GraniteGrok

Clearly, there has been something deeper at work and it is important that we understand the underlying dynamics that lead us to where we are today. The answers to these questions will undoubtedly help shape and guide our future public policy. Beyond the fact that we are in a sharp economic downturn, there are important reasons why the banks are very hesitant to lend. Until we come to grips with those issues, we are not apt to make much progress.

In truth, the hidden secret for the past twenty-five years is that most banks are very hesitant to make loans - even in the best of times. This is particularly true of the major “money center” banks which deal in the large wholesale segments of the financial markets. Frankly, lending money had become an increasingly unattractive business to be in and most of the excesses of the time reflect a desperate attempt to get away from direct lending. Two factors have created this phenomenon.

The traditional role of banks has, of course, been to act as a bridge between people with savings and those who need investment funds. The banks acted as society’s stern intermediary, judging who should and, equally as important, who should not be given new capital. After all, the money being lent out belongs to depositors who entrusted their hard earned funds to the banks with the promise that they be held in safe keeping.

But beginning in the 1970s, large corporations grew tired of paying intermediaries (banks) a commission for placing their funds with third party investors. The corporations discovered that they could easily lend directly to each other and by doing, could save substantial amounts of money by cutting out the middle man. As this phenomenon grew, it became increasingly clear that that the larger players in the financial markets could bypass the banks altogether, except on some of the most basic banking functions such as moving money from one location to another.

Over time, the banks found themselves being gradually eased out as the intermediary (dis-intermediated out) which negatively affected their business model, profits and viability. In an effort to remain competitive, they started acting less like old “commercial banks” (that lent out deposited money) and more like “investment banks” that accepted a fee for putting savers and investors together. This had the effect of making old fashioned lending less and less profitable and thus less attractive. As the old fashioned business of lending dried up, it accelerated the perceived appeal of investment banking.

While this shift started in the wholesale segments of the banking world, it was quickly adopted into the retail segments of the market. As the capital markets grew, it was discovered that packages of small loans could be bundled together into larger portfolios of loans and sold off in giant blocks to willing wholesale investors. It was thus almost by accident that the capital markets were born; no one planned out any of this.

Traditionally, the investment banks were almost totally unregulated as they carefully did not accept or invest depositor’s savings. This also contributed to the demise of the commercial banks as it gave the investment banks a huge cost advantage. Regulation is expensive and time consuming. For one thing, some ten percent of any loan must be set aside as a reserve in case a loan goes bad – a very expensive proposition. Then there is the cost of filing, reporting and monitoring, all very labor intensive and expensive. The older commercial banks and their shareholders were thus desperate to leave old style banking (lending) behind and actively sought for the repeal of the old Glass-Stiegal Act, a depression era law which largely kept the two worlds apart.

To the extent that banks still make loans such as for mortgages, car loans, credit cards, etc., they work to get these off of their own balance sheets by bundling them together and selling them off to third party investors in a process known as securitization. Since the investors who buy these loan bundled loan packages have also been unregulated, they can arguably accept a lower rate of return. Before the current crash, 50% of all loans in America were securitized.

Low Cost Money

This trend away from bank lending was also accelerated by the sudden influx of the low cost money that started pouring into the financial markets in the 1970s. In October 1974, the quadrupling of world oil prices by OPEC saw an unprecedented new surge of money into the financial markets. At the same time, the Japanese banks began their major international expansion in an effort to gain market share, often with a complete disregard for earnings.

In keeping with the laws of supply and demand, the price of money started to drop as the quantity of money in the system far outstripped the immediate demand. The excess of funds on the world markets quickly forced down the margins associated with lending. As profits dropped, so did the banks’ margin of error; one bad loan could wipe out the earnings of many other good loans.

With the exception of the early Volker era when the Federal Reserve deliberately held interest rates high to combat the spiraling inflation of the time, the trend has been towards greater quantities of money (aka liquidity) in the system. For the most part, the past thirty years has been an extraordinary period in world economic growth, the most notable example being the rise of Asia. The amounts currently swirling around the financial markets are nothing short of staggering.

