Kevin Kallaugher’s cartoon from the September 18th issue of The Economist does an excellent job of putting the financial crisis of 2008 into a proper perspective:
Category Archives: Financial Crisis
Diamond and Kashyap on the Recent Financial Upheavals
University of Chicago professors Doug Diamond and Anil Kashyap “…discuss what has happened in the financial sector in the last few days, why it happened, and what it means for everyday people” on the Freakonomics weblog; see “Diamond and Kashyap on the Recent Financial Upheavals”.
I want my RTC!
I want my, I want my, I want my RTC! (apologies to Dire Straits!). Yesterday, Nicholas Brady, Eugene Ludwig and Paul Volcker published an article in the Wall Street Journal entitled “Resurrect the Resolution Trust Corp.” This article makes the case for the establishment of a new, “temporary” credit crisis resolution mechanism. As Brady, Ludwig, and Volcker note, “There are precedents — such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.”
Well, it appears that Messrs. Brady, Ludwig and Volcker may have gotten their wish today. According to a Wall Street Journal article entitled “U.S. Plans to Clean Up Finance System As Part of Widening Effort to Stem Crisis”, the federal government, “…is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s. At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies, according to people familiar with the matter, a device that echoes similar moves taken in past financial crises. It’s size could reach hundreds of billions of dollars.”
The stock market reacted very positively this afternoon to this news (with gains in the major indices ranging from 3.9-4.8%), and as I write this, stock futures contracts are also pointing toward a substantial continuation of this rally tomorrow. The main effect of this plan seems to be that it has assured investors that there is a plan in place for an orderly resolution of credit crisis. Markets hate uncertainty, and the rather ad hoc nature to date of the various US federal government interventions (e.g., involving Bear Stearns, Fannie, Freddie, and AIG) would now appear to be a thing of the past. Having said this, the amount of skin that the US taxpayer now has in the game has increased substantially. Before this news came out, the feds had already put around $800 billion of taxpayer capital at risk since March 2008 (putting this into perspective, this amounts to per capita contingent capital of nearly $2,700 for every man, woman and child living in the United States). It now appears that the level of contingent U.S. taxpayer capital committed to resolving the credit crisis has increased substantially!
Wharton Faculty Discuss Financial Crisis
I would like to call attention to four videos which I showed in my risk management course this morning at Baylor University (in the order in which they were presented):
1. Jeremy Siegel: On the Resilience of American Finance
2. Joseph Gyourko: Fannie, Freddie, and the Housing Bust
3. Franklin Allen: Lessons from the Subprime Crisis
4. Richard Herring: What’s Next for Investment Banks
All four of these lectures were delivered at Wharton on Tuesday afternoon, September 16 at a Wharton “Teach-In” (see http://www.wharton.upenn.edu/teach_in_09_16_08.cfm). I also recommend viewing a panel discussion from that same day featuring Wharton professors Franklin Allen, Richard Herring, and Susan Wachter entitled “Wall Street’s Day of Reckoning: Turmoil in the Global Market”.
After viewing these videos, I now feel like I have a rough idea of how this (the so-called credit crisis) all came about. It’s really all about (perverse) incentives. I hope we can figure out a way to sunset (that’s a politically correct way of saying “get rid of”) Fannie Mae and Freddie Mac. We also need to think seriously about reforming public policy toward real estate; e.g., by abolishing the tax deductibility of mortgage interest. During the bubble we were encouraging consumers to make highly levered bets on a risky asset class (i.e., residential real estate), and it was funded by the likes of investment banks like Bear Stearns who had only had $1 of their own money and $32 of other people’s (creditors’) money at risk.
Also, according to the Wharton professor Joseph Gyourko, it now appears (after the fact) that the rating agencies probably relied too much upon historical US real estate market price data which showed that prior to the crisis, the national average price for residential real estate had never declined during the course of the postwar (WWII) period. The rating agencies incorrectly inferred from these data that real estate isn’t all that risky, and this helped to feed unrealistic expectations concerning real estate as an asset class (specifically that unlike all other asset classes, real estate “always” goes “up”!).
