerging market debtors and risk-free credit markets. Example. The average interest rate paid by risky sovereign issuers in emerging markets is currently 6.19% (see). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for risky sovereign emerging markets issuers is 6.19% and the interest rate for US Treasury debt is 3.82%, then the credit spread is 6.19% minus 3.82% = 2.37% [Note: these rates change every day, every hour, every minute!]

DURING A FLIGHT-TO-QUALITY EPISODE, CREDIT SPREADS INCREASE, AS INTEREST RATES IN RISKY CREDIT MARKETS RISE, WHILE INTEREST RATES IN RISK-FREE CREDIT MARKETS DECREASES.

MORE INFORMATION COMING UP SOON...