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
19
80
19
82
19
84
19
86
19
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????