this is an email sent to my CIO, Head of Fixed Income and Fixed Income team members on July 5, 2007, which I am now posting later
I’ve been contemplating putting this email together
for weeks. I don't want to barrage you with stuff that you don't want to
receive, particularly at quarter-end when everyone is busy, but I still want to
rationalize my viewpoint from our forecast meetings, and expand on my concerns
about the greater possibility than normally assumed for a major credit-related
tail event.
We've discussed housing, the labour market, and
recession risks quite a bit and everyone is well aware of the issues/concerns,
so I won't belabor those areas. But it seems clear that my concerns about a
credit bubble and the likelihood of its bursting are not shared
(notwithstanding our caution on credit spreads), and I suspect that in addition
to my forecast being too far outside the realm of normal experience, it may also
simply be because most of us have more immediate things to track and worry
about than credit bubbles. But, on the offhand chance that I'm right, the
bursting of a credit bubble could have huge ramifications, including deflation
(something like 1990s Japan or 1930s Depression should not be considered
totally out of the question).
In fact, the Bank of International Settlements (BIS) warned just last
week in its latest annual report (http://www.bis.org/publ/arpdf/ar2007e.htm)
about just such a risk (BIS warns of Great Depression dangers from credit
spree: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/06/25/cncredit125.xml
; Credit crunch will 'shred investment portfolios
to ribbons' : http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/02/bcncrunch102.xml
); meanwhile Lombard Street Research, among others, are ringing similar
warning bells following the Bear Stearns fiasco ( Banks
'set to call in a swathe of loans' : http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/06/26/cnusecon126.xml
)
The Bank is clearly concerned about the risks
associated with today’s global credit buildup.
Without naming names, the Bank noted that there are
basically three prevailing views among monetary authorities around the world
about how to include monetary and credit aggregates in the formulation of
policy: (1) the output gap between aggregate supply and aggregate demand is
what matters, and monetary &/or credit growth is uninformative (Fed); (2)
the output gap impacts short-run inflation, but monetary trends have
significant influence on inflation in the long-run (ECB); (3) monetary, and
especially credit, growth are of great importance, particularly in periods when
rapid growth of these aggregates combine with deviations of spending patterns
from traditional norms, portending not just inflationary outcomes in the medium
term, but more significantly a boom-bust cycle with significant economic costs,
including deflation over the long-run.
Not only did the Bank make clear that it is not an adherent
of the 1st school and cite the fact that the 2nd and 3rd schools of thought
have been gaining influence of late, but it in particular said “new crises and
the further analysis of old ones have provided empirical evidence to support
the specific arguments for concern expressed by the third school”.
The Bank also discussed the question of “how best to
deal with what seems to be the natural pro-cyclicality of the financial
system”, i.e. asset bubbles and global financial imbalances, endorsing a monetary
policy approach of reacting when a number of indicators (asset prices, credit
growth, spending patterns) exceed normal ranges.
Without naming it as such, the Bank criticized the
“Greenspan Put” of mopping up with vigorous monetary easing after a bubble
bursts, due to that approach’s “shortcomings”. For one, as in Japan’s
experience of “pushing on a string”, it “might not always work”, as the “zero
lower bound for policy rates proved an important constraint”, and “excessive
investment and debt built up in the good times weigh heavily on the economy for
many years”. The Bank also reflected on the post I.T. bubble experience that
“lower rates have unwelcome side effects” (“below-equilibrium interest rates
effectively transfer wealth from creditors to debtors, which will tend to lower
savings rates and economic potential over time”; “search for yield might
encourage imprudent behaviour”). In essence, “these factors make the economy
more vulnerable to shocks over time. In effect, dealing with today’s problem of
deficient demand through sustained monetary accommodation can sow the seeds for
more serious problems further ahead.” Clearly, the Bank is suggesting that the
Fed policy of easy money after the stock market bubble burst has fostered new
bigger problems currently than those the Fed originally had to deal with.
But the U.S. is certainly not the only concern of the
Bank: “given the recent rates of credit expansion, asset price increases and
massive investments in heavy industry, the Chinese economy also seems to be
demonstrating very similar, disquieting symptoms” to those experienced prior to
the 1991 Japanese bust, which “were actually sown in the preceding, rampant
monetary expansion designed to keep the yen down.”
All told, the Bank is not forecasting the certainty of
a major financial and economic event, but it is warning loudly that ignoring
monetary and credit aggregates is wrong-headed, that complacency is foolhardy,
and that the risks are currently much greater than is widely appreciated:
-
“As a near-term proposition, a forecast that says the future will be a lot like
the past has a lot to recommend it…. Yet it is not difficult to identify
uncertainties that could conceivably cause this near-term forecast to come
unstuck, or that could result in less welcome outcomes over a longer horizon.”
These include:
o
Possible resurgence of global inflation
o US economic
growth soft landing would be welcome to tame inflation, but too-much-of-a-good
thing is quite possible as the positive forces that supported US
housing/debt/consumption all reverse, in conjunction with “corporate fixed
investment already inextricably weak given high profits and low financing
costs”, leading to a hard landing
o
Persistent and substantial global trade imbalances
o Reliability of
public sector inflows has also become more uncertain, and holders of large
portfolios of reserves might begin to reduce the proportion of new reserves
held in US dollars
o
Potential vulnerabilities in financial markets and possible knock-on effects on
financial institutions
-
“Behind each set of concerns lurks the common factor of highly accommodating
financial conditions”… “tail events affecting the global economy might at some
point have much higher costs than is commonly supposed”
-
Irrational exuberance: “There seems to be a natural tendency in markets for
past successes to lead to more risk-taking, more leverage, more funding, higher
prices, more collateral, and, in turn, more risk-taking… Apparently, the
observed resilience of markets to successive shocks has increasingly encouraged
the view that lower prices constitute a buying opportunity. The danger with
such endogenous market processes is that they can, indeed must, eventually go
into reverse if the fundamentals have been overpriced. Moreover, should
liquidity dry up and correlations among asset prices rise, the concern would be
that prices might also overshoot on the downside. Such cycles have been seen
many times in the past.”
