From
Doug Noland... Want a thorough rundown of today's crisis? Read and weep...
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A Run on Wall Street Finance
The week commenced with the fanciful notion that increased purchases by the GSEs would suffice to re-liquefy the U.S. mortgage marketplace. The NYSE Financial Index proceeded to rally 7% before reality began to return Wednesday afternoon. A tumultuous week of faltering international Credit markets ended with the major global central banks injecting liquidity to the tune of $140bn, including Federal Reserve mortgage-backed securities purchases of $38bn. This afternoon it was reported that Fannie Mae sought permission for asset growth of “a moderate increase in the range of 10 percent” – a $70bn or so drop in the bucket.
The GSEs will certainly not be bailing out the global Credit system. Instead, the question has become how successful global central bankers will be in restoring confidence in a system that so has so abruptly begun coming apart at the seams. At this point, I will assume that global central bankers have come to accept that only their aggressive interventions offer the hope of a liquidity backstop sufficient to bolster fading confidence and stem a modern-day Run on “Wall Street Finance.”
The Risk Market Contagion that erupted in U.S. subprime mortgages has now fully engulfed the heart of “structured finance” – the CDO marketplace, asset-backed securities, the “repo” market, Credit derivatives, “structured products,” and even the perceived pristine “money” market fund complex. The cover story from today’s Financial Times (see above) quoted Marc Ostwald, fixed income strategist at Insinger de Beaufort: “There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas’ statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch.”
Central banks do retain significant potential firepower to buttress marketplace liquidity in the near-term. Yet the ongoing impact such interventions will have in restoring trust in market pricing, securities ratings, sophisticated model-based trading strategies, counterparty risk, general risk management capabilities and liquidity in Wall Street’s newfangled “structured” products is very much an open question. It is my view that some Crucial Financial Myths have been Thoroughly Shattered.
I have often addressed the notion of the “Moneyness of Credit” – in particular, the vital role played by what had been the prevailing Credit market perception that myriad debt instruments are both a store of nominal value (“safe”) and readily marketable (“liquid”). In general, a market’s belief that Credit is as attractive as “money” plays a decisive role in fostering Credit expansion. Over time, as the perception of moneyness is applied to expanding types and quantities of Credit instruments, a full-fledged Credit Bubble will take hold. And, as we’ve witnessed, the longer Credit excesses inflate asset prices, corporate earnings, and household incomes - the more seductive the Myth that the underlying Credit instruments are increasingly safe and liquid.
It takes years (decades?) and, importantly, the successful perseverance through at least a few close calls, for the perception of Moneyness to become fully embedded in the structure of the Credit system. Emboldened market participants eventually come to believe that that nothing can interrupt the boom. Each near crisis surmounted leads to only greater confidence in the underlying Credit system and the capacity for the authorities to sustain the boom - each period of greater excess layering more dangerous layers of risk on top of risk.
Last week I discussed the previous (unsung) hero role the GSEs played in multiple near financial crises going back to 1994. Whether they acted in concert or not, timely Fed rate cuts coupled with huge GSE market purchase operations provided an epic market support mechanism throughout a period of unprecedented Wall Street innovation and enlargement. The powerful process of expanding Moneyness of Wall Street Credit is beholden to the Fed and GSEs.
Importantly, over time the market perceived that liquidity could be taken for granted under virtually all circumstances. Clearly, any “AAA” security would remain highly liquid – even during those occasional (and brief) bouts of market turbulence. “Triple A” came to mean “money” – an instrument that would always entice a buyer at a fair market price. Better yet, often such instruments even increased in value during market tumult. It certainly didn’t hurt that GSE debt dominated the entire “AAA” market – their short- and long-term debt instruments as well as agency MBS equipped with their guarantees. And as the leveraged speculators repeatedly took full advantage – certainly in 1994, 1998, 1999 and 2000 - the GSEs were more than happy to pay top dollar or more for MBS, mortgages, and other debt instruments any time the markets lurched toward de-leveraging and illiquidity.
Administrations, Congresses, and the Fed took no issue with the marketplace’s implied government backing of GSE debt, allowing the GSEs for years to luxuriate in their unlimited access to market-based borrowings. Indeed, GSE debt enjoyed the extraordinary status of being completely immune to market liquidity concerns. The GSEs could borrow as much as they wanted – especially during periods of market tumult – and buy as much MBS and as many debt instruments in the marketplace as they (and the market!) desired. I can't stress too strongly how this profoundly distorted the markets’ perception of pricing and liquidity risk for agency debt as well as for the markets overall - and for years nurtured today's unfolding financial crisis.
But why do I this evening insist on rehashing the sordid history of GSE/Fed market interventions? Well, I think they played the key role in the market’s momentous misperception that “AAA” stood for “Always And Anytime liquid.” For a decade GSE-related debt instruments dominated “AAA” and anything associated with the GSEs was always highly-liquid in even the most adverse market conditions. And this liquidity had very much to do with the extraordinary mechanism whereby, during periods of financial stress, eager buyers of GSE debt (especially foreign buyers) would provide the GSEs unlimited wherewithal to provide a Liquidity Backstop in MBS, mortgage, and mortgage company debt instruments.
Not only were the GSEs not susceptible to “Ponzi Finance” dynamics, these strange government-sponsored market operators evolved into the Anti-Ponzi. Whenever market confidence began to wane, “money” flooded into the GSEs and right out to the increasingly speculative markets – and everyone enjoyed robust returns provided by an unparalleled and seemingly endless liquidity-generating machine. And, let there be no doubt, the sophisticated leveraged speculating community took complete advantage of the extraordinary liquidity backdrop. I really believe that if there was no extended GSE boom – there would have been no Mortgage Finance Bubble – no Wall Street Bubble – no derivatives Bubble – and no protracted economic consumption-based U.S. economic boom.