In 2004 McKinsey Global Institute (MGI) issued a report stating that the world was experiencing and unprecedented surplus of funds which were flooding the world’s financial markets. Their report estimated that the world’s financial markets were struggling to find investment opportunities for $142 trillion in global “liquidity.” That sum was at an unprecedented level, roughly 3.5 times the aggregate global GDP of $52 trillion. In 2006, MGI upped that number to $167 trillion.i At the same time, the Deputy Secretary of the U.S. Treasury Robert Kimmitt estimated the figure at $190 trillion.ii

Regardless of which figure is the most accurate, the impact of such daunting quantities of money in the international financial system has had a profound impact. They readily distorted the decision making and the incentives of everyone involved. Cheap and plentiful money meant that thousands of new investment funds were opened, risk management systems were flooded and financial leverage (borrowing) levels reached unprecedented new levels.

Parallel Banking Institutions

The over abundance of money has also meant that in the past thirty years a wide range of non-bank financial institutions ( unregulated) have come into the markets and made off with large portions of the business. New financial institutions such as GE Capital, CIT, etc. started eating into the business. They could afford to do so both because their unregulated nature kept down the cost of lending and because they could take on much higher risk levels through more aggressive “structured” financial services that also had equity and “near equity” components – something the commercial banks could easily not do. Even the consumer companies got into the business of financing their customers, though this downturn is teaching them that lending is not an attractive business.

Because banking (at its best) entails serious financial analysis of the ability to repay loans, weaker companies very much relied on the commercial banks to provide them credit, something the capital markets traditionally did not do. But in the 1980s the capital markets also invaded even this segment of lending business with the advent of “junk bonds.” The pioneering work of Drexel Burnham Lambert was quickly copied by most of the investment banks and eventually the commercial banks themselves as they took on new investment banking powers.

With so much money in the system, the banks were facing an almost impossible financial task in trying to lend money. Thus, they intently focused their efforts into becoming much more like the investment banks. This had the disturbing effect of driving the classic investment banks into newer areas of business such as “proprietary trading.”  In the past ten years, even the greatest of the investment banks, Goldman-Sachs, has become (in effect) large hedge funds, seeking new and more sophisticated ways of investing money on the world’s financial markets.

Massive Leverage

The era of cheap and easy money also brought with it another critical problem – massive borrowing. Borrowing too much and saving too little seems to be a uniquely American peculiarity. In the financial markets, however, the people who should know better began to take on massive amounts of debt relative to the financial foundation provided by equity. Most corporations usually have a fifty-fifty split between debt and equity. The more stable corporations like utility companies can safely leverage out more. Banks with their (supposedly) keen risk management skills and high degree of regulation usually can go up to ten to one.

In the last few years, however, the massive amounts of cheap and easy money brought on unprecedented amounts of new borrowing, not just in the U.S. but around the world. Such venerable and “smart’ institutions such as Germany’s vaunted Deutsche Bank took on leverage up to forty to one. This was also true of most of the hedge funds and private equity funds, some of which managed to go as high as one hundred to one. When everything was going along smoothly, this was fine. When the financial gales stated blowing it became evident that they were much too top heavy and thus wholly unstable. Many were blown over.

The situation has been made much worse by the massive losses the banks have taken in the sub-prime markets and as businesses across the world deteriorate and fail. The associated losses to the banks served to further weaken their existing foundation.

To correct these excesses the financial firms must now do one of three things: they must either take on much more in the way of new equity or sell off their old loans or get out of them to the extent possible. In the midst of a severe financial crisis, these options are nearly impossible. While they are coping with these problems, new loans are out of the question no matter how loud the demands for new lending. While the popular sentiment is that the banks must make more loans with the TARP funds they accepted, it is altogether clear that the combined weight of the downturn, weak equity foundations, asset valuation uncertainties and market volatility makes new lending virtually impossible.  

The Brave New World

As the competitive pressures built up to invest the every growing quantities of money in the system, the larger financial institutions began to rely on more diverse and more sophisticated ways of putting money to work. These pressures coincidently dovetailed into the revolutionary new financial theories and tools that were pouring out of the University of Chicago starting in the 1970s. The work of such luminaries as Fisher Black, Myron Scholes, Merton Miller, Franco Modigliani, Harry Markowitz and other Nobel Prize winners started a revolution in the world of finance.   

