Into the Weeds The Treasury Department"s oldest function is to raise the money needed to fund the government by collecting taxes and issuing debt. It has numerous ways of borrowing, but the most important is through public auctions of Treasury bills, which mature in one year or less; notes, which mature in 1 to 10 years; and bonds, which mature in 20 to 30 years. It also raises money by selling bonds directly to the public, and to state and local governments. Investors usually buy securities through designated primary dealers who bid on their behalf at auctions. Big money managers and foreign central banks can submit their own bids, either via a dealer or directly through the Fed.
Total Treasury borrowing is limited by a law called the debt ceiling. Because the national debt keeps growing, Congress must regularly raise this ceiling, though it usually grandstands a bit first.
Treasurys are the world"s most heavily traded and trusted security and the volume of bids at auctions routinely exceeds the amount for sale by a factor of two to three. For the Treasury to sell less than it needs would be like the Jonas Brothers failing to sell out a high school gym: it would be a shocking blow to U.S. prestige and investor confidence. The Treasury carefully manages the process to avoid that, with plenty of advance notice of how much it intends to borrow, and rules designed to ensure that if customers are scarce, dealers are there to buy.
So how big is the national debt? Well, it depends on one"s definition of national debt of which there are quite a few as Table 13.1 Table 13.1 shows. In September 2009, the gross federal debt was almost $12 trillion or 83 percent of GDP. However, almost $5 trillion of this is owed to other parts of the federal government, princ.i.p.ally the Social Security and Medicare Trust funds. That debt doesn"t trade in the markets. After excluding that debt and the debt held by the Federal Reserve, the net federal debt drops to under $7 trillion, or 48 percent of GDP. This is the figure most often compared across countries. shows. In September 2009, the gross federal debt was almost $12 trillion or 83 percent of GDP. However, almost $5 trillion of this is owed to other parts of the federal government, princ.i.p.ally the Social Security and Medicare Trust funds. That debt doesn"t trade in the markets. After excluding that debt and the debt held by the Federal Reserve, the net federal debt drops to under $7 trillion, or 48 percent of GDP. This is the figure most often compared across countries.
Table 13.1 How Big is the National Debt? How Big is the National Debt?
Source: U.S. Treasury, Office of Management and Budget, Federal Reserve. U.S. Treasury, Office of Management and Budget, Federal Reserve.
(As of September 2009) $ trillion Share of GDP Gross federal debt 11.9.
83%.
Minus debt owed to other parts of the government (e.g., Social Security Trust Fund) 4.6 4.6.
Equals publicly held debt 7.5.
53%.
Minus debt held by the Federal Reserve 0.8 0.8.Equals net federal debt 6.8.
48%.
Add state and local debt (excluding receivables) 2.4 2.4.
Equals general government debt 9.1.
64%.
Federal government financial a.s.sets 0.9 0.9.
The federal government also has a.s.sets: the investments in banks, auto companies, and mortgage-backed securities made during the financial crisis, worth some $800 billion in September 2009. Its other a.s.sets, like aircraft carriers and the Washington Monument, aren"t that useful for paying bills.
The Hidden National Debt Taxpayers are on the hook for far bigger obligations than just the bonds the Treasury has issued. The present value of health and pension benefits promised to future civil service retirees, veterans, and military personnel amount to some $5 trillion. Then there"s the $104 trillion unfunded liability in Social Security and Medicare.
Unfunded obligations are based on current forecasts and current law. But forecasts can change and Congress can change the law.
.These debts, however, are different from Treasury debt: They"re estimated obligations based on current forecasts and current law. But forecasts can change and Congress can change the law, and indeed, it probably will. It may pay a political price but it is not as traumatic as defaulting on a bond.
Finally, Uncle Sam has in effect cosigned trillions of dollars of others" loans with various backups and guarantees. For example, the Federal Deposit Insurance Corporation (FDIC), has guaranteed the safety of over $5 trillion in deposits. The Pension Benefit Guaranty Corporation backs private pension plans. Ginnie Mae has guaranteed $1 trillion of mortgages insured by the Federal Housing Administration and Veterans Administration. And, most contentious of all, since 2008 the federal government has stood behind more than $5 trillion of debt and guarantees issued by Fannie Mae and Freddie Mac, two formerly privately controlled mortgage companies that became insolvent during the financial crisis.
