The unfortunate truth is that the loudest wails of panic have been those emanating from within the executive suites themselves – that is, from those who should know most about what’s going on inside the new financial order.
The short-term money markets and overnight interbank funding nearly seized up in August because these same top executives had clearly lost faith in the highly complex financial system that they and their firms have helped to create and have profited hugely from.
When repo desks shut their doors to whole classes of collateral and groups of counterparties over the summer, it was because senior managers had told them to. When liquid banks became reluctant to lend out overnight funds for fear that even large counterparties might go bust at any moment, surely this was the panic-ridden over-reaction.
It showed how fearful senior managers of financial firms were of the sheer scale of risks and potential losses hidden from view and also how completely they had lost the capacity to monitor these.
Which counterparties were most in danger via what exposures to which underlying credit, market and liquidity risks? These senior people seemed to have little precise idea and, unfortunately, it’s a reasonable bet that they couldn’t even answer those questions about their own firms’ exposures.
What has happened here?
Let’s go back to basics. First, in a fit of naked greed, the financial firms turned their backs on conventional best practice. Bankers, the textbooks used to say, should only make loans when they are 99.9% confident of a borrower’s ability to repay. Instead, the financial system churned out credit to many borrowers that a child could tell were 99.9% likely to be unable to repay.
The key players at the centre of the system, the big banks and investment banks, saw themselves as no longer in the business of holding risk: they only sought to distribute it. Lending discipline was an old-fashioned and unnecessary luxury with which they felt able to dispense.
On top of that, they layered huge complexity through all manner of structures designed to emphasize portfolio diversification and to secure AAA ratings for securities to sell to real-money and hedge fund investors, while at the same time drawing attention away from the leverage packed on to juice returns from increasingly expensive, low-yielding asset classes.
And when this started to break down, as it surely had to, the senior executives of the banks who had overseen this market’s creation were, tellingly, the first to take fright.
Some now are whimpering that the central banks won’t rescue them. But why should they lift a finger to help out this self-enclosed, virtual financial system? Let it fall and let the pain of the crash be a lesson to the survivors.
Lots of people are struggling to find the best comparison to past crises: is this 2001 all over again or 1998, or 1994? Let’s not forget that, financial market volatility aside, there are real credit blow-ups to come among over-levered LBO companies exposed to a likely economic slowdown, and mortgage borrowers exposed to rising debt service costs and falling asset values.
That’s most reminiscent of 1989-91, when Citibank teetered on the point of bankruptcy under the weight of bad real estate and HLT loans.
In the ensuing crash, the entire Savings & Loans system collapsed and, on Wall Street, Drexel Burnham Lambert went bankrupt, EF Hutton disappeared, First Boston had to be bailed out, Kidder Peabody had to be rescued, Lehman Brothers sold itself to American Express and there were others.
Senior bankers will tell you that it won’t be so bad this time. The system might have obscured risks but has also spread them wider and thinner.
Let’s see. Maybe they will look better coming out of this crisis than they do now on the way in.
