Some of you might remember back to the stock market crash of October 1987, when major indices fell about 25% in one day. There was a lot of finger pointing at the time about the cause, but I remember a number of people saying that a major mutual fund company decided to unload a lot of stocks quickly. That crash of 1987 happened and reversed quickly, partly because stock markets are so big and liquid. But what about other markets, such as high-yield and distressed bonds.
New attention is being drawn to the fact that a few large mutual fund companies control major positions in some asset classes and even in the bonds of some companies. There are several potential concerns. One is that all this mutual fund buying gives a false picture of how liquid and efficient the market is. Another concern is that if these funds suffer large redemptions they’ll have to sell the bonds quickly and at whatever price they can. It could be like the fall of 2008 again. Read the linked article for more.
The chief risk officer of Goldman Sachs, Craig W. Broderick, warned at the I.M.F. meetings last week that the asset management firms that now hold the bulk of these bonds had not yet been tested in terms of how they would react to a market shock.
“Now there is plenty of liquidity,” Mr. Broderick said. “But when things are different, the alternative providers will not be there.”
The term of art for this scenario is a liquidity mismatch, with some going so far as to call it a systemic liquidity mismatch. If, for example, there is a sustained emerging-market crisis and a fund wants to liquidate these bonds to meet redemption demands, the manager will be required to provide cash immediately even though it may take several days to sell the securities in question.
The big stock slide Monday generated a lot of discussion about its causes, especially since the market indices seemed solid the first part of the day. I think a big reason investors are concerned is the impasse among policymakers in Europe, especially the monetary policy of the European Central Bank. Take a look at this Bloomberg.com article. It details the back and forth between ECB President Mario Draghi and German Finance Minister Jens Weidmann. I suspect Draghi has the votes to do what he wants. The questions are how long it will take and how will Germany react? Will it consider leaving the European Union if it doesn’t continue to get its way?
“There’s an enormous conflict within the Governing Council on what the ECB should do,” said Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt. “Clearly, it’s Draghi against Weidmann once again. In the end, Draghi will get his way and we will see quantitative easing next year.”
The ECB is swelling its balance sheet as it seeks to revive inflation of 0.3 percent, the lowest in almost five years. By buying private-sector assets, as it plans to do from this month, or continuing to accept collateral from banks in return for cheap loans, it is pushing liquidity into the economy. Still unresolved is if it will ultimately buy sovereign debt, a taboo subject in Germany where politicians worry it amounts to financing governments and removing pressure on them to act.
I’ve pointed out recently that the European economy is nearing a turning point. Actions of the last few years arrested the downward spiral. But the economy is losing momentum and is close to entering a new deflationary depression spiral. Major policy changes are needed. But European policymakers don’t seem able or willing to do what needs to be done. Here’s the latest summary of where things stand.
RBS estimates that the inflation rate has already dropped to below 0.1pc in the eurozone if one-off tax rises and fees are stripped out, and this measure may turn negative in October. “Deflation is already knocking on the door. We think it could happen as soon as next month given the latest fall in food prices,” said Mr Roberts.
“We are reaching the end game in Europe. If they don’t launch real QE and start reflation by the end of the year or soon after, the consequences are too awful to contemplate,” he said.
Recently there’s been a lot of discussion about the financial crisis of 2008. Earlier this week The New York Times published a report stating that the government probably could have bailed out Lehman Brothers if it wanted to. I linked to that report previously. This seems to have generated a lot of second-guessing and third-guessing of the second-guessers. Here’s an essay arguing that in the long run it was a good thing that Lehman Brothers went bankrupt. I don’t find this compelling, primarily because it says several times that the Dodd-Frank financial regulation law wouldn’t have passed without the crisis, and that the law is a good thing. I don’t see much good in Dodd-Frank.