The actual risk is much smaller than those hair-raising figures imply. Few of those guarantees will have to be honored because most banks won"t fail and those that do will be paid for by the banks that survive. Ginnie Mae, Fannie Mae, and Freddie Mac can repay most of their own debts with the fees, interest, and princ.i.p.al from the mortgages they own or guarantee. But crises and recessions have a way of turning these contingent liabilities into real ones.
The Bottom Line * Chronic deficits compete with private borrowers for limited savings driving up interest rates, r.e.t.a.r.ding investment, and impairing future economic growth. Interest on the national debt starves other government programs.* Budget deficits can be good. During recessions, tax revenues fall and spending on the poor and unemployed rises, softening the sting. There"s less compet.i.tion with private borrowing.* Governments sometimes use fiscal stimulus-that is, a deliberate increase in the deficit-to boost a weak economy. This is usually unnecessary, unless the Fed is unable to do the job because it has already cut interest rates to zero.* A breaking point can come when debt is so high that investors suspect governments will try to renege either by defaulting, or through inflation.* The United States" long history of fiscal probity, favorable long-term growth outlook and control of the world"s reserve currency, suggest it has a long way to go before it faces a crisis, but the risk can"t be rule out.
Chapter Fourteen.
Love-Hate Relationship The Bipolar Financial System-Essential for Economic Growth But Sometimes It Goes Nuts IN TOM WOLFE"S 1987 novel Bonfire of the Vanities, Bonfire of the Vanities, a bond trader"s daughter asks him what he does for a living. His wife explains, "Just imagine that a bond is a slice of cake, and you didn"t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that." a bond trader"s daughter asks him what he does for a living. His wife explains, "Just imagine that a bond is a slice of cake, and you didn"t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that."
That image pretty much sums up the popular view of financiers: They don"t make anything, they just get rich rearranging the fruits of others" labor. At times of crisis, that cynicism turns venomous, such as when Charles Gra.s.sley, a Republican senator, in 2009 urged the richly paid employees of one bailed-out firm to resign or commit suicide.6 Yet, finance is as essential to economic growth as it is unpopular among Congressmen. The financial system channels capital from those who have it to those who need it, much as the circulatory system moves blood from the heart to the lungs and muscles. A simple example shows how. Imagine that you have money to invest while a colleague at work needs to borrow money to buy a house. Why not bypa.s.s the bank, and lend him the money? It seems like a win-win: you"d charge him more than you"d earn on a certificate of deposit and he"d pay less on his mortgage. Upon reflection, it is obvious why this seldom happens. He may need more than you have. He may want to borrow it for 10 years but you only want to lend it for one year. Most important, you don"t know if he"ll pay it back.
The financial system solves all these problems. It matches savers with borrowers with neither having to know each other. It conducts the necessary due diligence; if the borrower defaults on the loan, the saver still gets his money back. It also spares the borrower of the burden of repaying the saver before he"s done with the money.
One way of appreciating the importance of the financial system is to imagine what happens when it stops working. As Ben Bernanke reportedly warned in the wake of Lehman"s bankruptcy: the "economy"s arteries, our financial system, is clogged, and if we don"t act, the patient will surely suffer a heart attack."7 An example of a country suffering such a heart attack is Iceland, whose gross domestic product (GDP) sank some 15 percent after all its banks failed in 2008. Inflation and unemployment skyrocketed, restaurants emptied, and the once globe-trotting population found itself grounded . . . literally. An example of a country suffering such a heart attack is Iceland, whose gross domestic product (GDP) sank some 15 percent after all its banks failed in 2008. Inflation and unemployment skyrocketed, restaurants emptied, and the once globe-trotting population found itself grounded . . . literally.
