Liquidity in Crisis

Charles R. MorrisOctober 20, 2008

Where We Are Now

• Bank systemic solvency no longer at issue

• Serious recession inevitable

• Big in drop Personal Consumption share of GDP both essential and inevitable

• Post-crash economy likely to be quite different from recent experience

How We Got Here

Debt and GDP: The Last Quarter-Century

Debt as Percent GDP: 1973-2008

0

50

100

150

200

250

300

350

400

Perc

ent G

DP

HH Mortgages HH Other Business Debt

Federal Financial Sector Other

Debt/GDP by Sector Indexed Scale

Year HH Fin Fed Bus

1980 100 100 100 100

1985 108 144 143 115

1990 124 217 163 122

1995 131 276 187 105

2000 143 400 131 125

2007 196 557 141 144

 

Trading Book

YtY Increase

Total Assets

Gross Leverage

Operating Cash Flow

Bear 122.5 13.0 395.4 33.5 11.1

Lehman 313.1 86.5 691.1 30.7 -45.6

Citigroup 539.0 145.1 2,187.6 19.3 -71.4

JPMorgan 491.4 125.7 1,562.1 12.7 -110.6

Merrill 234.7 30.9 1,020.1 32.0 -72.4

Goldman 406.4 118.0 1,119.8 26.2 -68.2

           

Totals 2,107.2 519.2 6,976.1 20.2 -357.1

The Leverage Factory in 2007

Fed Funds lower than inflation rate for 31 months from mid-2002 to early 2005.Spreads over all risky instruments dropped like a stone

Shift from Lending to Trading: Big Increase in

Leverage

IMF

IMF

CDOs Show ‘HighPreference for Subprime…In CDO Collateral….forYield in Mezzanine’ Tranches.(S&P) Subprime and Alt-A = 41% New Mtgs in 2006.

Fannie and Freddie involvementin subprime and Alt-A marketswas actually fairly modest,although it bounced up sharply inthe second half of 2007, whenABS issuers exited rapidly

BIS Net Financial Sector Lending by Lender Type: 2000-2007

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2000 2001 2002 2003 2004 2005 2006 2007

$ B

illio

ns

Depositary Banks Insurance/Pension Funds ABS Issuers

GSEs Finance Companies Broker Dealers

Other MMFs

From Countrywide 2007 10-K:

Countrywide YE Mortgage Book

Pay-Option ARMs 28B 32%

Seconds 34B 39%

Total Book 87B 100%

On pay-option loans: “ Our borrowers’ ability to defer [payment]… may expose us to increased credit risk…. Our underwriting standards include [various strict rules]… However, most of of the pay-option loans we hold were underwritten with stated or limited income documentation.”

Pay-Option Statistics

Year 2007 2006

% No/Lite Docs 81% 81%

% Def Payment 71% 77%

% Delinquent 5.36% 0.63%

Risk Compounded by MassiveEmbedded Leverage

3% Equity Layer

3-6% Mezz D

6-9% Mezz C

9-12% Mezz B

12-18% Mezz A

78% SeniorCDO Bonds

33:1 Leverage

HF LPs: $1

HF Banks:

$4

HF Leverage5:1

HF Leverage: 165:1

Mortgages

RMBS

RMBS

RMBS

RMBS

RMBS

AA

ABBB

BBB-

AAA

The Tireless SearchFor ‘Alpha’

Hedge Fund

Adapted from Fitch (2006)

Set-up for Disaster

• The risk paradigm– Very large embedded leverage– Illiquid assets– Mismatched funding– Underlying assets highly default-prone – Tight coupling (rapid transmission) through CDS

• Plus late-stage bubble-baroque– Synthetic CDOs with multiple asset classes– CDOs-squared and CDOs-cubed

High-Risk/Leverage => Disproportionate ProfitsFinancial Sector Share of Corporate Profits and Value Add

1980-2007

NIPA Profits

NIPA Value Add

BEA-NIPA/FRB

NB: Very high nominal services productivity in 2000sdriven by financial sector profits

Should we retro-fix economic data?

