Redstate

How the world invests

By blackhedd Posted in Economy | federal reserve | subprime crisis — Comments (20) / Email this page » / Leave a comment »

I was the first person I know to write about the similarity between the credit crisis that erupted in early summer of 2007, and the Long-Term Capital Management Crisis of the early fall of 1998. How did I make the connection? By observing how the prices of various asset classes were moving relative to each other.

Modern risk management depends on predicting these relationships with mathematical models. Late last spring, asset prices started doing things that were supposed to be impossible. Just as in the summer of 1998.

The 1998 crisis had no impact on the real economy. If you weren't paying attention, you weren't even aware of it. The prior year, however, there was a financial crisis that had a devastating impact on the real economies of a number of East Asian nations, including Thailand, South Korea and Indonesia.

It just occurred to me that there is a similarity between now and 1997.

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What happened in 1997 is still the subject of much study and controversy. (Ten years from now, we'll still be debating what happened in 2007. We'll also be dealing with the unintended consequences of the sweeping regulatory legislation that will be enacted in 2009.)

To keep it short: for several years prior to 1997, several Asian countries benefited substantially from "hot money," or inflows of capital in search of high rates of return. (Many of these countries, including Thailand, ran high policy interest rates, partly in order to attract foreign capital.)

Capital always seeks out the highest risk-adjusted rate of return, like water seeking its level. And like water, capital is highly mobile. It will flow out of an asset class (or a country) practically overnight, if the numbers stop making sense. (The crisis was triggered when people recognized that Thailand's currency, the baht, had become far overvalued.)

How does that relate to the US housing bubble and the collapse of mortgage-backed securities?

Financial engineering played a key role. The world of money is now a world of mathematical theory. And where there is theory, there are bright young theorists figuring out different ways to solve the equations. (If you've ever wondered what happens to newly-minted math and physics PhDs: Wall Street is crawling with them.)

And the engineers have figured out all kinds of clever ways to analyze and re-package the risk inherent in all normal economic and financial activity. The general idea is that you can enhance risk-adjusted rates of return, if you can sell the sub-components of risk to the market participants that are in the best position to price and hold them.

This is all really marvelous stuff, and I'm not being sarcastic. Modern risk-management technology is extremely useful, and its use will not diminish after the crisis abates (unless we regulate it out of existence).

What happened next, though, is full of mystery, and no one really understands it yet. (The people who figure it out might get the next round of economics Nobel Prizes.)

But it was suddenly possible to apply vast amounts of short-term capital from non-traditional sources, to capital markets for long-term assets with poorly-understood risk profiles. Including mortgage-backed securities.

Think back to the strange days of 2005 and early 2006. They were strange because the risk premia for long-term assets had come into an unusually benign relationship with those of short-term assets. (I think part of this ironically stemmed from the Asian Crisis, but that's another story.)

Ordinarily, an investor demands a higher price for a long-term asset because, given more time, there's more that can go wrong with the asset. But during the housing bubble, it seemed like no one was thinking of the future as a place where bad things can happen.

I have an intuition that if some clever young economics PhD candidate were to study the issue, she'd find that a historically-abnormal amount of short-term money went into funding long-term assets. And those long-term assets, including mortgage-backed securities, became the foundation of a large amount of real economic activity.

When housing prices started to break in early 2006, the pattern reversed fast. And now we have a credit crisis because almost no one is willing to lend money to anyone, for any risky purpose. That's going to lead to major pain in the real economy, to a degree that has yet to become clear.

All of this intuition-level analysis is important because the question of the year is: what is Washington going to do about the mess on Wall Street?

The Federal Reserve is doing all it can with the tools at its disposal to keep the financial and banking systems stable. They're doing a good job. (Even though I've been accused many times of being a Federal Reserve fanboy.)

But what happens next?

It would be a mistake to ban advanced financial technology and risk management. Anything that reduces friction in capital markets has the practical effect of making more capital available. The regulatory response to this should be to extend the same kinds of reserve, net-liquidity and capital-ratio requirements to the newer kinds of capital, that have been in place for decades with commercial banks.

How to do that? Well, there is a whole pack of devils in the details. This needs to be done slowly and carefully. As I said, the Nobel Prizes haven't been earned yet.

Borrowing short and lending long is what bankers have been doing ever since humans climbed down from the trees. Why is that activity not dangerous? Because bank deposits tend to be relatively stable. And why is that? In large part because of deposit insurance.

But the Bear Stearns episode shone a bright light on an aspect of daily Wall Street life that perhaps escaped many people. Investment banks and broker-dealers borrow and repay gargantuan amounts of money every night. It's how they finance their asset portfolios.

But there's no deposit insurance available for money flows that measure in the trillions of dollars every single night. And disrupting that flow of short-term funds is what almost melted the world down a week and a half ago.

-Francis Cianfrocca ("blackhedd")