The U.S. financial system is one of the most diverse and complex in the world-sometimes it is too complex for its own good. Thomas Philippon, an economist at New York University, estimates that in 1947, finance accounted for 2.3 percent of GDP. By 2005, it was almost 8 percent. That"s an awful lot of cake, and a lot of it was just sugary icing with no nutritional value: leveraged buy-outs, speculative stock trading, and financial engineering whose main purpose was to layer on more bets.
But just because finance has its periodic excesses shouldn"t blind us to the fact that most of the time it is useful. Much of that cake represented 401(k)s, life insurance, and taking Microsoft and Google public. The historical record has the same message: Financial innovation usually helps growth; it doesn"t hurt it. Something akin to joint stock companies in ancient Rome helped spread large-scale mining technology. Preferred shares were one of the financial innovations that made the railroad-building boom of the nineteenth and twentieth centuries possible. Countless studies also have found that countries with more developed financial systems grow faster.
So does the diversity of the U.S. financial system encourage compet.i.tion and growth, or does it feed speculation and breed crises? In fact, it does both.
Where Have You Gone, George Bailey?
Think of our financial system in two parts: 1. Inst.i.tutions. Inst.i.tutions. This part includes regular banks, investment banks, and This part includes regular banks, investment banks, and shadow banks shadow banks (i.e., companies that act like banks but aren"t regulated the same way). (i.e., companies that act like banks but aren"t regulated the same way).2. Capital Markets. Capital Markets. This part is comprised of securities and derivatives that investors trade back and forth. This part is comprised of securities and derivatives that investors trade back and forth..
Banks remain the foundation of our financial system, but over the years their importance has shrunk.
.Let"s look at inst.i.tutions first. A bank is the most basic part of the financial system, and the most basic sort of bank looks like the Bailey Building and Loan a.s.sociation run by George Bailey in the film It"s a Wonderful Life It"s a Wonderful Life. It starts with shareholder capital, raises deposits, and makes loans.
Banks have gotten a lot more complex since Jimmy Stewart played George Bailey in 1946. Deposits now contribute just 60 percent of their funding; they get the rest from bonds, short-term IOUs like commercial paper, wholesale loans from other banks and big investors, derivatives, and other things. They lend to countries, companies, and individuals through loans, securities, credit cards, lines of credit, and countless other avenues.
Although banks remain the foundation of our financial system, their importance has diminished over the years. In 1980, banks supplied 50 percent of the economy"s credit; by 2007, that had shrunk to 23 percent. Capital markets, which I"ll describe more below, and inst.i.tutions that look, act, and smell like banks but aren"t regulated like banks have taken on a larger lending role. These shadow banks, as PIMCO, the bond fund manager, calls them, match savers savers and and borrowers, borrowers, but they don"t take deposits. Instead of deposits, shadow banks fund their lending by issuing bonds and short-term IOUs or by getting rid of their loans through securitization. but they don"t take deposits. Instead of deposits, shadow banks fund their lending by issuing bonds and short-term IOUs or by getting rid of their loans through securitization.
You"ve probably done business with a shadow bank. Some are neighborhood fixtures, like mortgage brokers, payday lenders, and leasing companies. Others are nationally known. Fannie Mae and Freddie Mac, for example, guarantee or hold mortgages; Ally Financial, the former General Motors Acceptance Corporation (GMAC), makes car loans, and General Electric Capital Corporation makes leases and loans to businesses. Subprime mortgage lending was dominated by shadow banks like New Century Financial, now bankrupt, and Countrywide Financial, now part of Bank of America. Finally, there are some that you"ve never heard of, such as Sigma Finance, a so-called structured investment vehicle that at its peak had $57 billion in such a.s.sets as mortgage-backed securities, more than most U.S. banks.
Investment banks, also called broker-dealers, broker-dealers, are another type of shadow bank. Rather than lend money directly, they match savers and borrowers in the markets by underwriting and trading stocks, bonds, and other securities; delivering the proceeds to the borrower or company; and taking a fee in the process. are another type of shadow bank. Rather than lend money directly, they match savers and borrowers in the markets by underwriting and trading stocks, bonds, and other securities; delivering the proceeds to the borrower or company; and taking a fee in the process.