These theories all depended on highly quantitative descriptions and theories of market behavior. They went a very long way towards explaining the relationship between market risk and price. In so doing, they gave market analysts revolutionary new insights that promised to give the banks an enormously valuable set of tools that would provide the all important edge in market trading. What started out as purely descriptive mathematical theories of how the markets behaved under conditions of uncertainty, quickly turned into day to day tools of market action.

“Sharper pencils” that could tease more money out of money seemed to be the new road to riches. The banks and other financial institutions seized on these ideas and began to recruit platoons of highly skilled quantitative young analysts (the quants) who could decipher and put to use these new theories. Many of them held PhDs in mathematics and physics from the finest universities and the competition for their skills quickly drove their salaries into six and seven figures. So great was the esteem that they were held, that their work and their financial models ultimately drove the investment of tens of trillions of dollars.

Unfortunately, as it turned out, the older managers who sat above them had little ability to fully understand the mathematics that was being used; nor did the senior most managers let alone the Boards of the banks that hired them. Their brilliance was such that they could usually talk their way around any questioning of their ideas or trading activities. This was even truer of the bank regulators and the risk rating agencies. The young poorly paid examiners and analysts these institutions could afford to hire did not stand a chance against the quants; they were totally out gunned.

The mathematical techniques were also started an explosion in the use of sophisticated new “derivative” instruments. Derivatives have been around for roughly one hundred and fifty years and have a very important purpose in business and finance. But the new quantitative tools turbo charged the use of these instruments to unimaginable new levels. This market grew to an astonishing $531 trillion level – roughly ten times the size of the world’s aggregate economic activity (GDP). Much of these instruments were used in an effort to provide a floor on trading losses.

The limitations of such trading techniques were made very evident in the late 1990s with the spectacular collapse of the firm Long Term Capital. LTCM was one of the forerunners of the move into quantitative trading. It included in its ranks the legendary Wall Street star John Meriwether as well as Myron Scholes and Robert Merton who shared the 1997 Nobel Prize. By combining such sophisticated and esoteric techniques such as statistical arbitrage, pair bonding and fixed income arbitrage with very high levels of leverage (debt), LTCM produced initial rates of return in excess of 40% per annum, after fees.

As the saying goes, if things are too good to be true, they usually are. In 1998 Russian financial crisis (which had nothing to do with LTCM) brought much of the financial world to a standstill and caused the financial models to show their limitations. LTCM crashed and burned and the Federal Reserve had to jump in and save them. It was a full dress rehearsal of today’s crisis.

The core lesson that came out of the LTCM crisis was that when the entire system is crumbling, no degree of brilliance, diversification or financial acumen will insulate you. To be technical about it, you can’t hedge against systemic risk. Unfortunately, this lesson seems to have been lost on the regulators as well as the financial system as a whole. In the wake of the LTCM debacle, everyone went back to their accepted ways of doing business – but at an unprecedented new level.

In the years leading up to the 2008 collapse, the number of new private equity and hedge funds skyrocketed to over 19,800. None of these new financial players were in anyway regulated (as if that would have greatly helped) and lending volumes to these entities climbed sharply.

Risk Management

As the bank lending model disappeared, the use of the capital markets for financing grew steadily. The banks themselves seemed to be less reliant on good credit analysis and more determined to package loans and sell them off to willing third party investors. Risk analysis was someone else’s problem. Increasingly, it fell on the rating agencies.

But the rating agencies had troubles of their own. First, they were never able to recruit the best and brightest as the pay levels they offered were much lower than any of the money center banks offered. Sadly, the corporate owners of the rating agencies treated them as cash cows; money was drained away as fast as it came in and very little was reinvested back into the business.

The constant pressure was on to generate new business as agency’s profits were quickly siphoned away. What then happened was that the investment banking community quickly discovered they could shop around for the best ratings, in effect playing of one rating agency against another. As a result, in 2007 roughly 50% of all new ratings received the highest possible rating of AAA. Clearly, this was an aberration and made very little sense. Although most people in the financial markets understood that the rating agencies were in over their head, they continued to use them and tout the quality of the portfolios with the high ratings.