-
“The attention of financial markets first focused on the US subprime mortgage
market, but the underlying issue is much broader.” The “too rapid growth of
[monetary and credit] aggregates could be either a harbinger of inflation or
the sign of financially driven boom-bust cycle with its own unwelcome
characteristics.”
-
the difficulty of economic forecasting, particularly at cyclical turning
points: “The Great Inflation in the 1970s took most commentators and
policymakers completely by surprise…. Similarly, virtually no one foresaw the
Great Depression of the 1930s, or the crises which affected Japan and Southeast
Asia in the early and late 1990s, respectively. In fact, each downturn was
preceded by a period of non-inflationary growth exuberant enough to lead many
commentators to suggest that a “new era” had arrived.”
One of the experts on credit cycles was an economist
named Hyman Minsky. I've attached a report on the prospects of a "Minsky
Moment" from a UBS economist, George Magnus, and there are a few introductory articles
about Minskian beliefs below.
- AN ARTICLE FOR YOU, FROM ECONOMIST.COM -
PONZIFICATING
Mar 15th 2007
Is the financial system a confidence trick?
CHARLES PONZI was a likeable man. That helped him persuade American
investors in 1920 that he could deliver returns of 50% in just 45 days
by exploiting a loophole in the pricing of international postal
coupons. In a way, he was advertising an early version of an arbitrage
fund.
In reality, the loophole could not be practically exploited. So Ponzi
exploited his customers instead. He could deliver returns only by
taking money from new investors to give to his early backers. But
although he died in poverty, the Italian immigrant achieved immortality
of a sort: fraudulent moneymaking operations are often known as Ponzi
schemes.
In the world of finance, describing something as a Ponzi scheme is a
standard form of abuse. This insult has been bandied around a lot of
late. Financial-sector profits have grown far faster than GDP over the
past 25 years; everyone has become richer by lending money to everyone
else. Household debt is running at about 100% of GDP in America and
higher still in Britain. Credit derivatives are soaring in value and
payment-in-kind notes (which pay interest with more debt, rather than
cash) are in vogue. Last month Tim Lee, a strategist at pi Economics,
described the whole financial system as "the equivalent of a gigantic
Ponzi scheme."
In one sense, of course, he is right. Many elements of the system are
Ponzi-like in that they depend on confidence--they would collapse if
all investors demanded their stakes back--or they rely on new backers
to keep them going. Pay-as-you-go pension systems, for example, depend
on there being enough workers to fund promises made to retired
employees.
The health of the commercial banking system depends on the assumption
that, at any time, most depositors will keep their money in the bank.
That allows banks to borrow short and lend long; earning higher rates
on loans to business. When depositors panic and start to withdraw their
money, the result is usually an economic catastrophe.
Ponzi's original scheme was fraudulent from the start. But even if he
had found some exploitable anomaly in the financial system, his
rationale was flawed. Because he offered such a high rate of return
over such a short period, claims on the "Bank of Ponzi" would quickly
have reached ridiculous levels.
So perhaps there are good and bad Ponzi schemes. Good schemes will do
more than funnel money from latecomers to early takers, allowing the
foremost to prosper at the expense of the hindmost. And they will not
allow claims to increase too fast. That was the big mistake of John
Law, the pioneer of paper money in early 18th-century France. Law's
system eventually collapsed, but he did have the insight that the
creation of credit might increase trade, and thus general welfare.
But how to tell when a scheme has gone too far? Hyman Minsky, an
American economist, distinguished three kinds of borrowers. Hedged
debtors can safely meet all debt payments from their cashflows.
Speculative borrowers can meet current interest payments from cashflows
but need to "roll over" their debt in order to pay back the principal.
And Ponzi borrowers can pay neither interest nor principal from
cashflows but rely on rising asset prices to keep going.
The American housing market seems to be suffering from the unravelling
of a Ponzi-type system. Subprime loans were offered on generous terms
that, implicitly or explicitly, depended on rising house prices. The
banks that made these loans bundled them up and sold them in the credit
markets to investors, eager for high yields. This was supposed to make
the financial system more secure by dispersing risk more widely.
But look what is happening now. The buyers of these loans are asking
the original mortgage-writers to buy them back. But these homelenders
do not have the money to do so. The confidence that sustained their
balance sheets has evaporated, leaving many in dire trouble.
Might the problem be more widespread than housing? The latest
stockmarket wobbles suggest investors are asking themselves the same
question. Financial-sector debt has risen from virtually zero 50 years
ago to 100% of American GDP today, and Europe's financial corporations
have helped to accelerate the money supply.
George Magnus, a strategist at UBS, has just written a research note
entitled "Have we arrived at a Minsky moment?" His big worry is of a
contraction in credit supply. As lending standards tighten, consumer
demand could suffer, possibly prompting a recession in the United
States. No one knows when the credit cycle will end, he says. But the
pyramid is beginning to look a bit top-heavy.
See this article with graphics and related items at http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=2512631&story_id=8864415
ALSO, FROM MONEYWEEK
http://www.moneyweek.com/file/27889/have-we-reached-a-minsky-moment.html
If economist Hyman Minsky is right, then our economy
is like a giant Ponzi scheme, and the rush for the exits is due to start. Is he
right? Simon Wilson reports
Why is Minsky suddenly popular?
Minky was a moderately well-known US economist who
died in 1996 at the age of 77. He was well regarded within academia, but it
wasn’t until after his death that he became a cult hero among more bearish
commentators after his model of a credit-driven asset-bubble, proposed back in
the 1970s, was almost uncannily played out shortly after he died. Minky’s
postulated stages of how a bubble develops and ends (see below) described
almost exactly the rise and demise of the tech bubble.
And now the US subprime mortgage meltdown is following
a similar pattern.
What were his economic ideas?