For all their myriad names and legal charters, banks and shadow banks live or die by two things: capital and liquidity.
.Over the years, the lines between banks and shadow banks have blurred. Commercial banks now trade stocks and bonds and investment banks make loans. Loans themselves are often chopped up and turned into securities. Commercial banks provide back-up credit to shadow banks, in effect acting as their lenders of last resort. Commercial banks and shadow banks may be part of the same holding company. Some shadow banks like Ally Financial and General Electric Capital own banks of their own.
For all their myriad names and legal charters, banks and shadow banks live or die by two things: capital and liquidity.
Capital is like armor on a warship. More armor makes a warship more resistant to enemy fire, but slower. With more capital a bank can endure more loan losses, but it is less profitable because its profit must be spread among more shareholders. is like armor on a warship. More armor makes a warship more resistant to enemy fire, but slower. With more capital a bank can endure more loan losses, but it is less profitable because its profit must be spread among more shareholders.
The ratio of a.s.sets to capital is called leverage leverage and it is an indicator of how reliant a company is on debt. Consider Bank A: It has $1 of shareholders" capital, raises $9 in deposits, and makes $10 in loans. Its leverage is 10. If it gets another dollar of capital it can make $10 more in loans. Bank B, however, has leverage of 20: With each additional dollar of capital it can make $20 in loans. You can see why banks and their shareholders like leverage. But leverage works in reverse as well. Just as a thinly armored warship is more easily sunk, a thinly capitalized bank is more likely to fail. For Bank A to become insolvent and have its capital wiped out, 10 percent of its loans would have to go bad. For Bank B, just 5 percent would. and it is an indicator of how reliant a company is on debt. Consider Bank A: It has $1 of shareholders" capital, raises $9 in deposits, and makes $10 in loans. Its leverage is 10. If it gets another dollar of capital it can make $10 more in loans. Bank B, however, has leverage of 20: With each additional dollar of capital it can make $20 in loans. You can see why banks and their shareholders like leverage. But leverage works in reverse as well. Just as a thinly armored warship is more easily sunk, a thinly capitalized bank is more likely to fail. For Bank A to become insolvent and have its capital wiped out, 10 percent of its loans would have to go bad. For Bank B, just 5 percent would.
Federal regulations require banks to hold capital of at least 8 percent of a.s.sets, while shadow banks get by with far less. This is one reason why more of them failed during the financial crisis. For example, Fannie Mae and Freddie Mac operated with capital of less than 4 percent to juice their profits. But when mortgages turned sour, their capital disappeared and taxpayers bailed them out.
Liquidity refers to cash and things that are almost like cash that can be used to meet pressing needs. Your house may be worth $300,000, but that"s not much help if you need $5,000 today to replace a broken furnace. So you keep cash on hand or a home-equity line of credit for the unexpected. It"s the same for a bank. If it can"t pay back depositors and lenders, it will fail. So banks keep cash in the vaults, hold securities (like Treasury bills) it can quickly sell, or maintain lines of credit with other lenders. They can also borrow from the Federal Reserve. refers to cash and things that are almost like cash that can be used to meet pressing needs. Your house may be worth $300,000, but that"s not much help if you need $5,000 today to replace a broken furnace. So you keep cash on hand or a home-equity line of credit for the unexpected. It"s the same for a bank. If it can"t pay back depositors and lenders, it will fail. So banks keep cash in the vaults, hold securities (like Treasury bills) it can quickly sell, or maintain lines of credit with other lenders. They can also borrow from the Federal Reserve.
If capital is a warship"s armor, liquidity is its ammunition. Too little liquidity is as lethal as too little capital. Without it, a bank would succ.u.mb to creditors pulling out their money just a warship that"s out of ammo will succ.u.mb to enemy fire.
The importance of liquidity was forgotten in the years leading up to the crisis when a tidal wave of easy money fooled many firms into thinking they could always borrow when they needed. But when panic hit, that a.s.sumption proved very wrong.
