Tuesday, February 15, 2011

Crisis Economics: A Crash Course in the Future of Finance

2008 and 2009 witnessed one of the worst, if not the worst, financial crisis of the modern world. Financial markets worldwide suffer an unprecedented panic and large institutions such as Citigroup and AIG were at the verge of collapse. I remember vividly at that time where my director wanted to plough all his money into buying AIG stock at the height of the crisis but I cautioned him from doing so after listening to advise from some of my friends from the finance and banking industry. Anyway, he could have profited handsome profits if he went ahead and put all his money into AIG which he did not at the end. Well, the story is not about loss opportunity but rather illustrates the height of the panic when institutions such as AIG where its complete failure would have been unimaginable just a few years earlier suddenly found itself in such deep trouble. Such is the magnitude of the crisis where the effects of that event can still be felt now especially with the collapse of Lehman Brothers. I also have friends which have lost millions because their money is deposited in Lehman Brothers.

Many have argued that the event is a 100-year storm event and no one would have been able to see it coming. In my opinion, this is a convenient lie put forward by the reckless bankers who take risky bets in order to earn preposterous bonus. To say that no one would have been able to see it is wrong as Nouriel Roubini has cautioned about the housing bubble well ahead before the crisis. So are a host of other notable economists. The book "Crisis Economics" is a good book if one wishes to understand what happened during the 2008/2009 crisis and more importantly, to learn from past mistakes and be prepared for the next crisis, which may be even more severe than the crash of 2008/2009 and it is likely to happen in the foreseeable future, i.e. less than 10 years.


As usual, I will summarise some important points which I gather from the book as follows:

1) Financial crises generally follow the same script over and over again.

2) In the last few hundred years, many of the most destructive booms-turned-bust have gone hand in hand with financial innovation, the creation of newfangled instruments and institutions for investing in whatever is the focus of a speculative fever.

3) As is so often the case, a speculative boom and an excessive accumulation of debt stood at the center of many of these crises. Governments, corporations, individual households, or some combination thereof borrowed too much money, much of it denominated in foreign currencies. At the same time, banks and other financial institutions lent too much against collateral of shaky value. This situation was unsustainable, and eventually doubts about the viability of all those loads triggered a panic. The resulting crisis necessarily hit both excessively indebted borrowers and excessively leveraged lenders.

4) Feedback theory suggests that investors who watch prices go up will jump on the bandwagon, sending prices still higher - which, in turn, only attracts more investors, who inflate the bubble still further. Eventually, the feedback mechanism causes the prices to become untethered from any rational basis, spiraling skyward until they can go no higher. Then they crash, creating a "negative bubble", in which prices plummet precipitiously.

5) According to Minsky: An economy would become vulnerable to collapse should its various players resort to debt to finance their activities. He believed that the greater the reliance on debt and leverage, the more fragile the financial system.

6) In 1981 houshold debt in the United States was 48 percent of GDP, but by 2007 it had risen to 100 percent. The household-debt-to-disposable income ratio went from 65 percent in 1981 to a staggering 135 percent by 2008. It is interesting to compare Malaysia's household debt to GDP of 76 percent (from 47% in 2000) and household-debt-to-disposable income ratio of 140.4 percent in 2009. Are we heading towards a crash especially in the property sector?

7) A sudden aversion to risk, a sudden desire to dismantle the pyramids of leverage on which profits have until so recently depended, is the key turning point in a financial crisis. In earlier times, it was called "discredit" or "revulsion"; more recently it has been called a "Minsky moment".

8) When one country's boom goes bust, other countries that have racked up the same kind of excesses tend to collapse as well.

9) Similar crises emerge in different places with seeming synchronization because of shared weaknesses.

10) The (US) Fed, in its rush to prop up the financial system, rescued both illiquid and insolvent financial institutions. That precedent may be hard to undo and, over the long run, may lead to a collapse of market discipline, which in turn may sow the seeds of bigger bubbles and even more destructive crises.

11) Irving Fisher believed that depressions became great because of two factors: too much debt in advance of a crisis, and too much deflation in its wake.

12) Deflation increases the real value of nominal debts. Instead of getting ahead of their debts, people fell behind. Fisher called this the "great paradox" - the more people pay, the more their debts weigh them down.

13) Inflation is the debtor's friend: it effectively erodes the value of the original debt.

14) We can glimpse the liquidity trap in the gap or "spread" between interest rates paid on supersafe or otherwise solid investments and those paid on riskier investments.

15) The fiscal interventions (interventions by adopted by various countries in response to the financial crisis) certainly helped to arrest the slide toward depression, but a few words of caution are in order. For starters, fiscal policy isn't a free lunch: if a government increases spending and cuts taxes - and does so during a recession, when tax revenues decline - the budget deficit will soar. The government will have to issue more debt, which it will eventually have to pay. If it doesn't pay the debt, and its deficits grow larger every year, then it will have to entice investors to buy more debt by raising interest rates. Those higher returns will then compete with interest rates on other investments - mortgages, consumer credit, corporate bonds, and auto loans - and can drive up the cost of borrowing for everyone else, thus reducing debt-financed capital spending by firms and consumption spending by households.

