$Trillion Losses: the Minsky Moment Continues
Last summer George Magnus of UBS asked whether or not we were at a Minsky moment. That is a
situation when leveraged borrowing had progressed from sound borrowers (who can repay) to speculative borrowers (betting on cash flow) to Ponzi borrowers (guess !) and we were about to proceed with the reverse unraveling. As the previous and many other posts here have argued not only wasn't the credit market contagion NOT confined to sub-prime, or even housing-realated, markets but there were many rocks and then boulders which would topple into the ponds of the credit markets. And the effects would be self-reinforcing as the various ripples from those topplings impacted not just adjacent markets but distant ones as well. In this recent FT 3-part interview George updates his outlook and it is anything but sanguine, in the modern sense of the word. The old sense of sanguinary was bloody - as in the aftermath of a major battle. We use it in that sense. The vidclips can be reached thru clicking on thru the picture and we HIGHLY recommend that you do so. The interview is pretty non-technical but the numbers and consequences are startling.
Below the line we've gone back over the last several months posts and collected up a bunch of the critical readings related to these issues. Including one that introduces the original Minsky Moment phrasing (BTW - for the record the person who really first started talking about Minsky-like problems was Paul McCulley of PIMCO and he did it back in '06.) We also re-list the links to our prior posts on the credit crisis, perverse incentives and the "rocks in the pond" model.
While it's tempting with short-term satisfactions to indulge in some schadenfreude we'll postpone that for this evenings scotches...yes that's plural. This is too severe a problem, spreading too rapidly to be fully savored (our previous labeling was Ebolatization of the credit contagion and we used the movie of the same name as our model. That still seems to be accurate IOHO !).
BTW - this is a 3-part interview and you really should watch all three, you really...really should. And HT to Barry Ritholz for posting this before we got to the FT today as well. Anyway if you'll listen to all three you'll hear George pretty well - we actually exactly - concur in that marvelously understated British way with our take on the credit markets, the economic outlook, the worldwide slowdown and the market's lack of awareness. Or that's what we think we heard. You decide - because you will one way or another !
READINGS
Are We at The Peak of a Minsky Credit Cycle? It is always risky to call an equity market peak and the beginning of a bear market in equities; so I will not try to do that. But leaving aside equity valuations, it increasingly looks like we are at the peak of a credit/debt cycle, in the US and globally. Specifically, the crucial macro question that we should ask ourselves today is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist George Magnus – an expert of financial instability - put it: “Have we reached a Minsky moment?”
In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations. The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.
Our Risky New Financial Markets Tremors from America's quaking subprime mortgage market have spread throughout the financial world. This latest disturbance in global financial markets is neither isolated nor idiosyncratic. It points to deeper, enduring changes in the structure of our markets -- changes that have profoundly altered the behavior of market participants in ways that tend to encourage risk-taking beyond prudent limits. Just as troubling is the failure of official policy makers to effectively rein in such excesses, leaving our financial system vulnerable to similar turmoil in the future. The principal structural driver behind this and similar financial tribulations is the massive growth of financial markets, combined with a plethora of new credit instruments. By any measure, current financial activity -- new financing or secondary market trading volume -- dwarfs the past. The outstanding volume of nonfinancial debt now exceeds nominal GDP by $15 trillion, compared with $6 trillion a decade ago. Traditional credit instruments such as stocks, bonds and money-market obligations have been joined by a long and diverse roster of new obligations, many of them extraordinarily complicated. Along with the arcane tranches of mortgages that recently garnered attention are a myriad of financial derivatives, ranging from those traded on exchanges to tailor-made products for the over-the-counter market.
Some major prior readings: Weekly Reader 19Aug07: Markets & Investments
The Minsky Moment Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.
Bookstaber Asks: Where Were the Risk Managers? What a mess. With multibillion dollar trading losses, we are starting to see heads roll. Citigroup is losing its longtime fixed-income head Tom Maheras and several of his lieutenants. Merrill is continuing in its approach to managing human capital, bringing in new blood and losing experienced hands in the fixed income business. Oh, and they are putting someone into a Chief Risk Officer role. Talk about closing the barn door…. Other firms have fared very poorly but so far without executing any of the troops. Morgan Stanley layered a heart-stopping $390 million one-day loss in its proprietary trading desk on top of far bigger losses on leveraged loans and the like. This loss in Process Driven Trading was similar in timing to the losses at Goldman’s Global Alpha fund, AQR and other quant hedge funds. Which pretty much tells us that what this secretive group at Morgan Stanley was up to was a not-so-secretive strategy: They had a lot of capital riding on the same sort of momentum and value versus growth quant equity strategies as the rest of the gang. What I don’t understand in all of this is that for all the mention in the press of the risk takers, there is not a single mention I have found of the people who are supposed to be overseeing the risk. If you are the Chief Risk Officer and everything blows up, don’t you bear some responsibility? To get the idea of the CRO job, let me tell you a bit about myself. Although I am older and have a slight build, I am an Olympic athlete. My event is the shot put. I consider myself a top notch athlete in this event. I work out like the other competitors, follow a high protein diet, steer clear of performance enhancing drugs and train at the local track. The only trouble I have is when the Olympics roll around every four years, because it turns out that for an Olympic athlete, I am not very good. But then, that is only an occasional blip in my otherwise Olympic-worthy regimen.
MAJOR PRIOR POSTS
More on the Credit Crisis: the Rocks in the Pond "Model", Rocks, Ponds, Perverse Incentives: More on Credit Contagion
Understanding the Credit Crisis: More Readings & Resources,The Fed and the Credit Crisis: More Readings & Resources,The Fed & the Credit Mess: Readings II