A popular source of liquidity is the repo market, which is kind of a p.a.w.n shop for financial inst.i.tutions, but instead of pledging grandma"s jewelry, a bank might pledge $1.1 million worth of mortgages, loans, and corporate bonds in order to borrow $1 million from a money market mutual fund for one day. In early 2008, investment banks had borrowed $4.5 trillion via repo loans, more than banks had in federally insured deposits at the time. But repo loans have no federal guarantee. When lenders grew skittish about Bear Stearns and its collateral they stopped rolling over repo loans, precipitating its collapse.
As a result of the financial crisis of 2007, financial inst.i.tutions now need more capital and liquidity, because both regulators and the investors who lend to them demand it. This will make them safer, less profitable and, for a while, less able to lend.
Capital Markets Banks and shadow banks have a vital role to play in supplying credit, especially to small businesses and households. But larger firms can raise capital by issuing stocks, bonds, and other types of securities directly to investors. If you belong to a pension plan, have a life insurance policy, or own a mutual fund, you are helping finance business investment as surely as your savings account makes your bank"s lending possible.
Debt (also called credit) and equity (also called stocks) serve different purposes. Debt is temporary with limited upside . . . at best. Debt holders get back their princ.i.p.al plus interest, nothing more. They do, however, get repaid first if the venture goes bad. Equity is a permanent: The company has no obligation to ever repay your investment. Equity brings ownership. Stock holders share in the rewards of success and the losses of failure.
Stocks are simple and glamorous. Credit is complicated and dull. Yet it matters more to the economy.
.Most companies have one common equity or stock. It trades on a public exchange like the New York Stock Exchange and NASDAQ Stock Market where everyone can see it. A company may, however, have numerous types of debt: short-term, long-term, secured, unsecured, convertible to shares, and so on. A lot of this debt is seldom traded so it is poorly suited to a public exchange. Instead, you buy it from, or sell it to, a dealer.
Stocks are simple and glamorous. Cable television tracks minute-by-minute moves in the Dow. Friends share stock tips and magazines celebrate entrepreneurs made rich by their initial public offering. By contrast, debt is complicated and dull, usually relegated to the inner pages of the financial papers. Yet it matters more to the economy. Most companies don"t issue stock; they are privately held. Households and governments don"t issue stocks at all. At the end of 2009, all the stocks in the United States were worth about $20 trillion. All debt was equal to about $52 trillion of which households owed $14 trillion; businesses, $11 trillion; financial inst.i.tutions, $16 trillion; and governments, $10 trillion. This means that an interruption in the supply of credit hurts a lot more parts of the economy than a fall in the stock market.
An important difference between banks and capital markets is that while a bank usually holds its loan until it matures, securities in the capital markets change hands often, and are valued at whatever price they could fetch in the market today. But there have to be a lot of buyers and sellers willing to trade at that price. Straightforward, popular securities like Treasury bonds and shares of IBM are thus highly liquid. Wall Street"s propeller heads have made some securities so complex that in times of panic it became impossible for buyers and sellers to agree on a price. What were once liquid markets became dry as the Gobi Desert.
Two popular types of debt security that played a starring role in the financial crisis is the a.s.set-backed security, or ABS, and the mortgage-backed security, or MBS. An ABS or MBS is almost like a share in a mutual fund: It gives you partial ownership of a pool of mortgages, credit card receivables, auto loans, or other securities. They are structured to pay you interest even if some of the loans in the pool go bad.
Mortgage-backed securities are a great idea that Wall Street, as is its habit, took to excess.
.ABS and MBS sound exotic, but they"re not. They have been around for decades. Here"s how they work. Suppose a small bank has made $100 million in mortgages. It can package them as an MBS and sell it to a pension fund or a foreign central bank. It then takes the proceeds of the sale, and makes $100 million more in mortgages.