Minsky is most famous for the idea that ‘stability is
unstable’. In short, unusually long periods of economic stability lull
investors into taking on more risk. This leads them to borrow excessively and
to overpay for assets. Minsky suggested three main types of borrower,
increasingly risky in nature. Hedged borrowers can meet all debt payments from
their cash flows. Speculative borrowers can meet their interest payments, but
have to keep ‘rolling’ the debt over to pay back the original loan. Ponzi
borrowers (named after the notorious American pyramid-scheme conman) can repay
neither the interest or the original debt, and rely entirely on rising asset
prices to allow them continually to refinance their debt. The longer a period
of economic stability lasts, his argument goes, the more society moves towards
being full of Ponzi borrowers, until the entire economy is a house of cards,
built on excessively easy credit and speculation.
Is this an orthodox view?
No. Mainstream economics generally views capitalism as
essentially stable – tending towards steady growth. Crises arise either from
preventable mistakes by policy makers (eg, the Federal Reserve’s too-tight
monetary policy, widely supposed to have exacerbated the Great Depression), or
by external shocks, such as Opec’s oil price hike in the early 1970s. Minsky,
by contrast, argues that capitalism is prone to crises from within; even good
times are destined to end as people start to get cocky about risk and borrow
too much.
Why is he so relevant now?
Minsky’s Ponzi borrowers are all too familiar from the
US subprime debacle. But Minsky went further, describing the process whereby
financial institutions, which also take more risks when stability reigns,
devise ways of getting round regulations and norms once seen as prudent. Again,
we can see this in US senators and regulators’ current concerns about lax
mortgage lending – but it also applies more broadly. Joseph Schumpeter (under
whom Minsky studied) is famous for the idea that capitalism renews itself
through competition and innovation – ‘creative destruction’ that chucks out the
bad and ushers in the good. But while Schumpeter focused on technology’s role
in driving capitalism, Minsky’s focus is on banking and finance. In a 1993
essay, Schumpeter and Finance, he wrote: “Nowhere is evolution, change and
Schumpeterian entrepreneurship more evident than in banking and finance and
nowhere is the drive for profits more clearly a factor in making for change.”
It’s this focus on financial innovation as a destabilising influence that is
now ringing alarm bells on Wall Street and in the City.
Why should we worry about instability?
Because much of the financial world shows signs of the
same kind of “this-time-it’s-different” mentality, as Edward Chancellor says in
Institutional Investor (see below). The success of the authorities in avoiding
a deflationary bust in 2002 through easy-money policies encouraged people to
take on huge debts, while competition among big lenders has loosened lending
standards (making the present private-equity boom possible, for example). The
rise of credit derivatives means loans are increasingly parcelled up in
innovative ways, insured, reinsured, and sold on – using a web of transactions
to bypass regulations intended to protect the credit system, as Minsky
predicted. The question now, as UBS economist George Magnus put it, is “have we
reached a Minsky moment”?
What’s that?
The Minsky moment comes when “lenders become
increasingly cautious or restrictive and when it isn’t only over-leveraged
structures that encounter financing difficulties”, says Magnus. Then, Minsky’s
credit cycle, extended beyond apparent breaking point as long as there are
profits to make and bonuses to collect, tips towards bust. As Chancellor
concludes, “investors who accept this analysis will probably conclude that risk
and reward are currently out of whack. They will position their portfolios
defensively, keeping cash on hand to spend when the rewards for risk appear
more compelling.”
How does Minky’s bubble model work?
Minsky said that a bubble begins with a
‘displacement’, such as a significant invention – the internet, for example.
This creates profitable opportunities in the sector affected, but alone it’s
not enough – financial innovation is needed to give people access to the cheap
credit required to kick-off the next phase: overtrading. People pile into the
sector, driving demand and prices higher. A euphoria phase ensues as ‘Ponzi’
investors speculate, often with borrowed money, on the basis that a ‘greater
fool’ will buy their assets at an even higher price. But eventually, whether
down to insiders selling out, or lenders tightening lending criteria, the
market hits a peak, panic sets in, there’s a stampede out of the market, and
bankruptcies ensue.
AND, FINALLY, FROM INSTITUTIONAL INVESTOR:
http://www.iimagazine.com/Article.aspx?ArticleID=1234217&PositionID=16672
Ponzi nation
07 Feb 2007
Edward Chancellor
Low volatility and easy credit are boosting asset
prices. But according to the late theorist Hyman Minsky, today's stability may
be sowing the seeds of its own demise.
Credit has grown rapidly in recent years. This
expansion has come in many forms, from home mortgages to newfangled structured
products created by clever financial engineers. There are, broadly speaking,
two views about these developments. The conventional wisdom -- held by most
economists and denizens of Wall Street -- is optimistic. Higher rates of credit
growth and increasing levels of leverage, they maintain, are reasonable in
light of increasing economic stability.
An opposing view -- held by a miscellaneous bunch,
including some notable investors and Wall Street observers -- holds that the
massive buildup of debt augurs ill. Drawing on the work of a little-known,
deceased economist named Hyman Minsky, the pessimists contend that the recent
calm has induced people to take on too much risk. "Stability is
unstable," this group says, quoting Minsky. Like the differences of
opinion toward the end of the last decade concerning the existence or not of a
stock market bubble, the current argument will be settled only by the unfolding
of events. Either the prosperity will continue in the years to come, or a
financial crisis will occur.
But not everyone can afford to await the passage of
time. Professional investors are paid to anticipate. Adherents to the
conventional view will construct radically different portfolios from those who
accept the instability hypothesis. Many investors, however, are undecided. They
believe, or perhaps just hope, that prosperity will endure while at the same
time they may feel uneasy about the growth of credit and other risk-taking
behavior evident in today's markets. The purpose of this essay is to introduce
Minsky's unorthodox ideas and relate them to recent developments in the
financial world. Readers should then be better able to judge for themselves
where they stand.
