"Mind the Gap" and the 1980s S&L Crisis: Financial Turmoil 21st Century-Style

Make no mistake, what we've got today is a mess. And it is hard to put your finger on any one thing and say "this is the proximate cause" of the dislocation, except to maybe say "easy money." How that easy money manifested itself, however, is what makes the story so interesting. If, for a moment, we buy the argument that the US Fed kept rates too low for too long after injecting massive amounts of liquidity into the market in the wake of the tech bubble bursting in 2001, and that it neglected to sop up all those extra dollars sloshing around the system after the crisis passed, its impact has had a ripple effect that provided a window of opportunity for businesses and consumers alike through:

• Cheap consumer mortgage loans with heavily back-ended costs;

• Cheap private equity/LBO loans with weak covenants;

• Cheap hedge fund loans with easier collateral requirements; and

• An abundance of opportunity through the "carry trade" across markets and asset classes.

And when I think about this from a historical perspective, it seems to me like a synthesis of the Savings & Loan (S&L) crisis of the 1980s and the junk bond implosion of the late 1980s/early 1990s. The S&L crisis was fueled by a classic blowing-up of the carry trade, as shorter-dated liabilities repriced at much higher levels much faster than longer-dated assets, causing balance sheets to bleed until capital was wiped out. Yes, the regulatory environment was a principal driver of this dislocation (as rates paid for deposits were de-regulated, causing a competitive environment for attracting financing for all those low-earning, long-dated asset portfolios), but this was a brilliant example of the carry trade gone awry.

Gillian Tett, who penned an article in the Financial Times asking why the market missed this new "monster" (e.g., long-dated, illiquid asset vehicles funded by short-dated commercial paper), said the following:

But while risk managers have been obsessively watching hedge funds, another problem has been brewing, unnoticed – conduits and structured investment vehicles.

For though few observers outside the halls of high finance had heard of SIVs until this summer (let alone their mutant cousin, SIV-lites), these vehicles are now throwing global money markets into a panic.

In particular, what investors have suddenly realised in recent days is that not only have financiers created these vehicles on a startling scale this decade but they have also done so using an appalling funding mismatch.

Most notably, while these vehicles typically invest in long-term assets that tend to be illiquid, they finance themselves with asset-backed commercial paper that typically lasts just three months. This summer, however, investors in the ABCP market have gone on strike. Thus conduits and SIVs are now suddenly calling on bank liquidity lines instead.

From my standpoint there is nothing new here. This monster - poor gap management - is nothing new. It has plagued financial systems from time immemorial. And this isn't really a regulatory issue, it is an investor due diligence issue. So I don't believe the issue is being framed right; regulators should have nothing to say about this particular monster, unless issuers provided false or misleading disclosures (in which case the regulators have an historical tangle on their hands). If investors are inclined to do stupid things, that is their prerogative (though their investors may vote with their feet and walk to their nearest class-action lawyer to ponder a lawsuit), but the relationship is between the investors and issuers, not regulators.

That all said, I think we're all going to be just fine because of two key things:

• Global central banks, led by the US Fed, will pump the necessary liquidity into the market to avoid a monetary meltdown; and

• Global institutional investors, with the liquidity and the desire to put trillions to work, will keep asset prices from reaching the rock-bottom levels generally found at the end of epic credit crunches and liquidity crises.

I've touched on this previously as has another of my favorite writers from the FT, John Authers. Ultimately, the is a liquidity crisis and the Fed is taking the lead on managing this crisis on the global stage. And they're not going to screw it up. The stakes are just too high. We've seen this movie before, as have members of the Fed and other leading central bankers. The only question is whether or not they'll keep too much liquidity in the system as they did post-2001, laying the groundwork for another bubble. Hopefully they'll let investors take some of the pain and get us on solid, stable, healthy long-term footing once again.

Comments

[Michael]

Re Scott: "I am worried about what we haven't thought of. "

In "The Age of Turbulence" (ha ha), chaos spawns new life. Worry gets in the way.

As a coder of an overtly simple predictive trading system, this turbulence is awesome, and fairly predictable if one can remove the clutter. I believe that's what M110 is attempting to do by quantifying blogs. I do it by quantifying human emotions.

Tomorrow, Monday Sept 17, the Fed will be dealing with the surging emotions surrounding Greenspan's thoughts.

Again :)

[Scott]

Great post as always Roger.

I agree with your analogy to the late 80's and S&L Crisis. Unfortunately, I believe we are in the early innings of this unwind and recalibration of a massive failure in risk/gap management.

I hope the Regulators' have their eye on the ball. This seems too easy since we are already seeing distressed funds set-up and the vultures at bay. I am worried about what we haven't thought of. The late 80's and early 90's were brutal and costly -- remember when no one would buy even Citi's secondary except a
prince -- we may have a long way to go to shake this one off.

[Adamchik]

Is it a liquidity crisis, or a crisis of insolvency?

Roubini makes a pretty good case for insolvency - liquidity won't help much with that:

http://www.rgemonitor.com/blog/roubini/213894

[Shrek]

Yea there going to blow another bubble. A CPI bubble. Gas bubble? How about a wheat bubble?

[MT57]

Interesting post, thanks. Tend to agree with you in part. However, (1) a covenant-lite loan is not a diligence problem so should not be lumped in here; in economic terms it is at best a monitoring weakness but even then it may be priced correctly to take that into account. After all, for decades, billions of dollars in corporate bonds have been covenant-lite and no one has identified that as a big risk. Covenant-lite senior debt has just arrived coincidentally with the other credit market developments you point to. It is not itself a systemic issue. (2) If at some point investor diligence mistakes become so large as to threaten the financial system, maybe you have to bail out but don't you also need some regulatory approach or other mechanism to eliminate/reduce the risk that the investors whose lack of diligence caused the systemic problem can't do it again and others can't replicate the diligence mistakes?

[Byrne]

If what we're seeing now is a symptom of excess liquidity, I would think that increased liquidity would just compound the problem (though it might delay it).

Glad to see you're back to blogging.