Wall Street has a bad habit of taking a good idea to excess, and MBS were no exception. To appeal to more investors, financiers divided MBS into tranches tranches with differing characteristics: some that were safer because they were paid interest first, and some less safe because they took the hit if any mortgages in the pool defaulted. Then they took these MBS and recombined them into new securities called with differing characteristics: some that were safer because they were paid interest first, and some less safe because they took the hit if any mortgages in the pool defaulted. Then they took these MBS and recombined them into new securities called collateralized debt obligations, collateralized debt obligations, or CDOs. or CDOs.
Years ago you would put your money in a bank and the bank would grant a mortgage to your neighbor. Now, you: * Put your money in a pension fund* Which is a partner in a hedge fund* Which buys a collateralized debt obligation* Which holds a mortgage-backed security* That a bank put together* Out of mortgages it acquired from a mortgage broker* Who made the original loan to your neighborDid you get all that? Don"t feel bad, neither did some of the world"s most sophisticated investors. With so many steps, many investors didn"t know much about who they ultimately lent to, and simply outsourced their due diligence to credit rating agencies. Those agencies in turn thought the securities were worth AAA ratings because they badly miscalculated how much home prices would fall and how many of these loans would default.
The Teenage Boys of Finance Derivatives are one of the most maligned and least understood part of the financial system. They are the teenage boys of finance-energetic and full of potential but the first to be fingered when someone totals the car. are one of the most maligned and least understood part of the financial system. They are the teenage boys of finance-energetic and full of potential but the first to be fingered when someone totals the car.
A derivative is a contract whose value is derived from some other price or security: an interest rate, a currency, a stock index, a commodity. The first derivatives were on agricultural commodities. A farmer would enter into a binding contract with a food processor to sell his corn to that same processor six months later, locking in the value of future sales. Now, a U.S. company that plans to deliver parts to a European customer may use a derivative to lock in today the value of the euros he"ll receive in six months" time. Suppose you want a 10-year loan but your bank would rather make a one-year loan. It can make you the 10-year loan, then use an interest-rate swap to make it resemble a one-year loan.
Currency and interest rate swaps are the clean-cut honor roll students of derivatives who almost never cause problems. Credit default swaps (CDS) are the tattooed skateboarders forever giving the school princ.i.p.al heart palpitations.
The idea of a CDS seems innocent enough. Suppose you made a $100 loan to your brother, but you worry he won"t repay you. You pay a bank $5 a year on the condition that if your brother defaults, the bank pays you $100. The CDS thus make it possible for you to hedge your loan. The problem is they also give you less reason to be careful about lending to your brother. CDS thus may be one reason so many bad loans were made.
a.s.set-backed securities and derivatives are too useful to disappear. Crises are extremely effective at killing stupid financial innovations.
.The growth in derivatives has been nothing short of phenomenal. Between 1998 and 2009, their global notional value grew eight times to $615 trillion. Now, what"s notional value? Suppose you enter a contract to pay 5 percent interest on someone else"s $100 loan. The contract"s notional value is $100 but your actual exposure is only $5 per year. In this instance, notional value overstates the actual risk.
Nonetheless, this growth has brought dangers. Derivatives encourage leverage because they require less of a down payment than the same bet made with cash. They are also opaque: A company knows how much it owes to a bank or bondholders, but it may not know how many CDS are riding on its solvency. Orange County, Barings Bank, and American International Group lead a list of organizations that blew their brains out on derivatives. Consequently, derivatives have been prime suspects in many market blow-ups. Portfolio insurance, a popular hedging technique using stock index derivatives, helped cause the 1987 stock market crash.
Regardless of these dangers, ABSs, MBSs, and derivatives are too useful to disappear. Crises kill off stupid financial innovations-the 1987 stock market crash deepsixed portfolio insurance and the latest crisis has done the same for exotic mortgage securities. But, derivatives are here to stay. Like teenage boys, though, their potential is best realized with plenty of adult supervision. That means that they require plenty of capital and liquidity and, wherever possible, transparency in the open market, such as on a public exchange instead of in a private dealing room.