THE GREAT MODERATION
Just over a decade ago, a Wall Street equity
strategist published a report that helped give birth to the so-called New
Paradigm of the 1990s. The monetary authorities, asserted David Shulman of
Salomon Brothers, had improved their handling of the economy. Recessions had
become less severe and frequent, and inflation was under control. Shulman
argued that as a result of these developments, equities should trade at higher
multiples than in the past -- the "valuation paradigm" had changed.
The New Paradigm was later used to rationalize the
lofty equity valuations at the turn of the century and was much mocked when the
bubble eventually burst. But it didn't entirely go away. Rather, the New
Paradigm was given a name change. According to central bankers, we currently
live in the age of the "Great Moderation" -- a term coined by Ben
Bernanke, now Federal Reserve Board chairman, back in 2004. His argument was
very familiar, although expressed, in the argot of modern finance, in terms of
risk and volatility: The world had become more stable and predictable, economic
growth was steadier, and inflation didn't oscillate so violently.
This calm was reflected in the market behavior of
various asset classes, including equities and bonds, which had become less
changeable and were expected to remain so in the future. Because volatility is
equated in theory with risk, it's safe to say the financial markets had become
less risky places for investors. As Yogi Berra noted, "The future ain't
what it used to be." Today the outlook appears less uncertain and less
daunting than in the past.
A recent paper from the Bank for International
Settlements, the central bankers' central bank, analyzes the reasons for the
decline in financial market volatility. The report's authors argue that
alongside more-astute monetary decision making, which has reduced inflation and
extended the business cycle, several other factors should be considered. They
ascribe lower volatility in part to the benefits of globalization and
improvements in information technology. Rising profits and a decline in
corporate leverage in recent years have also played a role.
The report draws attention to changes in financial
practices. An increasing number of loans are now packaged and sold on through
securitizations. The complex world of structured finance, with its alphabet
soup of CDOs and CLOs, allows credit risks to be chopped up and parceled out.
Credit derivatives enable lenders to insure against defaults. The sophisticated
players in this multitrillion-dollar market have been improving the management
of credit risk, which is no longer concentrated in banks but has shifted toward
hedge funds and other new intermediaries that are more willing and able to hold
it. As a result, risk premiums have fallen.
This new financial order has demonstrated its
robustness. It has coped well with a variety of shocks, including the bursting
of the bubble in technology stocks in 2000, the attacks of 9/11 and the
subsequent war on terror, the corporate credit crisis following the failures of
Enron Corp. and WorldCom, the run-up in the price of oil and other commodities,
and institutional failures such as the bankruptcy of commodities brokerage
Refco in 2005 and the recent collapse of Amaranth Advisors, a hedge fund that
once boasted $9 billion worth of assets. The recession that appeared in 2001
was mercifully brief and shallow, a small black cloud that scudded across the
blue sky and was soon forgotten.
There is no doubt that volatility in the financial
markets has declined dramatically. In late November the Chicago Board Options
Exchange volatility index, also known as the "fear gauge," which uses
options prices to measure the implied volatility of stocks in the Standard
& Poor's 500 index, fell to its lowest level in 12 years. The volatility of
bonds, which is recorded by the Merrill Lynch MOVE index, also hit an all-time
low in 2006.
Various analysts have observed a strong correlation
between the decline of U.S. stock market volatility and falling corporate bond
spreads. It's no mystery why premiums on bonds, which compensate investors for
the risk against default, have narrowed. The number of business failures has
fallen dramatically. According to recent figures from the Administrative Office
of the U.S. Courts, Chapter 11 bankruptcy filings are at roughly half the level
of five years ago. In September defaults on U.S. high-yield bonds reached a
record low of 0.89 percent, according to S&P.
The BIS authors conclude that "if the reduction
in the volatility of stock returns turns out to be of a permanent nature,
sooner or later the equity risk premium will have to adjust downwards." In
other words, stock prices would have to rise (as, in fact, they did in the
months after the report was published last August).
The Great Moderation, however, isn't generally
associated with the case for more-generous equity valuations. Rather, it has
been used to rationalize the extraordinary growth of credit in recent years.
After all, if economic cycles are longer and less volatile, if interest rates
don't jump around as much as in the past, and if the threat of bankruptcy has
permanently diminished, it makes sense for everyone -- households, corporations
and financial players alike -- to take on more debt.
It's only to be expected that credit should increase
with economic activity. But in recent years it has been expanding more rapidly
than that. Between the end of 2002 and the third quarter of 2006, total
outstanding debt in the U.S. expanded by more than $8 trillion, according to
Federal Reserve data. During the same period the gross domestic product
increased by $2.8 trillion. That means credit has grown by nearly three times
the incremental increase in economic activity.
The exponents of the Great Moderation are unfazed.
They argue that as the credit system evolves and becomes more resilient, it can
support greater debt levels for a given degree of activity. The rising ratio of
debt to GDP is a sign of the "deepening" of the financial system.
According to this view, the recent increase in liabilities has been driven by a
combination of rising demand (because of greater stability) and plentiful
supply (because of improvements to the financial system).
SOME CONCERNED VOICES
Not everyone is so sanguine. In the months before
leaving office last January, thenFed chairman Alan Greenspan made several
speeches alluding to the possibility of excessive risk-taking in financial
markets. In July 2005 he warned that "vast increases in the market value
of assets are in part the result of investors' accepting lower compensation for
risk. . . . History has not dealt kindly with the aftermath of protracted
periods of low risk premiums."
In a September 2005 speech, Greenspan commented that
"extended periods of low concern about credit risk have invariably been
followed by reversal, with an attendant fall in the prices of risky assets.
Such developments apparently reflect not only market dynamics but also the
all-too-evident alternating and infectious bouts of human euphoria and the
instability they engender." He summed up the irony in words that echoed
Minsky's: "Success at stabilization carries its own risks."
Several other central bankers have expressed similar
thoughts. In October 2004, Malcolm Knight, general manager of the BIS,
cautioned that "lending booms can boost economic activity and asset levels
to unsustainable levels, sowing the seeds of subsequent instability." A
large appetite for risk, Knight suggested, "can sow the seeds of
subsequent problems."