Here’s an interesting essay by Andrew Ross Sorkin asserting that people shouldn’t be mad that the bailout of AIG actually was a bailout of Wall Street, because that’s what was intended. No one should be surprised that saving the rest of Wall Street was the reason for bailing out AIG or believe that the government was deceptive about it. I find that commentary refreshing, and I think that is accurate. My concern always has been that the government confused saving the system with saving the individual players and firms in the system. Bailouts could have been structured and managed so that the system didn’t collapse but people who helped cause the chaos didn’t profit from it.
The government sought to save A.I.G. for only one reason: because it was “systemically important,” which is not-so-hard-to-decipher code for a company whose failure would have had a ripple effect on large swaths of the industry — in this case, dozens of banks. To pretend that the rescue of A.I.G. was anything but an effort to make sure the rest of the industry didn’t go under is to misunderstand history. The entire point of the A.I.G. bailout was to bail out Wall Street and reinstall confidence in the system so that it didn’t collapse under even more uncertainty.
The government never sought to couch A.I.G.’s lifeline as a way to push money into the hands of Goldman Sachs, Deutsche Bank, Société Générale and the dozens of other banks around the world that were the beneficiaries. That idea was never going to win a popularity contest. But that was the effect of the assistance to A.I.G. And that was the point.
The sudden bankruptcy of Lehman Brothers in 2008 turned a difficult situation into a deep global financial crisis. For years, government officials involved in the process at the top levels said that they had no legal authority to bail out the firm, as it did for others before and after the Lehman bankruptcy. The firm’s assets were too highly leveraged to provide a loan or other assistance.
But a new report in The New York Times provides new, anonymous sources that claim that wasn’t the case. They say the government lawyers never said a bailout wasn’t allowed and also that a team of analysts at the New York Federal Reserve had concluded that the firm had enough equity to qualify for a bailout. But they say they never presented their information to the top decision makers.
Whether the Fed should have tried to save Lehman is still a subject of heated debate. And it is unclear whether the firm could have been rescued at all.
What happened that September was the culmination of circumstances reaching back years — of ordinary people too eager to borrow, of banks too eager to lend and of Wall Street financial engineers reaping multimillion-dollar bonuses. Even so, saving Lehman from complete collapse might have shielded the economy from what turned out to be a crippling blow. And as the subsequent rescue of A.I.G., the insurance giant, demonstrated, a rescue could have included substantial protections for taxpayers.
As the financial crisis developed during 2008 and into 2009, many people believed that commercial real estate would be the next shoe to drop. It never happened. There’s more than one reason why. For example, commercial mortgage lenders are more willing to renegotiate and revise than residential mortgage lenders. This study says another reason is that real estate investment trusts have a strong presence in commercial real estate and provided a stabilizing influence. They prevented speculation in the boom period and avoided panic in the bad times.
The proof of the hypothesis, the researchers say, is that overshoots and undershoots of construction in the U.S. office building market were more moderate at times when REITs had a bigger market share. They presume that the rest of the market pays more attention to the REITs at times when their market share is bigger. To zero in on the impact of REITs’ market share, they held constant two other factors that might affect office building construction, namely the prices of buildings and the cost of construction. Similar effects were found in other commercial real estate sectors in the U.S., as well as with office buildings in Japan.
One of the hardest things about giving people sensible financial advice, especially investment advice, is competing with the story tellers and prediction experts. They’re very good at promotion and very good about pulling together a lot of facts and theory that support their extreme predictions, without addressing anything that doesn’t support their theories. This article does a good job of dissecting the predictions and failures of some of the prominent doom and gloom forecasters of recent years. While these people can be entertaining, don’t get caught in their emotional currents.
It draws viewers to TV, eyeballs to websites and buyers to books from “Crisis Investing,” published in 1980, to “Surviving the Great Depression of 1990” to “The Collapse of the Dollar and How to Profit from It” (2008).
The financial crisis and Great Recession created a bull market in doom and gloom. But nearly six years after Lehman Brothers’ collapse, the worst hasn’t happened — unless you consider a 180% advance in the S&P 500 Index a disaster. Which it was, to those who avoided U.S. stocks because they believed the doom-and-gloomers.
So, now, enough time has passed to label certain outrageous forecasts as just plain wrong and to call out the people who made them.
