The Credit Crunch - Coursework Example

There are many different reasons a credit crunch can take place. The central bank can suddenly cut back on the amount of reserves available to the banking system, with a consequent contraction in banks' ability to make loans. This is what happened in the US in 1979-80 and in Japan in 1989-90. Central bank credit contraction is not, however, a significant factor in the US or Europe in October 1998. There can be bank failures due to bad loans, creating perceptions of increased risk, which causes other banks to tighten their lending criteria and to restrict credit. (Even in good times, bankers prefer to lend money only to those who do not need it.) Risk- related restriction in bank lending has been widespread in Southeast Asia throughout 1998. There can be bond defaults, which causes credit spreads to widen. Interest yields on lesser grade corporate bonds and asset-backed securities increase dramatically, in a "flight to quality". The flight to quality takes the form of a dash to purchase government bonds, believed to be risk-free. Thus the diminishing supply of capital is further depleted as it becomes available for immediate government consumption. There can be a credit crunch because of panic disintermediation. Panic disintermediation is the dumping (rapid sale) of securities, commodities, and other assets in a scramble over possession of the limited supply of money (cash). Portfolio managers were telling investors, and each other, that being out on the long end of the yield curve was the best hedge against a downturn in the world economy. It took only 48 hours in the real-world classroom for them to learn differently. There can be a credit crunch because of a run on the currency. This source is actually the same as that of the only difference being that there is panic liquidation of financial assets in one currency, in exchange for cash in another currency. This happened in October 1998 as the yen rose in value from Yen 131/dollar to Yen 111/dollar in less than two days (Oct. 7-8). The dollar had become less attractive relative to the yen: the Fed cut the discount rate, hedge funds unwound short yen positions, and Japanese banks and other financial institutions dumped dollar securities because they needed the capital at home (especially after the Nikkei 225 dipped below 13,000). Borrowing in yen at extremely low interest rates was considered a free lunch. Then one day the free lunch disappeared. Tiger Management, a hedge fund which had been borrowing in yen to buy dollar assets, suffered a loss of almost $2 billion on Oct. 7 due to the surge in the Japanese yen against the U.S. dollar. That was about 9 percent of the fund's value. Credit crunches used to be banking phenomena almost exclusively. No more. During the 1980s and 1990s formerly illiquid assets became more marketable or tradable. They no longer just sit on the asset side of some bank's balance sheet. "Securitization" is the process by which a collection of receivables is put together in a package, and then bonds are issued against the package. The package may be a collection (or portfolio) of credit card receivables, or automobile lease payments, or commercial mortgages, or some similar type of asset which provides "backing". Payments made to the owner of the packaged assets are then passed along, in part, as interest and principal to the bondholders. The bonds (which may have various strange and wonderful names, such as "CMOs"--collateralized mortgage obligations) trade in a secondary market, so the whole process has turned fairly illiquid items (the original credit card payments, or whatever) into tradable securities. The term "disintermediation" is also used, meaning that banks (or other financial intermediaries) are no longer the direct lenders, but rather bond purchasers become the direct lenders. Repayment to the bond investors depends on the good credit of those making payments into the asset pool (of commercial mortgages, or whatever), so that the interest payments on the bonds reflect a "credit spread" over some benchmark bond interest yield, such as the interest yield on US Treasuries. In the first half of 1998, more credit was provided in the asset-backed securities market than provided by the entire US banking system. Thus the bond markets immediately reprice credit spreads, and there is nothing the Federal Reserve can do about it. (It would be even worse if there were no securitization and all capital flowed instead through the banking system. For in that case, an attempt to "hold down" credit spreads would simply result in credit rationing: some entities would get credit, and others would get nothing.) The globalists fanatically deny this, saying, "We are in charge; or else, we would be, if only you would give us more money for the IMF, for the World Bank; if only you would do these new and wonderful things like open the Federal Reserve spigots or create an international' lender of last resort, etc., etc." Yes, all the globalists will become Big Swinging Dicks if only you gave them a few billion dollars to play with. Meanwhile, the conspiracy theorists say, "Some secret group is causing all this financial turmoil," and can't figure out why the likely suspects seem so disarrayed. Both groups believe the world is a giant machine, and just by turning this or that dial, or squirting a little oil here or there, or replacing the engineer, we can put everything right again. As for the three partners, finance theory says don't invest in the stock of the company where you work. For the obvious reason that if the company falls on hard times, the stock will likely be taking a hit just as you are being fired. But True Masters of the Universe don't bother with such trivial notions of diversification. They prefer a Texas Hedge: go long two call options and buy the underlying asset. At the beginning of 1998, LTCM had $4.7 billion in capital. LTCM has dozens of trading strategies, none of which is public information. But it is clear they like to deal in bond credit spreads. They had several bets that credit spreads were going to narrow. So they were long commercial-mortgage backed bonds and junk bonds, and short US Treasuries. They also expected credit spread narrowing in Europe because of the interest rate convergence required for the introduction of the Euro. Hence LTCM was long Italian government bonds, and short German government bonds. The fund had a bad month in June, when the fund was down 10 percent. But in July the IMF saved Russia. And as of mid-August LTCM still had $3.7 billion in capital. Then Russia defaulted, and credit spreads widened greatly. US Treasuries soared in price, as did German government bonds, and lesser credits took a dive. So did