Timothy Geithner, president of the Federal Reserve
Bank of New York, has pointed out that "against the background of an
apparently healthy financial system, market participants report a substantial
rise in transactions leverage, erosion in the use of loan covenants, more
favorable financing terms for hedge fund counterparties and especially a
pressure to reduce initial margin against OTC derivatives exposure to hedge
funds." At the Bank of England, deputy governor Sir John Gieve warned a
gathering of hedge fund managers last July of the "danger that risk models
are giving too much weight to the low volatility of recent times."
"There is an underpricing of risks in general in
financial markets," Jean-Claude Trichet, head of the European Central
Bank, told a BIS summit in Australia in November. "We don't exclude the
possibility that there will be a repricing of risk." At the same meeting
Australian Treasurer Peter Costello compared the current "general
euphoria" to 1997 before the Asian crisis.
It's only to be expected that central bankers should
attempt to jawbone market participants about taking on too much risk.
"Moral suasion" is the fancy name given to this generally futile
activity. However, other prominent figures in the financial world are also
concerned. In a recent letter to investors, Jeremy Grantham, head of Boston
fund manager GMO, observed that "long periods of stability cause all types
of leverage and other risk-taking to grow. . . . This process can go on and on
until finally something goes badly wrong."
Those who are concerned about excessive leverage often
cite the work of economist Hyman Minsky. Grantham credits Minsky as the source
for his observation that "stability is unstable." Over the course of
the past year, Paul McCulley, Fed watcher and investment committee member at
bond powerhouse Pacific Investment Management Co.; Michael Hughes, chief
investment officer of Barings Asset Management; and James Grant of influential
investment newsletter Grant's Interest Rate Observer have all cited Minsky to
support their assertion that risks are rising as the rewards for taking risk
have declined.
WHO IS HYMAN MINSKY?
The name of Hyman Minsky, who died just over a decade
ago, isn't well known in financial circles. He never won a Nobel Prize or
published a best-selling book. In fact, he spent most of his professional life
in the relative backwater of Washington University in St. Louis. Nevertheless,
Minsky has attracted something of a cult following over the years. Conferences
are held in his honor, and collections of learned (and largely unreadable)
essays are published to celebrate his legacy. Hard-core Minsky fans pay upwards
of $3,000 for used copies of his last work, Stabilizing an Unstable Economy,
published in 1986.
Born in 1919 to Russian immigrant parents and raised
in Chicago, Minsky was educated at Harvard University, where he came into
contact with famed Austrian economist Joseph Schumpeter. From Schumpeter,
Minsky learned about both the potential destructiveness of competition and the
centrality of credit to economic development. Minsky also greatly admired John
Maynard Keynes. These two great economists shaped Minsky's thought, along with
a number of other influences, including John Stuart Mill, Karl Marx and Irving
Fisher. Given this unorthodox mélange, it's hardly surprising that Minsky's
ideas aren't taught in Econ 101.
Most economists see the world in terms of production
and exchange, with money added on somewhat as an afterthought, but Minsky had a
very financial understanding of the capitalist system. He looked at all
participants in the economy -- whether households, companies or financial
institutions -- in terms of their balance sheets and cash flows. Minsky's
experience as a consultant and later director of the Mark Twain Bank of St.
Louis (acquired in 1997 by Mercantile Bancorp.) probably contributed to this
strikingly original perspective. Balance sheets are composed of assets and
liabilities, while cash flows validate the liabilities. Minsky's economy
comprises what he calls a "web of interlocking commitments" -- a vast
and complex network of interconnected balance sheets and cash flows that is
always changing and evolving.
During periods of stability people feel more
confident. According to Minsky, they respond by increasing their liabilities
relative to income. Borrowing the phrase of Warren Buffett's mentor, the noted
value investor Benjamin Graham, Minsky suggests that the "margin of safety"
declines.
Minsky created his own categories of balance sheets,
which reflected the degree of risk market participants assumed. The riskiest of
these he categorized as "Ponzi finance," named after the swindler
Carlo Ponzi, who operated a notorious pyramid scheme in Boston in 1920.
The key feature of a Ponzi scheme is its need to
attract ever greater sums of money. Ponzi finance, in Minsky's terminology,
describes the condition of those who can neither repay the principal on their
liabilities nor meet their interest payments from current cash flows. To
survive they must refinance, either by selling assets or by raising more debt.
For this to happen asset prices must continue to rise. Ponzi finance typically
emerges during a speculative bubble, when the margin of safety has been
extinguished.
Stability is not the only factor that induces people
to engage in risky behavior. Competition also plays a role. Minsky observed
that financial institutions compete furiously, both when investing and
providing credit to others. We read a lot nowadays about Schumpeter's notion of
"creative destruction" in relation to developments in technology.
Minsky saw this in a rather different light. "Nowhere," he wrote in
"Schumpeter and Finance," a 1993 essay, "is evolution, change
and Schumpeterian entrepreneurship more evident than in banking and finance and
nowhere is the drive for profits more clearly a factor in making for
change." Anyone who has spent some time observing the behavior of Wall
Street will understand what he means.
In the financial world, according to Minsky,
competition goes hand in hand with innovation. This tends to increase the
availability of finance, which boosts the demand for existing assets, pushing
up their prices. Higher asset prices, in turn, allow even more debt to be taken
on, thereby increasing the demand for finance. There is, however, a dark side
to financial innovation: It can be used to bypass existing regulations intended
to safeguard the credit system. In his 1982 book, Can "It" Happen
Again?, Minsky observed that in periods of stability there is "the
reappearance of prohibited practices in new and unprohibited forms."