The Bottom Line * You don"t have to hug your banker, but what he does is essential to economic growth. Banks and capital markets match savers with those who need capital.* Over the years, banks have been joined by shadow banks that, like banks, made loans but don"t take deposits and aren"t as tightly regulated. All these inst.i.tutions need capital to protect against losses and liquidity to repay lenders. Too much of either, and profits suffer. Too little, and the inst.i.tution could fail.* Equities get all the attention in the capital markets but the economy relies more on a healthy market for debt securities, such as money market paper, bonds, and a.s.set-backed securities.
Chapter Fifteen.
A Species of Neuralgia The Multiple, Recurring Causes of Financial Crises IN NOVEMBER 2008, as Britain sank into its worst recession since the 1940s, Queen Elizabeth asked the elite scholars at the London School of Economics, why didn"t anyone see it coming? The eminent economists convened a conference to study the question, then sheepishly drafted a letter to the queen. "Your Majesty, the failure to foresee the timing, extent and severity of the crisis," they wrote, "was princ.i.p.ally a failure of the collective imagination."
They shouldn"t have felt so bad. The only thing more inevitable than crises is our failure to antic.i.p.ate them. As Carmen Reinhart and Kenneth Rogoff note in This Time is Different: Eight Centuries of Financial Folly, This Time is Different: Eight Centuries of Financial Folly, crises have been a fixture of finance since 1340 when Edward III of England defaulted, bankrupting the Florentine bankers who financed his war with France. Almost continuously since 1800, some part of the world has been in a banking or debt crisis. And for centuries, societies have been trying to find ways to stop them. They created central banks to prevent crises by giving banks a lender of last resort, and the International Monetary Fund to do the same for countries. crises have been a fixture of finance since 1340 when Edward III of England defaulted, bankrupting the Florentine bankers who financed his war with France. Almost continuously since 1800, some part of the world has been in a banking or debt crisis. And for centuries, societies have been trying to find ways to stop them. They created central banks to prevent crises by giving banks a lender of last resort, and the International Monetary Fund to do the same for countries.
There"s no single definition of a crisis-as a judge said of p.o.r.nography, you know one when you see one. The trigger is unpredictable and the event is violent, often emotional, as investors and lenders move as a herd to protect themselves. Markets are normally self-correcting, as lower prices bring out buyers. Crises are self-reinforcing as lower prices bring out more sellers.
Almost by definition, crises are unexpected because they involve collective errors of judgment.
.Almost by definition, crises are unexpected because they involve collective errors of judgment. "Financial crises that are foreseeable . . . rarely happen," Alan Greenspan wrote in his memoir, The Age of Turbulence. The Age of Turbulence. If a crash seems imminent, "speculators and investors will try to sell out earlier. That defuses the nascent bubble and a crash is avoided." For example, in the late 1990s Ed Yardeni, a prominent economist, predicted that computers" inability to cope with Y2K, the millennial date change on January 1, 2000, could trigger a global recession. If a crash seems imminent, "speculators and investors will try to sell out earlier. That defuses the nascent bubble and a crash is avoided." For example, in the late 1990s Ed Yardeni, a prominent economist, predicted that computers" inability to cope with Y2K, the millennial date change on January 1, 2000, could trigger a global recession.8 Forewarned, the world spent billions of dollars to fix the problem and nothing happened. Forewarned, the world spent billions of dollars to fix the problem and nothing happened.
Crises will always be with us because they are rooted in humans" inbred tendency to extrapolate the past, their inability to predict the future, and their regular swings between greed and fear. Of course, these things are always present in the economy. For them to produce a financial crisis, though, some combination of other conditions must also be present.
Condition 1: Afloat on a Bubble Every a.s.set has some intrinsic value. For a stock, it is future profits, dividends, and cash flows. For a home, it is the cost of renting instead of owning it. For oil, it is the cost of getting more of it out of the ground. Yet calculating intrinsic value is never easy. What are future profits? Are there any other houses like this? How soon can that oil be pumped? Most of us end up a.s.suming an a.s.set"s value is what other people think it is worth, much as we choose a restaurant not based on a careful examination of the menu and critics" reviews, but on how crowded it is. These a.s.sumptions make it relatively easy for an a.s.set to become unmoored from fundamentals. In 2000, the S&P 500 topped 30 times earnings, double its historical average. In 2006, the ratio of home prices to rents reached 47 percent above its multiyear average.