Some thoughts about AIG being "too big to fail"
Today, I learned an interesting fact about the AIG CDS situation. Apparently AIG has in excess of $400 billion in exposure to credit derivatives, much of which were sold to foreign as well as U.S. banks. The reason why banks like to purchase CDS’s is that this enables them to satisfy risk-based capital requirements associated with holding risky bonds (e.g., instruments like mortgage backed securities (MBS’s) and collateralized debt obligations (CDO’s)) in their asset portfolios. Therefore, AIG may in fact be big to fail because if it does, then this would likely unleash a financial contagion throughout the banking system which would substantially limit the availability of credit throughout the US economy.
Here’s a simple explanation of how financial contagion could occur if AIG were to fail. If AIG failed, then banks who relied up AIG’s contingent capital (in the form of CDS’s) would be required to raise cash in order to comply with risk-based regulatory capital requirements. Probably quite a few banks would not be successful in doing this on a timely basis, and would be forced to file for bankruptcy. In this scenario, surviving banks who managed to comply with regulatory capital requirements would naturally become quite reticent about lending. The net result would be a substantial credit shock for the overall real economy.
One final point; apparently the U.S. penchant for bailing out “too big to fail” financial institutions is going global. For example, lately the Bank of England is beginning to act much more “Fed-like” in terms of establishing contingent credit facilities for troubled financial institutions in the UK. Anyway, the real world is providing us with lots of risk management data and it will be interesting to see how this all plays out.
Some thoughts about AIG being "too big to fail"
Today, I learned an interesting fact about the AIG CDS situation. Apparently AIG has in excess of $400 billion in exposure to credit derivatives, much of which were sold to foreign as well as U.S. banks. The reason why banks like to purchase CDS’s is that this enables them to satisfy risk-based capital requirements associated with holding risky bonds (e.g., instruments like mortgage backed securities (MBS’s) and collateralized debt obligations (CDO’s)) in their asset portfolios. Therefore, AIG may in fact be big to fail because if it does, then this would likely unleash a financial contagion throughout the banking system which would substantially limit the availability of credit throughout the US economy.
Here’s a simple explanation of how financial contagion could occur if AIG were to fail. If AIG failed, then banks who relied up AIG’s contingent capital (in the form of CDS’s) would be required to raise cash in order to comply with risk-based regulatory capital requirements. Probably quite a few banks would not be successful in doing this on a timely basis, and would be forced to file for bankruptcy. In this scenario, surviving banks who managed to comply with regulatory capital requirements would naturally become quite reticent about lending. The net result would be a substantial credit shock for the overall real economy.
One final point; apparently the U.S. penchant for bailing out “too big to fail” financial institutions is going global. For example, lately the Bank of England is beginning to act much more “Fed-like” in terms of establishing contingent credit facilities for troubled financial institutions in the UK. Anyway, the real world is providing us with lots of risk management data and it will be interesting to see how this all plays out.
AIG for Dummies
In a nutshell, here’s what I understand to be happening with American International Group (AIG):
1. AIG is a major player in the market for “Credit Default Swaps” (CDS’s).
a. A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties.
b. A CDS provides its buyer with protection against default, a credit rating downgrade, or some other negative “credit event” (e.g., being put on a credit watch list by a rating agency).
c. The CDS seller (in this case, AIG) assumes the credit risk that the buyer does not wish to bear in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. Essentially, AIG’s CDS business is a form of financial insurance.