Thus, when the crash came, the very high credit scores bestowed on a wide variety of banking institutions and investment portfolios came crashing down to earth. This not only affected the immediate portfolios of individual investors, but it had a massive cascade effect on the financial system as a whole. As the high “investment grade” ratings crashed, they forced an avalanche effect with each sell-off triggering more and more selling. No one now knows what assets are worth. They also don’t know which businesses are viable and which are not. So how can they possibly lend to entities when they don’t know who will survive and who won’t? The heightened market volatility which came with the confusion and uncertainty has severely compounded the problem.

In the end, the market suffered a massive loss of confidence in the entire risk assessment system. As such, the capital markets have suffered a virtual collapse and a stand still of new issuance. The capital markets are now paralyzed while the older banking model is all but gone.

The Reckoning

With the financial collapse upon us, much of the former lending is now being unwound. What was gradually built up has come crashing down and must be built back anew – hopefully with greater soundness and long term strength.

Virtually all the world’s assets must be revalued to take into account the new market realities. Amazingly even though the rating agencies failed spectacularly, we continue to be heavily dependent on their assessments; we have precious little else to go with.

The financial markets must today cope with several problems. They include:

1. The true value of all assets (real estate, commodities, financial instruments, etc.) must be newly re-established. This is a massive undertaking and will take time given the unreliability and volatility of today’s markets.
2. The massive structural problems of the financial system must be dealt with. In the past year we have seen financial icons go up in smoke, the conversion of the investment banks into commercial banks, roughly 50% of hedge funds go under, massive de-leveraging, etc. What exactly emerges out of this wreckage is anyone’s guess.
3. With the rest of the world suffering even more than the US, the health of the international financial markets will have profound impact on America’s recovery. New international regulations and institutions will undoubtedly be created. These to will also have an undefined impact.
4. New domestic and international regulatory constraints on the financial industry are inevitable. Exactly what will be adopted both at home and abroad remains to be seen. Until they are in place regulatory uncertainty will remain high.
5. Until these and other serious issues are dealt with, it is hard to see the economy recovering to its previous levels of health and prosperity. Today’s economic problems are deeper and more profound than we have faced since WWII.

Conclusions

The world’s banking and credit markets are today essentially broken, in large part because the underlying risk management systems have also broken down. We need to repair them, which will certainly take time. The old model of the commercial banks lending to business and individuals essentially broke down and was supplanted by the capital markets. But in the last year and a half, the capital markets have collapsed due to the several reasons discussed above. As in any system, the more complex the mechanism the more fragile it is.

Credit is the lifeblood of the economy; our modern economy must have it for virtually every aspect of our day to day financial lives. Unfortunately, it is today broken. We will thus have to reinvent a new credit apparatus which will take time to formulate. It is time we do not have.

The collapse of the credit markets thus leaves us without a vibrant vehicle of allocating capital. For a society that is so heavily dependent on credit, this is a major blow to the functioning of the system. Restoring the economy will greatly depend on the restoration of credit but this will take a good deal of time as something new emerges from the ashes. What exactly does arise is hard to predict. But one thing is clear: until credit flows are restored the economy will have a very difficult recovery. The current market volatility undoubtedly reflect the uncertainty of all of these factors.

The demise of the commercial (lending) banks and risk management systems has been something that has been building for a very long time. For the past twenty years, we have convinced ourselves that the answer was investment banking which we blithely assumed could be wholly unregulated. But as the house of cards came crashing in, it has become clear that the underlying economics of the financial markets have driven our financial institutions into a cul-de-sac. How we get out remains to be seen. But it is now clear that the broader capital markets are (for now) broken.

When and how we emerge and what follows remains to be seen. What we will probably see is that the older commercial banking model will be called upon to pick up the slack. But clearly it will look very different from what we have had in the past. It is also clear that such radical change will not come easily or quickly and there are no easy answers. In the meantime, our credit dependent economy will continue to suffer.

Robert Bestani is a Visiting Scholar at the Collaboratory for Research on Global Projects at Stanford University. Prior to joining Stanford he has had a thirty–five year career in international banking and finance. He also served in the U.S. Treasury Department under George H.W. Bush and is a member of the Council on Foreign Relations.