Former Treasury Secretary Tim Geithner has had his book about the financial crisis published. I haven’t read the book but have read a number of reviews. It seems clear that he doesn’t answer the key questions about why regulators failed to see the crisis coming and of course doesn’t address the regulators’ role in creating the crisis and making it worse. If the reviews accurately reflect the book, it does confirm my long time view of Geithner. He’s a good administrator. He could handle almost any job in good, smooth times. But he doesn’t look forward and certainly isn’t going to do anything to innovate or rock the boat. I like this review, which also links to other review.
When I left Treasury at the end of the Clinton administration, my colleagues put together tongue-in-cheek recommendations for my next job; for instance, Rubin suggested I could be Larry’s biographer. Greenspan proposed “first assistant to the deputy to the managing director of the Asian Monetary Fund,” his wry way of celebrating its nonexistence.
A major cause of the financial crisis was the unregulated nature of private derivatives. These are futures and options contracts and other contracts that are traded off exchanges. They are deals between two or more parties, usually financial firms. Firms used these to increase their leverage and make investments or bets on a range of financial assets and outcomes. It’s no secret any longer that Brooksley Borne, then head of the Commodities Futures Trading Commission, wanted to regulate these contracts in 1998 but her efforts were rebuffed by Alan Greenspan, Robert Rubin, Arthur Levitt, and Larry Summers.
What was secret until recently is exactly what happened in the key meeting between those four. Now, at least a version of the meeting is public. A set of anonymous handwritten notes were released from the Clinton Library as part of a series of recent document releases. Most media ignored them, but Bloomberg BusinessWeek has a detailed analysis of them.
Undaunted by the bruising debate, Born went ahead on May 7 with the concept release, stressing that it “does not in any way alter the current status of any instrument or transaction.” Greenspan, Rubin, and Levitt issued a statement the same day expressing “grave concerns” about the CFTC’s release. That helped persuade Congress to block the CFTC from changing its regulation of swaps.
Born resigned in June 1999. On Dec. 21, 2000, Clinton signed the Commodity Futures Modernization Act of 2000, which formalized the exemption of most over-the-counter derivatives from regulation as either futures or securities. Regulators were thus only dimly aware of the explosive growth in new products such as credit default swaps, which helped pump up the housing bubble and in 2008 brought down American International Group, then the world’s largest insurer. Interviewed in 2010, Clinton told ABC News that his economic team got it wrong—“and I think I was wrong to take [their advice].”
There haven’t been many headlines from Europe recently. The financial crisis seems to be in the past, and European stock markets generated nice gains the last few years. But that’s only the surface analysis. In fact, European leaders haven’t done anything except stabilize the continent at depression levels. Growth is very modest. Unemployment still is very high and generating a range of social problems. The structure of the continent’s governing structures make it difficult to enact any policies that will do more than provide stopgaps to the serious problems. Stratfor.com updates the situation.
There’s a growing consensus that the European Central Bank needs to implement something similar to the quantitative easing policies of the U.S. and U.K. The ECB isn’t allowed to buy bonds the way those two central banks have. More importantly, a German court is reviewing a case in which it could sharply restrict the powers of the ECB, making it extremely unlikely that the ECB would be able to pursue aggressive policies. If the court does rule that way, it could change public perception enough to cause another panic and crisis.
Much like the U.S. Supreme Court, upon which Germany’s highest court was partially modeled after World War II, the German Federal Constitutional Court is the final interpreter of constitutional law. Accordingly, it has the last word on the legality of any treaties, agreements or actions undertaken by Germany at the European level.
The court already has challenged German involvement in some of the more creative legal acrobatics undertaken by the European Union. These include the establishment of the EU emergency bond-buying plan known as the Outright Monetary Transactions program. In that case, the German Federal Constitutional Court proceeded with caution and referred the case to the European Court of Justice. But there are strong indications that it could be more aggressive in future cases. A rejection of government moves in a landmark case, such as one involving potential German participation in a strengthened quantitative easing program, could derail the Continent’s recovery.