16) So far the recent crisis has produced little of the creative destruction that Schumpeter saw as essential for capitalism's long-term health. Preventing this necessary adjustment via tax cuts, cash-for-clunkers incentives, and programs designed to prop up the housing market will only delay an inevitable reckoning.

17) Contrary to conventional wisdom, the biggest problem with compensation is not the amount of money involved; it's the way this compensation is structured and delivered.

18) One incentive-compatible solution would be for firms to compensate the traders who work for them with restricted shares in the firm. (Restricted shares have to be held a certain amount of time before they vest). That way, everyone would have the long-term health of the firm in mind.

19) Unlike the purchaser of an insurance contract, the purchaser of a CDS didn't have to actually own a chunk of the asset that was the subject of the bet. Worse, anyone who had placed a bet that someone would default had every incentive to make this happen. In these cases, purchasing a CDS was akin to buying homeowners' insurance on a house that you didn't actually own - and then trying to set fire to it.

20) On the role of regulators: Plato's solution was an intriguing one: the guardians - and the people generally - would be told a "noble lie", or useful myth, that the guardians were more virtuous than other people. Convinced of their own goodness, they would scorn private gain and instead look out for the welfare of the republic. The illusion of virtue would be its own reward.

21) If the United States were an emerging market, it would have long ago suffered a collapse of confidence in its debt and its currency. That it hasn't reflects the fact that the United States is still regarded as a country that raises taxes and cut spending when necessary, putting its fiscal house in order. It do so in the early 1990s after a decade of soaring deficits; there's no reason it can't do so again. Moreover, unlike many emerging economies, the United States has never defaulted on its public debt. That goes a long way toward reassuring investors. Finally, and most important, the United States borrows from abroad in its own currency. The potential depreciation of the dollar doesn't increase U.S. liabilities. Instead, that currency risk is transferred to foreign creditors.

22) If the United States keeps running large twin deficits - or worse, starts to monetize its fiscal deficit - the resulting high inflation will accelerate the decline of the U.S. dollar as a major reserve currency, with unpredictable results.

23) A bubble can grow only if investors have a source of easy credit.

24) Using the magic of leverage, growing numbers of investors build soaring towers of debt - a sure sign that a bubble is brewing.

25) The economist, Hyman Minsky once observed, "There is no possibility that we can ever set things right once and for all; instability, put to rest by one set of reforms, will, after time, emerge in a new guise". Crises cannot be abolished; like hurricanes, they can only be managed and mitigated.

26) The most likely scenario at present is a U-shaped recovery in advanced economies, featuring weak, below-trend growth for a number of years.

27) The wall of liquidity and the Fed's suppression of volatility can keep the game going a bit longer. But that means the asset bubble will only get bigger and bigger, setting the stage for a serious meltdown.

28) Investors should remain wary of gold. The recent swings in its price - up 10 percent one month, down 10 percent the next - underscore the fact that its price movements are often a function of irrational beliefs and bubbles. Holding some gold as a hedge against inflation may make some sense, particularly if governments start to monetize their debt. But holding lots of gold makes no sense, particularly given the likelihood that inflation will remain in check.

In summary, the financial crisis of 2008/2009 originates from the "creative" securitization on a massive scale. "Originate and distribute" became a vehicle for originating junk mortgages, slicing, dicing, and recombining them into toxic mortgage-backed securities, and then selling them as if they were AAA gold.  The situation is fueled by record low interest rates after September 11 and was kept too low for too long. Banks and shadow banks leveraged themselves to the hilt, loaning out money as if risk has been banished. And then, like all bubbles, it stopped growing. Priced moved sideways;  a strange sort of stasis came over the markets. Then they collapse, a few institutions at first, then many. The effects reverberate throughout the financial system. Fear and uncertainty grip the markets, and while the price of bubbly assets crumbles, the real action lies in the financial institution that provided the credit behind the bubble. Deleveraging begins, and faced with overwhelming uncertainty, investors flee towards safer, more liquid assets. The crisis reached its climax with the collapse of Lehman Brothers. I agree with Roubini and Mihm's opinion that Lehman Brothers collapse is a consequence of the crisis due to various factors highlighted by them (e.g. record low interest rates for too long, toxic mortgage-backed securities, etc.). Some other popular opinions are that the crisis could have been averted if Lehman Brothers was bailed out. I don't think so!

Anyway, I have certainly grown less optimistic especially in Malaysian markets. The recent slew of mega projects costing billions of ringgits announced by the government and some private investors is certainly not viable and the expected returns from the investment certainly do not justify the initial outlay. My guess is that at the current low interest rates with cheap financing, we have simply jumped onto the bandwagon of expecting our assets' price will rise perpetually with time. We certainly know that this is not true. We should closely monitor property prices too and on a personal note, spend within our means.

Happy Chinese New Year!

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