Minsky also incorporated into his analysis Keynes's
notion of the fundamental instability of market expectations. Keynes's General
Theory holds that there are no rational or probabilistic grounds for valuing
share prices. Rather, our perceptions influence our activities, whether we are
borrowing or investing, and these determine future outcomes. This process is
inherently unstable, according to Keynes, and subject to sudden revisions. The
capitalist system, in the view of Keynes and Minsky, holds itself up by its
bootstraps. "Mere ideas about the future become realities as they become
embedded in financial relations," Barnard College Professor Perry Mehrling
quotes Minsky as having said in "The Vision of Hyman P. Minsky" in
the Journal of Economic Behavior & Organization. There is a danger that we
may misjudge our future income and not be able to make good the cash payments
on our liabilities.
"In economies where borrowing and lending
exist," wrote Minsky in his 1975 book, John Maynard Keynes,
"ingenuity goes into developing and introducing financial innovations. . .
. Financing is often based upon an assumption 'that the existing state of
affairs will continue indefinitely' [a quotation from Keynes]. . . . As a
recovery approaches full employment, the current generation of economic
soothsayers will proclaim that the business cycle has been banished from the
land and a new era of permanent prosperity has been inaugurated. Debts can be
taken on because the new policy instruments -- be it the Federal Reserve System
or fiscal policy -- together with the greater sophistication of the economic
scientists advising on policy assure that crises and debt deflations are now
things of the past. But in truth neither the boom, nor the debt deflation, nor
the stagnation, and certainly not a recovery or full-employment growth can
continue indefinitely. Each state nurtures forces that lead to its own
destruction."
This yin-yang view of financial life lies at the heart
of Minsky's financial instability hypothesis, a view that is best summarized by
his oft-repeated comment, "Stability is destabilizing."
Orthodox economics teaches that capitalism is
essentially stable and that it tends toward equilibrium. Crises are either the
result of preventable policy errors -- such as when a central bank pursues an
overly restrictive monetary policy (an accusation commonly leveled against the
Federal Reserve for its actions at the onset of the Great Depression) -- or
they result from uncontrollable external shocks, such as the OPEC oil price
hike in the early 1970s. Economists refer to such shocks as
"exogenous." Minsky's view is radically different. He suggests that
the crisis builds up inexorably from within, as people continually accumulate
fixed liabilities in a world where future cash flows are uncertain. His crisis
is "endogenous."
Minsky's cycle goes something like this: During a
period of stability, financial relations become increasingly precarious. Ponzi
finance is common. Banks and other financial institutions find novel ways to
evade prudential regulations. Long-term assets are financed with short-term
liabilities. Under such circumstances, it doesn't take much to trigger a
crisis. As debt increases, the maximum rate of interest that an economy can
sustain diminishes. The system becomes vulnerable to even a small rise in
interest rates. Alternatively, an unexpected drop in profits or the failure of
a financial institution may be all that it takes to generate a crisis.
Following the teaching of celebrated American
economist Irving Fisher, Minsky held that the crisis has a deflationary impact
as people seek to pay off debts. His prescription was conventional: More
government spending and lower interest rates from the central bank could
prevent debt deflation. His view on the consequences of these actions was less
conventional. Minsky contended that successful interventions during crises
discouraged financial conservatism. "If the boom is unwound with little
trouble," he wrote in Can "It" Happen Again?, "it becomes
quite easy for the economy to enter a 'new era.'" People respond to the
fact that the authorities are protecting them from financial catastrophe by
plunging anew into risky activities. The successful resolution of a crisis
creates a moral hazard.
Minsky's notion that stability induces people to take
on more risk is supported by recent work in safety studies. John Adams, a
British safety expert and author of Risk (Routledge, 1995), asserts that we all
come equipped with a "risk thermostat" that seeks to maintain the
same level of risk. "People modify both their levels of vigilance and
their exposure to danger in response to their subjective perceptions of
risk," he writes.
People balance risk with reward. Incremental
improvements in safety are likely to be accompanied by more risk-taking
activity. When motorcyclists don helmets, they open up the throttle a little
further. Contrary to common belief, the introduction of seat belt laws didn't
produce a decline in accident levels. Risk was transferred rather than
diminished. Faster cars ended up killing more pedestrians and cyclists. Safety
interventions that don't affect the settings of our risk thermostat are likely
to be frustrated by our behavioral responses.
A BRIEF MINSKIAN ACCOUNT OF THE PAST DECADE
Minsky died in 1996. However, it's possible to
construe how he might have interpreted developments in the financial world over
the past decade. As we have seen, the New Paradigm made its first appearance in
the mid-1990s. Volatility in the stock market dipped to very low levels at
around that time. This emboldened market participants. In the fall of 1998, a
sudden crisis occurred after the near failure of Long-Term Capital Management,
a hedge fund that had taken on extraordinary amounts of leverage.
The Federal Reserve responded to LTCM's problems by
organizing a bailout and cutting interest rates. As Minsky might have
predicted, this "Greenspan put" encouraged yet more risk-taking.
Shortly afterward a bubble appeared in the stock market. During the dot-com
frenzy many telecommunications and Internet businesses represented classic
examples of Ponzi finance. Their income was insufficient to meet their
expenditures, whether for new investment or to meet their debt payments. But as
long as the valuations continued to rise, these Ponzi companies were able to
attract new finance. When the market turned their fate was sealed.
U.S. companies in general greatly increased their debt
levels in the late 1990s. The failure of Enron and WorldCom precipitated a
corporate credit crisis. As risk premiums on loans soared, companies moved
rapidly to pay down their debts. Many commentators, including present Fed
chairman Bernanke, expressed a fear that deflation would ensue. The authorities
responded in an appropriate manner. Government spending soared, and short-term
interest rates were slashed. The Great Moderation was born.
MR. PONZI BUYS A HOUSE
If one is looking for contemporary evidence to fit
Minsky's financial instability hypothesis, there is no better place to start
than with the U.S. residential real estate market. Since the economy came out
of recession in 2002, the outstanding mortgage debt of U.S. households has
increased by more than 60 percent, to $9.5 trillion. This increase is larger
than GDP growth over the same period.