2. What’s AIG’s “problem”?
a. As the “credit crunch” has continued to worsen, AIG’s CDS’s are declining in value and becoming increasingly less liquid. Consequently, regulatory and rating agency capital standards are essentially forcing AIG to collateralize these assets by raising more capital. However, it is very difficult (particularly for an already credit-impaired firm like AIG competing in an adverse financial market environment) to raise the capital needed on a timely basis in order to be able to comply with these standards.
b. To make matter even worse, a substantial share of AIG’s business involves exposure to commercial insurance products, whose buyers (primarily private and public sector risk managers) expect to place their business with high credit quality insurers. As AIG’s credit rating continues to decline, this substantially puts at risk AIG’s valuable commercial insurance franchise, which in turn makes it all the more difficult for AIG to raise capital.
It can be very tempting to criticize someone else’s actions when you have the benefit of hindsight. Having said that, the credit crisis does expose a fundamental flaw with AIG business model; specifically, it probably doesn’t make much sense to expose a business which has tremendous franchise value (i.e., AIG’s commercial insurance business) to an inordinate amount of credit risk. It is interesting to note that by and large, most firms in the financial guarantee business (e.g., companies like MBIA and AMBAC) are monoline companies; i.e., they market and distribute financial insurance products only.
Observations concerning some of today's events in the worlds of finance, insurance, and risk management
1. Lehman Brothers and AIG: As John Markman cleverly notes, “…the Federal Reserve stood up to the big Wall Street financial houses on Sunday and essentially told them, ‘thanks but no thanks’ on their request for a bridge loan to nowhere”. Consequently, Lehman Brothers (the 4th largest investment bank in the world) has filed for bankruptcy protection, and its shares are trading today for 23 cents per share. Bill Gross made an interesting comment concerning Lehman and American International Group (AIG) this morning on CNBC; he noted that while AIG is technically solvent, it is highly illiquid, whereas Lehman is technically insolvent but otherwise quite liquid. Just one year ago, AIG had a market capitalization of nearly $200 billion, making it one of America’s most valuable publicly traded corporations. Today, AIG’s market capitalization stands at $18 billion. The problem AIG faces is that if this company can’t resolve its liquidity problems really soon (like sometime within the next couple of days), then it risks being downgraded by the credit rating agencies. If AIG’s credit rating becomes impaired, it stands to lose a substantial share of its client base. AIG is particularly heavily exposed to commercial insurance lines of business, and their clients have no interest in doing business with credit-impaired insurers. If this scenario plays out, expect to see AIG follow up with its own bankruptcy filing.
2. Hurricane Ike: The three major catastrophe risk modeling firms (Applied Insurance Research (AIR), EQECAT, and Risk Management Solutions (RMS)) project insured losses of between $6 – $18 billion, primarily in the Texas counties of Brazoria, Harris, Galveston, Chambers and Jefferson. Since the Texas Windstorm Insurance Association (TWIA) is heavily exposed to insured properties in these counties, I suspect that claims may very likely exceed TWIA’s capital base of $1.87 billion, which consists $370 million in a Catastrophe Reserve Trust Fund and $1.5 billion in reinsurance. Depending upon the magnitude of TWIA’s Ike-related losses, private insurers in Texas could face assessments which would have the potential for setting in motion a financially vicious cycle in which future earnings and capitalization are impaired, which in turn adversely affect insurer credit ratings. Matters can only get worse if the Texas gulf coast gets hit with any more hurricanes any time soon.
3. Oil Speculation: Apparently so-called “oil speculators” were not behind the large run-up in oil prices during the first half of 2008, any more than they were behind the subsequent retreat in oil prices during the past couple of months. Last week, the Commodity Futures Trading Commission (CFTC) issued a report which provides compelling empirical evidence to the effect that financial trading hasn’t been driving price moves in oil markets after all. For a synopsis of this study, see the article from today’s Wall Street Journal entitled “See You Later, Speculator”. As I noted in my July 10, 2008 blog entry entitled “Rebuttal of ‘An open letter to all airline customers‘”, this finding comes as no surprise. Thankfully American Airlines has finally gotten around to removing the link from its home page urging consumers to “stop oil speculators by sending Congress an S.O.S.”…
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