Endgame

For quite a while now, the Libor-OIS spread at 3 months and longer has mainly reflected perceptions of counterparty default risk rather than a systemic shortage of liquidity.[i]

Since the crisis started in August 2007, Libor has been the rate at which banks are unwilling to engage in unsecured lending to each other.  This is not just because even as a measure of the marginal cost of unsecured interbank funding, Libor is fatally flawed:  too few banks are involved in its construction and it is based not on the interest rates attached to actual transactions, but on banks’ (reported) estimates of the terms on which they would be able to borrow.  Cheap talk has never been a good basis for a price index.

Unsecured interbank lending has shrunk to the point of vanishing.  The reason is fear –  at first, fear of counterparty illiquidity or default; increasingly, just fear of counterparty default.

The reason for the reciprocal fear in the banking sector is obvious, and the fear is entirely rational.  Since the recovery from the tech bubble crash and especially during the period 2003 – August 2007, the banking sector in the US and in Europe expanded its balance sheet, employment and profits seemingly without bounds.  I include in the banking sector all the highly leveraged near-bank financial institution, the shadow banking sector (including all the off-balance sheet vehicles), hedge funds, private equity funds, sellers of insurance products for financial instruments like the Monolines and AIG, and anything else that is highly leveraged and subject to material asset-liability mismatch as regards maturity, liquidity, currency denomination and other payoff-relevant characteristics.

The result of this massive and excessive growth of the financial sector, and of the banking sector (broadly defined) in particular is a serious overcapacity – an unprecedented excess supply of financial services and products.  Much of the expansion in financial products and services of the past half decade involved transactions between an ever-growing number of financial institutions rather than intermediation between ultimate savers and ultimate investors.  Intra-financial sector intermediation was the source of much of the apparent profits and capital gains in the financial  sector.  While some of this intra-financial sector intermediation no doubt was efficiency-enhancing, much of it, perhaps most of it, was unproductive churning  – the organisation of expensive lotteries.

There will be a large contraction in the scale and scope of financial sector activities.  The gross balance sheet of the highly leveraged sector may halve or more, on average, and employment could contract by a third before the bottom is reached.

The survival of the fittest and the fattest 

The necessary contraction in the scale and scope of the financial sector will not occur through the equal proportional contraction of balance sheets and employment in all banks and other financial institutions.  It will instead be selective and uneven. Much of it will occur through the disappearance (via insolvency and bankruptcy, take-overs and mergers) of those among the weaker brothers and sisters that are not deemed too large, too interconnected or too politically connected to fail.

The failures or near-failures we have seen thus far have certainly not been random.  Well before August 2007, every trader in the City of London knew that the three banks with the highest exposure to the wholesale financial markets were Northern Rock, Bradford and Bingley and Alliance and Leicester.  Northern Rock is now in state ownership, Bradford and Bingley was saved by a shotgun rights issue forced down the throats of the unhappy underwriters by the UK authorities, and Alliance and Leicester is now owned by the Spanish bank Santander. A couple of small building societies were absorbed by a larger competitor just before they were to announce some poor results.  Consolidation in the home-lending sector will be dramatic.  Home lending by institutions other than banks and building societies (institutions that rely on selling securitized mortgages in the wholesale markets) has dried up completely and is unlikely to make a comeback anytime soon.

In the rest of Europe, large banks domiciled in small countries with their own national currencies (instead of the euro- a global reserve currency that bolsters the creditworthiness of banks domiciled in even the smallest nation in the euro area) look especially vulnerable.  Iceland and Switzerland are examples of countries in which the central bank may be hard-pressed to come up with the foreign exchange liquidity required for the effective discharge of the lender-of-last-resort and market-maker-of-last-resort roles.  The extremely low fiscal capacity of the central government of Switzerland (a Confederacy) also raises question marks about the fiscal back-up of the central bank should a large-scale recapitalisation of part of the banking system turn out to be necessary.

In Germany, the survival of the fittest points to the Landesbank that has dabbled in complex structures it wasn’t competent to handle, as a natural candidate for the chop.  The economic Darwinists have not been disappointed.