LTCM. The fund was down 44 percent in August, and its capital had dropped to $600 million by mid-September. The final straw in September seems to have been the unraveling of a stock bet that the merger of Ciena and Tellabs would go through. The US Congress afterward held hearing whether hedge funds should be regulated (just which genius are they going to get to do this job--maybe Merton and Scholes are out looking for work). Many people were upset because LTCM was "bailed out" without anyone being punished. But what is easily overlooked, however, is that LTCM was bailed out because of regulation. The Federal Reserve convened a consortium of banks who provided the infusion of capital. (LTCM partner David Mullins Jr., a former Vice-Chairman of the Federal Reserve Board, knew just who to call.) The banks could hardly refuse to show up, for they are, after all, regulated by the Fed. So they poured another $3.65 billion of capital into the LTCM capital destruction machine. And why not It was only depositors' money, and those deposits are insured. The risk of repaying bank depositors is carried by the FDIC. So why not invest in a hedge fund which is leveraged 250 to 1 (or is it only 100 to 1) If LTCM is lucky, the bank will make a lot of money. If LTCM is unlucky, the FDIC pays the piper. The system is good. It's win-win for the banks. So what are we going to do about the credit crunch Not much, I expect. In traditional central banking theory, the lender of last resort--the Federal Reserve, in this case--is supposed to halt the run out of relatively illiquid financial assets, and real assets (commodities, goods) and into money. How By making more money available. One deals with the drying up of liquidity by creating more. But how does one do that without exacerbating the current problem, or simply creating future inflation Who should get money, and why Doesn't postponing liquidation of assets postpone resolution of the crisis But moving along, Lenders of last resort-- whatever their supposed merits--respond necessarily to domestic considerations. So suddenly we are now witnessing a rash of proposals for an "international" lender of last resort, which will act from global motives, and not be bound by petty domestic considerations. The international lender of last resort is a deus ex machina that will somehow operate outside the world financial system to save the system from crisis. (For if the international lender of last resort is part of the system, then in what sense can it itself be exempt from crisis) Policy makers, who haven't a clue as to how to deal with the world financial crisis, are now being given a "solution" by economists--or whatever it is that people at the US Treasury call themselves--who are equally clueless, but who have seized on "international lender of last resort" as a counterfactual offering to policy makers: "Oh, what we need is an international lender of last resort." Since we don't have such a lender, the suggestion is nonfalsifiable, much like those historical arguments which say, for example: "If only Napoleon hadn't invaded Russia, then blah, blah, blah [make up whatever story you want to, because since Napoleon did invade Russia, history can't refute what you say]." Where would an international lender of last resort come from, with no world government, no world central bank, and no universally recognized system of laws And who wants any of these, anyway The analogy is with a domestic lender of last resort, such as the Federal Reserve. Now, there is no evidence that the Fed has prevented any financial crises--or, net net, prevented any more crises than it has generated. But all that doesn't matter: the very "experts" consulted are from the US Treasury, the Federal Reserve, the IMF, the World Bank--and they (surprise) uniformly see the need for a greater role for themselves and for people like them. Many see the IMF evolving into just that "international lender of last resort" role. Then the new mega-IMF can do for the global economy what the IMF recently did for Indonesia and Russia. On average, Americans carry eight cards per person and have a balance of $8,400 in credit card debt. Twenty percent of their cards are maxed out, reports CardWeb.com, which tracks the lending industry's machinations. And just 40% of Americans pay off their accounts in full at the end of the month. The average line of credit is around $3,500. (A decade ago it was just $1,800.) The average household pays their lender $1,000 a year in finance charges. That might not sound like much, but consider that the amount of interest they paid as a nation last year alone could have purchased the entire inventory of 5,000 Jaguar dealerships. Or a 2,000-year endorsement deal with Tiger Woods. Or IBM, the entire company, with $55 billion to spare. It's not just that we're borrowing more money and paying it back more slowly; it's that we're spending money we used to consider off-limits. Home equity loans are more popular than ever as people borrow against their home to feed their spending binge. Today, average homeowners owe nearly 50% of their home's value. Twenty years ago that figure stood at 30%. Can't you just picture the modern-day needlepoint plaque "Home, Sweet Credit Line." Not surprisingly, lenders' promiscuity is catching up with them. Subprime lenders -- who built their businesses by pursuing the un-creditworthy -- are getting squeezed by their customers. Job loss and other consumer hardships are affecting these bankers' bottom lines. Subprime lenders are writing off losses in the 15% to 17% range, versus the average industry loss rate of 6.5%. Delinquency rates now average about 10% while those for the rest of the lending industry average just 5%. In the past year, some big-name banks have been dealt pink slips of their own. REFERENCES: Bluhm, Christian, Ludger Overbeck, and Christoph Wagner (2002). An Introduction to Credit Risk Modeling. Chapman & Hall/CRC Born Losers: A History of Failure in America, by Scott A. Sandage (Harvard University Press, 2005) David Lawrence and Arlene Solomon, Managing a Consumer Lending Business de Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill Hayre, L. 2001, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, Wiley ISBN 0-471-38587-5 Hull, J.C. 2006, Options, Futures and Other Derivatives, Pearson ISBN 0-13-149908-4 Hearing before the U.S. House subcommittee on Policy Research and Insurance in "Asset Securitization and Secondary Markets" (July 31, 1991), page 13 Murray Bailey, Consumer Credit Quality: Underwriting, Scoring, Fraud Prevention and Collections The Committee on the Global Financial System defined Structured Finance, "The role of ratings in structured finance: issues and implications", January 2005 Read More