Jeremy Grantham, a fund manager who"s made the study of bubbles a personal pa.s.sion, says that in all of them, the a.s.set in question has reverted to its long-term average value: "There are no exceptions." Why then, do bubbles recur? At the start of every bubble is a kernel of economic truth: the Internet really was transforming U.S. business, just as railroads had a century and a half earlier. The public thus concludes old rules don"t apply. In the 1980s, j.a.panese stocks traded at two to four times the valuation of U.S. stocks, but this was attributed to the effect of cross-shareholdings between companies. Sky-high land prices were justified by j.a.pan"s shortage of land. Both, of course, collapsed.
Not all bubbles lead to crises. To produce a crisis requires leverage.
.Many people correctly identify a bubble before it bursts, but profiting from that prescience is difficult when the tide of opinion and money is running against them. The Economist The Economist raised alarms about U.S. property prices in 2002; prices rose for four more years. As I write this book, home prices in Australia and Britain, which rose far more than prices in the United States, had yet to deflate. History says they will; when, is anybody"s guess. raised alarms about U.S. property prices in 2002; prices rose for four more years. As I write this book, home prices in Australia and Britain, which rose far more than prices in the United States, had yet to deflate. History says they will; when, is anybody"s guess.
Condition 2: Leverage, the Prime Suspect Not all bubbles lead to crises. To produce a crisis requires something else: leverage, which means lots of debt relative to a.s.sets or income. Leverage does not cause a market to crash any more than driving fast on a highway causes your car to crash. But leverage, like speed, makes the crashes that happen way more deadly. Leverage amplifies profits and losses when markets move. Suppose you spend $1 on a stock and it falls 50 percent. You lose half of your investment. Suppose you take your dollar, borrow another dollar, and buy $2 worth of the stock, which then falls 50 percent. After repaying the dollar you borrowed, you"ve lost your entire investment.
The fall in house prices that began in 2006 did far more damage than the decline in stocks after the dot-com bubble burst in 2000, even though the loss of value was about the same. Why? During the dot-com bubble very few stocks were bought with borrowed money, whereas during the housing boom, almost all homes were. As home prices plunged, owners defaulted, and loan losses ate away at lenders" capital. Indeed, the worst financial crises usually involve banks because banks are, by their nature, leveraged.
Leverage often gets a helping hand from moral hazard, moral hazard, a term originally borrowed from insurance. It means that a person will take more risks if he is insulated from the consequences. If you pay for your son"s car insurance and speeding tickets, odds are he"ll drive faster. If investors believe the government won"t let a company fail, they"ll give it more money and charge it less interest. In the 1980s, federal deposit insurance enabled thrifts to lend recklessly to real estate developers. Investors lent to Russia on the view it was "too nuclear to fail." It defaulted in 1998. Though Fannie Mae and Freddie Mac were owned by shareholders, investors a.s.sumed the government wouldn"t let them fail and lent to them for almost as little as they charged the U.S. government. Can you blame them? After the two collapsed from all that subsidized borrowing, taxpayers bailed them out. a term originally borrowed from insurance. It means that a person will take more risks if he is insulated from the consequences. If you pay for your son"s car insurance and speeding tickets, odds are he"ll drive faster. If investors believe the government won"t let a company fail, they"ll give it more money and charge it less interest. In the 1980s, federal deposit insurance enabled thrifts to lend recklessly to real estate developers. Investors lent to Russia on the view it was "too nuclear to fail." It defaulted in 1998. Though Fannie Mae and Freddie Mac were owned by shareholders, investors a.s.sumed the government wouldn"t let them fail and lent to them for almost as little as they charged the U.S. government. Can you blame them? After the two collapsed from all that subsidized borrowing, taxpayers bailed them out.