It’s been five years since one of the most tumultuous weeks in modern financial history. In the span of three short days, Lehman Brothers filed for bankruptcy, Merrill Lynch sold itself to Bank of America, and the federal government assumed control of AIG, several weeks after having taken over Fannie Mae and Freddie Mac. Across the globe, equity markets tumbled, credit markets froze, and unemployment rates jumped.
In the months that followed, numerous economists, politicians, and regulators weighed in on the root causes of the financial crisis, and how best to prevent its repetition. Based on the then-current composition of the executive and legislative branches of government, the following determinations were reached: first, Congress would need to write laws to prevent the existence of too-big-to-fail financial institutions whose insolvency could undermine financial stability. Secondly, lenders would tighten underwriting standards considerably to keep mass quantities of high-LTV toxic mortgages from being repackaged and sold. Thirdly, loan-backing institutions with implicit government guarantees would need to be restructured and their roles reduced sharply, so that taxpayers would not be left covering losses while equity investors pocketed all gains. Lastly, users of financial derivatives would have to submit to greater transparency and collateral requirements, so that the system would be safer and more efficient.
How have we done in each of these key areas?
Too Big To Fail: In one important metric, the ratio of high-quality capital to assets, our money-center banks have improved considerably since the crisis. The Wall Street Journal notes that the top 18 banks had ratios of only 5.8% at the end of 2008, but that the ratio had improved to 11.3% just four years later. However, the substantial cost of post-crisis regulatory compliance all but encourages big banks to get even bigger – another Journal piece points out that the top 10 U.S. banks had $7.8 trillion of assets at the start of 2007, versus 11 trillion today. Imagine the cost of keeping one of these behemoths afloat if it ran into financial trouble. Post-crisis legislation has also introduced new too-big-to-fail institutions into the system, as derivatives clearing houses will handle an estimated 80% of derivatives trades once Dodd-Frank is fully implemented. In fact, the International Organization of Securities Commissions has written that “the possibility of reaching a point where [a clearing house] needs to be resolved by the relevant authorities cannot be ruled out.” While the probability and consequences of failure have likely been reduced, the temptation for government to intervene when one of these giants does wobble has likely not substantially diminished. Too big to fail is now too even bigger to fail!
Underwriting Standards: On the home lending front, average credit scores for mortgages appear to be improving. Fannie- and Freddie-guaranteed loans came with average credit scores under 710 in 2007, but now the mean credit score for mortgages they back stands at roughly 750. By contrast, on the corporate side, given near-zero interest rates on investment-grade bonds, investors craving higher returns are piling into junk debt at an unprecedented rate. At the current pace, junk bond sales in 2013 are set to surpass the record set in 2007 at $1.35 trillion; further, below-investment grade bonds have been at their lowest yields in a decade this year. Should interest rates rise substantially during the term of these bonds, in conjunction with the Fed’s wrapping up its bond-buying program, refinancing will be quite challenging. So if junk-bond issuers are paying the lowest yields in a decade to satisfy yield-seeking investors, have we traded better credit quality in residential mortgages for worse credit quality in corporate bonds?
Government Sponsored Lending: The good news about Fannie and Freddie is that out of $188 billion of taxpayer funds spent so far, the companies have already paid back $146 billion in dividends. So far so good. Unfortunately, rather than reducing their involvement in residential mortgages, these and other government agencies have stepped up their role. Inside Mortgage Finance notes that in 2007, fewer than 50% of new mortgage originations were backed by Fannie, Freddie, or other government agencies; in 2012 it was more than 90%. The issue extends well beyond residential mortgages to student loans as well. According to the St. Louis Federal Reserve’s data repository, in 2007 the amount of federal government loans to students was set at $93 billion; as of this year, it has more than quintupled to over $550 billion. Government sponsored lending is more than merely resurgent, it is exploding!
Derivatives: Many government officials and regulators have railed against the terrible toll exacted by derivatives during the financial crisis. Just this week, Princeton economist Alan Blinder wrote of the financial crisis that “wild and woolly customized derivatives … blew the problem into a catastrophe.” Incidentally, the data does not bear out Blinder’s claim: from the onset of the financial crisis until spring 2012, there were $2.1 trillion in financial institution losses, and less than 4% were attributable to derivatives (more than half of which was directly attributable to AIG). Meanwhile, the largest contributor to bank losses was the most simple of all financial products – the loan. Loan losses contributed 10x the losses of derivatives during the financial crisis. To be sure, derivatives need to be used judiciously, after careful analysis and quantification of financial risk exposures, and AIG’s failure demonstrated the need for greater regulatory oversight of the market. But the risk mitigation benefits of these products continue to be overlooked or even impugned by exaggeration. While we do expect some of Dodd-Frank’s derivatives requirements to reduce risk and increase transparency in the market, many other of its stipulations will make managing risk with derivatives considerably more expensive and capital intensive.
Fifty years ago this fall, Bob Dylan went to Columbia’s New York studio to record the epic words: “The line it is drawn, the curse it is cast, As the present now will later be past, The order is rapidly fadin,’ For the times they are a’changin.” But if Dylan were recording this classic in 2013 instead of 1963, and applying his legendary song-writing ability to too-big-to-fail institutions, underwriting standards, government sponsored lending, and derivatives, perhaps he’d borrow an 1849 phrase from Jean-Baptiste Alphonse Karr instead and sing: “Plus ça change, plus c’est la même chose.” (The more things change, the more they stay the same.)
If you’d like to reminisce about the last five years, talk about your hedging strategy for the next five years, or just share your favorite Dylan song, give us a call or send us email – because the times they aren’t a’changin’!