In the US, financial institutions dependent on wholesale market financing and exposed to the housing and construction sectors are the obvious ones on Darwin’s shortlist.  The Darwinian mechanism gets frustrated when size and connections trump efficiency qualifications for survival (if you define fitness as having whatever you need to survive in the world as it is, then managing to get too fat, bloated and politically well-connected to fail, would constitute a good Darwinian survival strategy for the individual institution, if not for the system).

Fannie and Freddie are the classical examples of ‘too fat and too politically connected’ to fail.  I have high hopes, however, that these institutions will not survive in their present form and size.  A single, small, state-owned institution with an explicit social mandate targeted at the bottom of the housing market would be a good successor to the two dysfunctional, institutionally corrupt housing heffalumps.

Bear Stearns was both the smallest and, as regards funding structure, the most vulnerable of the US investment banks.  It was also highly exposed to the RMBS market.  It was unlucky in that at the time it hit the wall, the Fed had not yet granted the primary dealers access to its  discount window (through the PDCF).  Neither had the TSLF (a provider of longer-term liquidity against MBS) seen the light of day.  To top it all off, there was no special resolution regime for investment banks, through which the regulator(s) could put a near-failing systemically important entity into administration (or Conservatorship, as it is called in the case of the GSEs).

Now, with Lehman Brothers fighting for its survival, there is better access for investment banks to external finance through the PDCF and the TSLF.  It is, however, incredible that, despite 6 months having passed since Bear Stearns hit the rocks, there still is no special resolution regime for investment banks in the US.  The US Secretary of the Treasury and the responsible parties in the US Congress should be taken away and shot after a fair trial for this dereliction of duty.  As a result of this bi-partisan procrastination, we continue to be in the position that, should another investment bank become non-viable, and should it be deemed (despite the presence of the PDCF and the TSLF) to be too large and/or too interconnected to fail, the only way to deal with the situation is another disgraceful last-minute, panic-drenched, non-transparent private sale rather than the orderly transition into administration, through the imposition of a Conservatorship along the lines of what was agreed for Fannie and Freddie (but preferably with a complete wipe-out of ordinary and preferred shares and with the imposition of a robust set of charges/haircuts on the other creditors).

Note that in the US too, the dominos are not falling randomly.  Any highly leveraged institution with short-maturity liabilities and long-maturity and/or illiquid asset can never be safe, regardless of how sound its assets are. So there is no such thing as a safe bank in the absence of a credible and effective lender of last resort and market maker of last resort.  We appear to be, however, beyond this stage of the game.  The Fed and the other leading central banks have got their lender-of-last resort and market-maker-of-last-resort act together.  Illiquidity now is mainly the result of fear of insolvency.  More than a year since the crisis started, banks find it increasingly difficult to hide the true extent of the mess they have accumulated on their balance sheet or are carrying through off-balance sheet exposure.  The dominos are falling in order of their perceived insolvency risk, and the perceived insolvency risk appears increasingly congruous with the fundamentals.

Financial institutions that are mostly heavily exposed on the funding side to the wholesale financial markets and on the asset side to the housing finance and/or construction markets are the ones that have failed or are at greatest risk of failing.  This holds for Countrywide and Indymac, for Bear Stearns and Lehman and for the medium-sized and small banks that invested heavily in ordinary and preferred stock of Fannie and Freddie.

The disappearance of a large number of banks, including, on both sides of the Atlantic, some household names, will boost the profitability of the survivors and is likely to produce a more speedy resumption of normal lending and funding activities than an equal sharing of pain, of the kind that was attempted in Japan following the collapse of its asset price bubble.  With a bit of luck the endgame for the banking sector will be short and the financial players will be able to start another game – with a rather different set of rules, I would hope.

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[i] The OIS rate is the fixed leg of a swap whose variable counterpart is the daily compounded return of some safe or secured benchmark rate on overnight transactions.  Typically, the overnight benchmark is the weighted average of the central bank rate.  In the US this would be the Federal Funds Effective rate.  In the UK it is SONIA, in the euro area EONIA.  Libor is the benchmark rate supposed to representative of the  interest rates at which banks offer to lend unsecured funds to each other in the London wholesale money market (or interbank market).