On Fragility of the Financial System

Fragility seems to be the word on everyone’s lips today. As reported in the Financial Times, UBS market strategist William O’Donnell said that the commercial paper markets had dried up and, “Now the buyers are only interested in Treasury bills.”

Overnight, Rams, an Australian home lender that, while not exposed to US subprime, had been making no-down-payment mortgages in Australia. Rams was unable to extend $5 billion of commercial paper and had to seek emergency funding. Similarly, in Canada, ten financial institutions are orchestrating a bail-out of certain commercial paper trusts to alleviate a seize-up in its $37 billion CP market.

No wonder we have comments like this. From economist Thomas Palley:

As recently as ten days ago Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and re-package loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.

Similarly, from Harvard’s Dani Rodrik:

But financial fragility surely has implications for the real economy. Is this the necessary downside of a sophisticated financial system? Or can we do better with an improved regulatory and prudential structure?

Now when the dust settles, we are sure to see a rewriting of recent financial history and in particular, some tough questions put to regulatory who gave cheery assurance that everything was for the best in this best of all possible worlds of financial innovation.

The sad thing is that it will be Timothy Geithner, president of the New York Fed, was widely regarded as fairly outspoken for a regulator. He is now likely to get a lot of heat. Geithner was put in the no-win position of being asked to lead oversight of derivatives and other new products, when he suffered the double disadvantage of not having any real regulatory authority and being given that role in a Fed philosophically opposed to meaningful supervision.

Nevertheless, it’s not clear whether Geithner drank the Kool-Aid or simply felt constrained to make only anodyne comments. From a March speech:

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

A second issue we need to consider stems from the complexity of the new credit instruments, the challenges they present in terms of valuation and risk measurement and their short history of experience in times of stress.

Even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses. Default rates are harder to predict where there has been a substantial change in the financial attributes of borrowers. The prices of instruments may not respond as expected to a given change in losses or in the value of the assets underlying these instruments. Hedging strategies may prove to be less effective than expected. Similarly rated instruments can behave very differently in stress events….

A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as “unscrambling the eggs,” could exacerbate and prolong uncertainty, and complicate the process of resolution…

All these challenges merit attention. They describe some of the risks that have accompanied the substantial benefits of credit market innovation. And they help illustrate why these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate….

It seems that Geithner, like the quants, underestimated tail risk.

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  1. Yves Smith

    Geithner is a very bright guy, but the Fed has never had the right to go in and kick butt and take names in the securities industry, and hedge funds are beyond anyone’s reach.

    So even if he suspected things were amiss, he had no factual basis for sounding alarm. And the last thing anyone wants out of a regulator is Chicken Little behavior.

    So yes, the effect was that he was dependent on dubious sources, but it he was constrained in getting independent data.

  2. Anonymous

    Derivatives maybe postponed, have certainly increased, the size of the adjustment and the degree of mispricing/repricing of the encounter with “tail risk”, .

    Since the underestimation and underprovisioning for, risk is what led us here, the risk should now be allowed to kick as much tail as possible before any intervention.

    Fragility is in the eye of the holder

  3. Yves Smith

    The one way the use of the term “fragility” is justified is that we are seeing a seize-up in the payments system. If firms can’t roll their commercial paper, they call on backup lines, which requires banks to cough up dough. And where do they get that dough? From the money markets. But if the money markets were working, there wouldn’t be these demands for cash.

    Now I am the first to agree that we need to see a lot more pain. We have yet to see an institution fail or need to be rescued (hedge funds don’t count).

    Things were much worse in the past (Citi nearly failed in 1991; both the 1980-1981 and the 1990-1991 recessions were nasty), but over 15 years of relatively smooth sailing has made people think they can have reward with no risk (I don’t see the dotcom bust as a major financial event, since the damage was contained to the stock market and Silicon Valley, and not the much larger credit markets).

  4. Anonymous

    I do not believe a conduit getting away 600 million in ABC paper says these markets are not working.