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

NIPA Value-Add

NIPA Profits

FRB Profits

Picking up the Pieces

Trade Deficit G&S, 1990-2007

0100200300400500600700800

$ B

illi

on

s

0.0%1.0%2.0%3.0%

4.0%5.0%6.0%7.0%

Perc

en

t G

DP

Trade Deficit Percent GDP

Home Equity Extraction for PCE 1991-2008

0100200300400500600700800900

Bil

lio

ns C

urr

en

t $

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%10.0%

Perc

en

t G

DP

I

HH Eq for PCE Percent GDPI

Total G&S TradeDeficit, 2000-07:$4.5T; 4.8% GDP

Home Equity Extraction for PCE, 2000-2007:$4.2 T; 6.1% ofDisp. PersonalIncome

Prosperity in the 2000s

Federal Reserve; BEA. PCE = Personal Consumption Expenditure

$ Billions 10/08/08 9/19/08 9/19/07 Percent Change

Gold, SDRs, etc. 14.5 14.7 0.4  

Securities      

Treasuries 285.3 362.6 777.7 -63%

Repos 100.0 98.0 32.7 206%

TAC 149.0 150.0 0.0

Other Loans 430.9 121.3 0.0

B-D Term Facility 191.3 117.3 2.0

BS Portfolio 29.5 29.4 0.0

Other Assets 374.9 99.3 38.2 881%

Misc. 17.6 17.8 21.0

       

Total 1,593.0 995.7 856.4 83%

Fixing the Problem?The Federal Reserve’s Balance Sheet

Federal Reserve Board

Net Financial Sector Lending by Lender Type: 1975-2007

0

5001,000

1,500

2,000

2,5003,000

3,500

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

$ B

illio

ns

Depositary Banks Insurance/Pension Funds ABS Issuers

GSEs Finance Companies Broker Dealers

Other MMFs

Loss of assets to the depositary system has been episodic and crisis-driven. If a policy objective is topreserve depositary banks’ asset shares, selectivere-equitizations may be more efficient.

Govt responsesmore typically to suspend accountingrules and infuseliquidity

Public Interventions So Far – Guesstimates

$ Billions

Increase in FRB Balance Sheet

~700

Fan and Fred Rescue ~250

AIG and Bear Rescues ~125

TARP 700

Total $1,800B

Sectors Not YetHeard From: - PE Takeover Loans - Corporate Bonds - CRE - CDS Defaults

NB: Banks cumulative asset write-downs $600 B,through Sept. 30

Restarting the Economy

Realities

• Can’t be a consumer-based recovery• Need to rebuild savings => higher rates• Can’t be trade-deficit dependent• Ideally, will attract back overseas dollar holdings

Privatized Infrastructure Push?

• Private project finance for infrastructure rebuilds– Attractive to SWF dollars (bond revenues)?– Jolt to a US heavy equipment industry– One of best export opportunities

• Some complexities– Fragmented electrical grid– Adverse consequences of high road tolls

And Health Care…..Really

Improvement Over 1968 Heart Disease

Death Rate Saves ~1 million Lives a Year

Actual CHD Mortality vs. Peak Mortality and Projected Trend: 1970-2004

0

100

200

300

400

500

600

19

70

19

72

19

74

19

76

19

78

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82

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19

86

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88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

Actual Rate Projected Peak Rate

Required huge infrastructure and technology expenditure (EMT, ER, Drugs, CBG, Stents, etc. And now millions of people are

walking around who have had heart attacks.

NHLBI

Economic historians call this ‘Progress’

PCE Share Trends: All Other vs Food/Clothing and Medical

0%

10%

20%

30%

40%

50%

60%

70%

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

Food/Clothing Medical All Other

The Myth of Medical ‘Crowding Out’

BEA/NIPA

“…So financials are going to shrink as an important part of the S&P 500, and the question is, "What's going to expand?" Two areas that have potential to expand are technology and health care.”

-- Byron Wien, Barron’s August 25, 2008

Life Sciences (biotechnology and medical devices) accounted for 28% of all venture capital investing in the first half of 2008 “in line with its dominant position in recent years.”

--PricewaterhouseCoopers

Health Care second largest sector of S&P 500, at 13%; Financial Services, 20%-- Wall Street Journal

Medical Device Industry (Imaging and Devices) ~$250 billion in Global Sales. U.S.

Considered Technology Leader

-- European Commission 2004

Canny Investors Love Health Care

The Cyclicality of American Politics

• 25-30 year cycles:• Keynesianism:

– Religion of intelligent governors– First wide cachet late 1950s– High point in 1960s– Excess and burn-out in 1970s

• Reagan/Thatcherism– Religion of infallible markets– First wide cachet late 1970s– High point in 1980s– Excess and burn-out 1997-2007

• Followed By????