As the housing market has boomed, lending standards
have deteriorated. The margin of safety has declined both for borrowers and
lenders. Banks have raised the maximum they are prepared to lend relative to
the value of the property. "Piggyback" loans have allowed borrowers
to take out simultaneous second-lien mortgages, further reducing the amount of
equity they are required to put into the home. Piggybacks also have enabled
borrowers to evade the rules requiring mortgage insurance on highly leveraged
home purchases.
Mortgage providers reduced minimum credit scores
required of borrowers. The market for so-called subprime lending has
experienced explosive growth: More than $2 trillion worth of subprime mortgage
loans have been made since 2002. The dangers posed by these loans have been
concealed by strong house price inflation. As long as home prices kept rising,
credit was available for fresh loans, and delinquencies could be kept in check.
Between 2001 and 2003, defaults of subprime loans fell by half.
A number of other corners were cut to make homes more
affordable to those without deep pockets. Although the Fed kept interest rates
low, borrowers were tempted to take out adjustable-rate mortgages, which had
lower monthly payments than traditional 30-year fixed-rate loans. And when the
Fed nudged up short-term rates, lenders pushed so-called affordability mortgages
with deferred interest payments. Interest-only loans and mortgages with
negative amortization became particularly popular in the hottest housing
markets, like California, where affordability was the most stretched.
On top of all this, banks are prying less into the
private lives of their mortgage applicants. Traditionally, lenders wished to
know something of the borrowers' background -- their jobs, their wealth and so
forth. In an age of perennially rising home prices, these tedious details could
be dispensed with. "Low doc" and "no doc" loans have
proliferated. One mortgage provider, HCL Finance, advertises itself as the
"home of the 'no doc' loan." Among the products listed on its Web
site is the NINJA loan: Even borrowers with "No Income, No Job and No
Assets" are welcome to apply.
Then there is the "stated income" loan,
known in the trade as the "liar loan." These loans typically require
only the applicants' verbal verification of their job history and stated
income, not a W-2 form or tax documents. It comes as no surprise that certain
borrowers choose to put a gloss on their circumstances when applying for these
loans. A survey commissioned by the Mortgage Bankers Association of 100 stated
income loans found that more than half of the borrowers had exaggerated their
incomes by 50 percent or more.
In August, Larry Goldstone, president of Thornburg
Mortgage in Santa Fe, New Mexico, told the Wall Street Journal that
"greater competition and the desire to simplify and quicken the loan
origination process has led more lenders to extend stated income loans to
borrowers with lower credit scores, and higher loan-to-value and debt-to-income
ratios than traditionally allowed." Underwriting standards have continued
to decline even as the housing market has slowed.
The booming real estate market has tempted consumers
to cash out their burgeoning home equity. Mortgage equity withdrawal reached an
estimated $500 billion in 2005. In recent years U.S. household savings
disappeared as consumer borrowing soared. Paul Kasriel, head of economic
research at Northern Trust Co., estimates that household borrowing surged from
about 5 percent of disposable income in the early 1990s to nearly 15 percent in
2005, before falling back below 10 percent in 2006. In aggregate, the household
sector has been running a financial deficit -- the excess of expenditure over
income -- equivalent to about 6 percent of GDP.
The behavior of U.S. households during the real estate
boom closely resembles the Ponzi finance described by Minsky. The danger is
that when home prices stop climbing, households may have to rein in their
spending or sell assets to make good on their debts. When U.S. corporations
followed the same course of action after the technology bubble burst in 2000,
they induced a recession, followed by a credit crisis and a deflation scare.
OUTSIDE THE HOME
Away from the housing market, much that has occurred
in the financial world appears to conform with the type of behavior described
by Minsky. A deflationary bust was avoided by the authorities in 2002. But the
very success of central bankers' easy-money policies has encouraged people to
play with fire. Debt has escalated. Competition among financial institutions
has contributed to looser lending standards. New entrants into the credit
markets and financial innovations have eroded the power of old regulations to
protect the credit system. In many financial transactions the margin of safety
has been whittled away.
There's ample evidence that people have responded to
more-stable markets by placing larger and more-hazardous bets. The greatest
beneficiaries from the decline in volatility have been riskier types of
securities. In the stock market that's meant a "dash to trash" as
small caps, cyclicals and emerging-markets stocks have outperformed blue chips,
which tend to have large market capitalizations and are less exposed to the
vicissitudes of the business cycle. Likewise, emerging-markets and high-yield
bonds have proved a better investment than government or corporate bonds.
Jan Loeys, the global markets strategist for J.P.
Morgan Securities in London, finds "strong evidence that bond managers,
credit managers, banks and hedge funds raise leverage when volatility is
low." This is hardly surprising. Modern techniques of risk measurement,
such as the widely used value-at-risk (VaR) approach, use historical volatility
as a proxy for risk. As volatility declines, financial institutions are obliged
to increase their leverage to maintain the same risk level. The VaR technique
is a kind of financial version of Adams's risk thermostat.
As inflation fears have subsided and the Federal
Reserve's moves have become more predictable, Treasury bonds have also become
less volatile. Bond market leverage, as measured by primary dealer borrowing in
the repo market, has doubled over the past three years, to about $1.25
trillion, according to investment research firm Bianco Research.
Recent surveys by both the Federal Reserve and the
U.S. Office of the Comptroller of the Currency point to looser lending
practices. The Fed's Senior Loan Officer Opinion Survey in October reported
that "all domestic and foreign respondents that have eased their lending
standards . . . pointed to more aggressive competition from other banks or
nonbank lenders as the most important reason for doing so." The banks in
the OCC's contemporaneous survey also alluded to competition, as well as a
higher risk appetite and the more benign economic outlook, as among the chief
reasons for their easing underwriting standards for the third year in a row.
Banks are not the only financial institutions
competing fiercely with one another for profits. Hedge funds play an
increasingly important role in the credit markets, providing liquidity to the
housing market by buying mortgage-backed securities and fueling the growth of
leveraged buyouts and structured finance. The Bank of England's Gieve has
warned that competition among hedge fund managers could lead to trouble in the
future. "The history of financial crises," he observed last July,
"is replete with injudicious attempts to 'keep up with the Joneses.'"