Well, the world of finance subtly changed with the revelation of the GSEs’ (inevitable) abuse of Phenomenal Financial Power. Issuance of GSE debt and Agency MBS stalled abruptly in 2004. Yet at that point Mortgage Finance Bubble Dynamics were in full force. After all, Inflationary Biases had taken firm hold in real estate markets across the country and throughout the Wall Street mortgage finance machinery. Indeed, the Street didn’t miss a beat with the hamstrung GSEs. The evolution of market perceptions of Moneyness to include ALL mortgage-related securities encouraged an historic issuance boom in “private-label” MBS and ABS (see charts above). Wall Street was quite keen to more than fill the GSE void with its own brand of top-rated "structured finance." And flood it they did.
Soon there were Bubbling markets for ARMs, jumbo, Alt-A, “teaser”, “exotic” and scores of subprime mortgages – the majority finding homes in the mushrooming market for Wall Street CDOs and other “structured products.” A protracted mortgage boom and inflated home prices created a history of minimal Credit losses, emboldening those rating mortgage-related securities as well as those happy to take leveraged positions in these instruments (including the proliferation of hedge funds, mortgage REITs, Wall Street trading proprietary trading operations, etc.). While the GSEs were left to spend billions sorting through their accounting mess, the various Bubbles they were instrumental in nurturing grew to unfathomable dimensions. Never in history were so many “AAA” (and “AA”) securities being created, many sliced and diced from less than money-like mortgages. This mortgage debt explosion dispersed “top-rated” U.S. debt securities throughout the U.S. and global financial systems.
Returning back to the subtle change beginning back in 2004, the character of risk associated with new MBS issuance changed markedly. While the “AAA” status remained constant, the non-GSE “private-label” variety of MBS/ABS were associated with increasingly risky underlying mortgages. The insatiable appetite for these relatively higher-yielding securities to satisfy the booming demand for CDOs and other structured products was sufficient to deaden any market sensitivity to the reality that the GSE “backstop bid” had been slammed shut. GSE balance sheets were no longer in a position to balloon on demand. Besides, most of these “private-label” securities were not within the charter of GSE purchases anyways. The marketplace might have been conditioned to believe liquidity risk had not changed – but it had and profoundly.
From the spectacular subprime implosion to this week’s rapidly unfolding global liquidity crisis, a clearer picture is emerging: It’s one of a momentous reversal in the liquidity backdrop from GSE-induced Anti-Ponzi to the Acute Financial Fragility associated with Minskian Ponzi Finance. No longer does a reversal in speculator leverage conveniently flow onto GSE balance sheets, setting the stage (with Fed rate cuts) for an only more egregious expansion of Credit and speculative excess. Instead, de-leveraging these days has quickly incited contagious marketplace illiquidity and a highly disruptive reversal of speculative flows from mortgage-related instruments, along with the very real risk of a mortgage Credit collapse.
It is popular to explain market gyrations as “re-pricing” of risk. Other comments suggest that this is only a “short-term Credit crunch” and that “this is a liquidity issue not a solvency issue.” This is much, much more serious. Key facets of “contemporary finance” are on the line. The entire process of Wall Street Credit and Risk Intermediation is today in jeopardy.
There are today literally Trillions of dollars of impaired debt instruments – previously “top-rated” securities that will never live up to their (fallacious) billing. And after a spectacular multi-year issuance boom, they are everywhere - especially in places appropriate for only the most “money-like” safe and liquid instruments. The perceived safest and most liquid securities found homes in various types of “money market” funds and other perceived low-risk investment vehicles. The perceived safest and most liquid instruments were fodder for the greatest abuses of leverage. The bottom line is that these securities were misconceived as “money-like” from day one, and the marketplace has shifted to the recognition that they are instead risky and inappropriate for most investment vehicles and for leveraging. This radical change in market percepts is wreaking bloody havoc on the untested Credit derivatives marketplace.
Global central banks can somewhat cushion the de-leveraging process, but I doubt they can do much more than slow the flight from risky Credit instruments and “investment” vehicles. Importantly, perilous market misperceptions with respect to risk and liquidity have been exposed. Speculative de-leveraging is unmasking serious flaws in various assumptions (including liquidity and market correlations) used by “black box” models in leveraged strategies across various securities markets. The bloom is off the rose and a tidal wave of hedge fund withdrawals – and further de-leveraging - cannot be ruled out.
The major international banks have been key players in U.S. structured finance, especially in money market “conduits,” “funding corps,” and “special purpose vehicles.” This might very well be the epicenter of the current liquidity crisis, and they will surely vow to avoid such exposure to U.S. Credit risk going forward. The highly leveraged Wall Street firms will struggle to rein in risk on myriad fronts and likely be forced to fight mightily for survival. And for how long the American public can hold its nerve is a major question. They have been conditioned to believe that their holdings in the stock, bond, and “money” market are safe and secure. And the longer central bank interventions sustain unsustainably inflated asset markets, the greater the opportunity for the speculator community to “distribute” their holdings to the unsuspecting public.
As much as I recognize the traditional role of central banks as liquidity providers of last resort, I just sense that being forced to move this early – with global stock markets at near record highs – provides confirmation of the Acute Fragility of the global Credit system. Such moves would appear to risk further destabilizing already highly unstable global markets, especially currency markets. This does look to me as a Run on Wall Street Finance – and an absolute mess.