    There has been some refusal granted, with some resorting to other avenues. Is there evidence that this is not a stand off with regard to pricing from sellers waiting for rates or conditions to improve and buyers betting they will not? In other words a transition from a seller’s to a buyer’s market?

  5. Yves Smith

    I’m not quite sure what you are referring to by “$600 million.” If you read Bloomberg or the Financial Times, it is clear that the commercial paper market has seized up.

    From Bloomberg:

    The amount of U.S. commercial paper outstanding had its biggest weekly drop since the 2001 terrorist attacks as investors cut off the financing of some mortgages.

    The amount dropped $91.1 billion, or 4.1 percent, to a seasonally adjusted $2.13 trillion as of yesterday from Aug. 8, according to the Federal Reserve. It’s the biggest decline since the week ended Sept. 12, 2001, the day after the attacks in New York and Washington.

    The decline was driven by a 4.3 percent fall in asset- backed commercial paper, which represents about half the commercial paper market and has been used to finance purchases of subprime mortgages.

    The fall is “validating the idea that issuers are being forced to make orderly exits from the commercial paper market and obtain financing elsewhere,” New York-based Miller Tabak & Co. Chief Bond Market Strategist Tony Crescenzi said in an e- mailed note today…..

    The loss of short-term funding through commercial paper and similar programs may result in the liquidation of $38 billion to $43 billion of securities backed mainly by mortgages, according to an Aug. 9 report by Bear Stearns Cos. analyst Gyan Sinha.

    UBS AG analysts said difficulties in finding buyers for some types of maturing commercial paper may lead companies to “dump” $50 billion to $75 billion of assets on the market, and shift the financing or ownership of as much as $125 billion of debt to banks and other institutions.

    While this fall may seem small in percentage terms, remember that 90 day CP is the norm (yes, there is overnight and there is also 270 day, but 90 days is the most common tenor). If 1/12 normally matures in a week, that’s 8.25%. So a 4.1% fall in outstandings means something like half is not being rolled. That’s massive. Hence the panic.

  6. Anonymous

    Coventree did 600M, Countrywide just raised 11.5 bn.

    I see 2 things here. First an anecdote, a statistic and couple of assumptions do not a clear picture make. Second the picture could just as well represent a transition from a sellers to a buyers market.

    You must remember there is a large potential for gaming of the CBs and of each other through the financial press.

  7. Yves Smith

    With all due respect to Anon of 4:50 AM, this is not a couple of anecdotes. ABCP, which is now half the commercial paper market, cannot be rolled. Have you ever been on a trading desk? Or worked in a corporate CFOs office? A seize up of the money markets, which are the most important part of the capital markets to have operating, are in serious trouble. And because less intermediation occurs through banks than even 10 years ago, they are more important than in the past.

    This isn’t Wall Street crying Chicken Little. This is a genuine big time problem. Now that doesn’t mean they deserve a bail out, nor do I feel that reckless institutions deserve to be salvaged, but central banks, particularly central banks all over the world, not our just our Fed which has become enamored of the Greenspan put, do not provide emergency funding casually. They monitor banks and are in a position to get real information. They most assuredly are not reacting to “a couple of anecdotes” and the press.

  8. Anonymous

    Well get the hell out there and trade then dude thats what you are paid for!!!!

    There are plenty of other markets that experience similar problems. Not even been a week. The prices have gone out… deal with it or fold. If they are not folding they do not need to deal. Period as they say!

  9. Anonymous

    If they do not deal they get shown the door. That’ll get some action going…

    The Fed is weak. They roll like a bitch in heat. If the other ladies are not so easy…watch out for the dollar!

  10. Yves Smith

    Hey gang,

    The problem is that problem is showing up where people least expect it. You don’t have big swinging dicks on money market desks. You have people in corporate Treasurers’ offices placing short term cash, money fund managers who are held to $1 NAV rules, and the cash management operations of banks and securities firms. These guys make their living picking up and watching pennies. They are not hired or bred for risk assumption.

    However, I agree that the Fed has moved too quickly. We’ve only seen the beginning of the unearthing of credit-related problems. They won’t have any credibility or dry powder if they keep reacting on a quick trigger.

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