As hedge funds are lightly regulated, little is known
about the true extent of their leverage or the positions they are taking.
However, their capacity to leverage is potentially enormous. A July 2005 paper
by Fitch Ratings suggests that by borrowing five times its assets and investing
in the riskiest part of a structured security such as collateralized mortgage obligations,
a credit hedge fund could in theory become the marginal lender on $850 million
worth of residential securities by committing just $10 million of its own
funds.
Hedge fund managers have a huge incentive to take
outsize risks, as they generally keep 20 percent of the gains while losses fall
elsewhere. Performance fees are paid annually. Because credit busts are
infrequent, managers stand to amass large personal fortunes even when making
loans that are fated to produce losses over a long stretch. Fitch also observes
that many credit hedge funds rely on short-term financing to pursue leveraged
strategies and warns of "a synchronous deleveraging of credit hedge funds
as a new risk element in the credit markets."
The financial innovations of recent years have taken
risk off the balance sheets of banks. Lenders can now use credit derivatives to
protect themselves against the possibility of a default. Loans are increasingly
insured, parceled up and sold in the secondary markets to hedge funds and others.
Yet innovation in structured finance is also being used to bypass regulations
intended to safeguard the credit system, as Minsky suggested would be the case.
The sellers of credit default protection are not
required to hold the same capital reserves as banks. Regulatory arbitrage,
together with the search for more yield in an age of low interest rates and
declining risk premiums, appears to lie behind much recent invention in this
field. Satyajit Das, a derivatives expert and the author of Traders, Guns &
Money (FT Prentice Hall, 2006), suggested in an interview with Financial
Engineering News that "the level of product innovation has run far in
advance of the capacity to utilize these products and the ability to understand
the risks and long-term consequences."
The recent surge in leveraged-buyout activity is
another consequence of the decline in financial volatility. Private equity
funds have raised more money than ever before. The amount of leverage the
private equity outfits pile onto the companies they acquire -- as measured by
the ratio of debt to pretax cash flow -- has crept ever higher. And the amount
of equity that buyout firms inject into their deals has diminished. Joshua
Galaun, a credit strategist at Dresdner Kleinwort, contends that in some cases
private equity firms have dispensed with equity and are financing their
acquisitions entirely with debt.
The risks are also rising for those who lend to
buyouts. Leveraged loans and high-yield bonds come with covenants that are
intended to protect creditors. Yet despite record loan volumes, the average
number of covenants has been declining, according to Fitch Ratings. Buyouts are
also being financed with riskier debt, such as subordinated second-lien loans
and payment-in-kind provisions, which allow borrowers to decide whether to pay
coupons in cash or with an additional issue of bonds. Furthermore, large LBOs
are occurring in sectors, such as technology, whose cash flows used to be
considered too volatile to support high debt levels.
Low numbers of defaults and a less volatile bond
market make high-yield bonds appear safer than in the past. But junk has never
been junkier. The high-yield-bond market is now populated by companies with
much lower credit ratings than at the end of the Michael Milken era in the late
1980s. Martin Fridson, editor of Distressed Debt Investor, recently warned that
a recession as mild as that of 1990'91 could produce a default rate for non-investment-grade
bonds even greater than that witnessed during the Great Depression.
LIQUIDITY AND CREDIT
Credit has a paradoxical effect on stability. Although
debt and leverage raise the level of risk, credit provides the markets with
liquidity that serves to dampen volatility. Stock market volatility is
inversely related to corporate profits. Credit growth boosts earnings, which in
the U.S. have recently touched 40-year highs relative to GDP, thereby reducing
volatility. Fridson suggests that the low current levels of distressed debt can
partly be explained by the fact that many potentially troubled companies have
access to finance. This keeps them out of the bankruptcy courts. Finally,
Pimco's McCulley points out that the increased demand for risky assets has
served to push down their volatility.
At the close of 2006, the markets were flush with
liquidity. If credit were to take flight, however, the rocks submerged by this
tide of liquidity might suddenly be revealed. This process already appears to
be under way in residential real estate, where slowing home price inflation has
been accompanied by a decline in mortgage growth, a drop in home sales and a
rise in delinquencies on subprime loans.
Two contrasting hypotheses can explain recent
developments in the financial world. The Great Moderation holds that owing to
better policymaking and structural improvements to the financial system, both
the economy and markets are more stable than in the past. The newfound
stability is viewed as a secular development. In other words, it's here to
stay. Therefore lower credit spreads and higher levels of leverage are
justified. Investors persuaded by this view will have few qualms about buying
risky assets despite their historically low yields.
Hyman Minsky, on the other hand, suggests that
people's response to stability engenders instability. Such behavior is not
necessarily irrational, as there are profits to be earned and bonuses to
collect as long as the good times last. In fact, the cycle may extend as long
as credit flows and people are hungry for risk. Yet Minsky's credit cycle heads
inexorably toward a bust. Investors who accept this analysis will probably
conclude that risk and reward are currently out of whack. They will position
their portfolios defensively, keeping cash on hand to spend when the rewards
for taking risk appear more compelling.
--------------------------------------------------------------------------------
Edward Chancellor, an editor at breakingviews.com, is
the author of Devil Take the Hindmost, a history of financial speculation.
The BIS suspects, and I truly believe, that a Minsky moment is at hand.
Many bearish commentators have been warning, prematurely, of excessive debt and
leverage for years, but things have kept going. And perhaps they could keep
going if there wasn’t a major episode to turn the tide. That episode is the
bursting of the housing bubble (even if there is no recession, which I suspect
too will happen).
Regards,
Mark Warywoda, CFA
Assistant Portfolio Manager, Money Markets
Co-operators Investment Counselling Limited
130 Macdonell Street
Priory Square
Guelph, ON N1H 6P8
phone: 519.767.3015
fax: 519.824.7040
email: mark_warywoda@cooperators.ca
