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The Credit Crunch

by J. Orlin Grabbe

A credit crunch happens when you go to the bank and can't get a loan, even though your personal circumstances have not materially changed from the time loans were available.

A credit crunch happens when you have existing credit lines at a bank, and these lines are suddenly withdrawn or contracted, particularly just when you need them.

A credit crunch happens when a company goes to the bond market to issue bonds, and suddenly finds that the interest yield that will be paid on these bonds must be radically increased, or, equally likely, that there is no market for the company's bonds at all.

A credit crunch happens when financing for real estate transactions disappears or is hard to find. Since financing is a significant component of demand, the price of real estate drops quickly.

A credit crunch happens when commodity financing is withdrawn, so that inventories of, say, nickel, copper, crude oil, or silver can no longer be carried. The inventories have to be rapidly liquidated--sold in the market--with a consequence depression in the price.

A credit crunch happens when the collateral posted in a loan or trade transaction suddenly drops in value, so that more collateral must be posted. When this is not possible, the collateral must be sold at its new low price in order to help repay the loan. Done in sufficient volume, this further depresses the value of the collateral.

Differing Origins of Credit Crunches

There are many different reasons a credit crunch can take place:

1. The central bank can suddenly cut back on the amount of reserves available to the banking system, with a consequent contraction in banks' ability to make loans. This is what happened in the US in 1979-80 and in Japan in 1989-90. Central bank credit contraction is not, however, a significant factor in the US or Europe in October 1998.

2. There can be bank failures due to bad loans, creating perceptions of increased risk, which causes other banks to tighten their lending criteria and to restrict credit. (Even in good times, bankers prefer to lend money only to those who do not need it.) Risk- related restriction in bank lending has been widespread in Southeast Asia throughout 1998.

3. There can be bond defaults, which causes credit spreads to widen. Interest yields on lesser grade corporate bonds and asset-backed securities increase dramatically, in a "flight to quality". The flight to quality takes the form of a dash to purchase government bonds, believed to be risk-free. Thus the diminishing supply of capital is further depleted as it becomes available for immediate government consumption. The Russian government default in August 1998 led to a dramatic widening of credit spreads as investors and portfolio managers dumped corporate bonds, convertibles, asset-backed securities, and junk bonds, and dived into US Treasuries. This widening of spreads drove one hedge fund, Long-Term Capital Management, into near default, after its capital fell from $3.7 billion to $600 million following the Russian government default and the ruble devaluation.

4. There can be a credit crunch because of panic disintermediation. Panic disintermediation is the dumping (rapid sale) of securities, commodities, and other assets in a scramble over possession of the limited supply of money (cash). This happened in October 1998 as US Treasuries were sold for cash, and the yield shot up from 4.73 to as high as 5.20 over a two day period (Oct. 8-9). Portfolio managers were telling investors, and each other, that being out on the long end of the yield curve was the best hedge against a downturn in the world economy. It took only 48 hours in the real-world classroom for them to learn differently.

5. There can be a credit crunch because of a run on the currency. This source is actually the same as that of 4., the only difference being that there is panic liquidation of financial assets in one currency, in exchange for cash in another currency. This happened in October 1998 as the yen rose in value from Yen 131/dollar to Yen 111/dollar in less than two days (Oct. 7-8). The dollar had become less attractive relative to the yen: the Fed cut the discount rate, hedge funds unwound short yen positions, and Japanese banks and other financial institutions dumped dollar securities because they needed the capital at home (especially after the Nikkei 225 dipped below 13,000). Normally this degree of price movement is only seen under fixed exchange rates, at a time when a fixed rate breaks down. However, in this instance, the common expectation that the yen would continue to depreciate to Yen 160/dollar acted as an anchor to fix the yen's value at a relatively low level. Borrowing in yen at extremely low interest rates was considered a free lunch. Then one day the free lunch disappeared. Tiger Management, a hedge fund which had been borrowing in yen to buy dollar assets, suffered a loss of almost $2 billion on Oct. 7 due to the surge in the Japanese yen against the U.S. dollar. That was about 9 percent of the fund's value.

Securitization

Credit crunches used to be banking phenomena almost exclusively. No more. During the 1980s and 1990s formerly illiquid assets became more marketable or tradable. They no longer just sit on the asset side of some bank's balance sheet.

"Securitization" is the process by which a collection of receivables is put together in a package, and then bonds are issued against the package. The package may be a collection (or portfolio) of credit card receivables, or automobile lease payments, or commercial mortgages, or some similar type of asset which provides "backing". Payments made to the owner of the packaged assets are then passed along, in part, as interest and principal to the bondholders. The bonds (which may have various strange and wonderful names, such as "CMOs"--collateralized mortgage obligations) trade in a secondary market, so the whole process has turned fairly illiquid items (the original credit card payments, or whatever) into tradable securities.

The term "disintermediation" is also used, meaning that banks (or other financial intermediaries) are no longer the direct lenders, but rather bond purchasers become the direct lenders. Repayment to the bond investors depends on the good credit of those making payments into the asset pool (of commercial mortgages, or whatever), so that the interest payments on the bonds reflect a "credit spread" over some benchmark bond interest yield, such as the interest yield on US Treasuries. In the first half of 1998, more credit was provided in the asset-backed securities market than provided by the entire US banking system.

Thus the bond markets immediately reprice credit spreads, and there is nothing the Federal Reserve can do about it. (It would be even worse if there were no securitization and all capital flowed instead through the banking system. For in that case, an attempt to "hold down" credit spreads would simply result in credit rationing: some entities would get credit, and others would get nothing.)

The bottom line is no one is in charge, and mommy can't take the hurt away. The globalists fanatically deny this, saying, "We are in charge; or else, we would be, if only you would give us more money for the IMF, for the World Bank; if only you would do these new and wonderful things like open the Federal Reserve spigots or create an `international' lender of last resort, etc., etc." Yes, all the globalists will become Big Swinging Dicks if only you gave them a few billion dollars to play with. Meanwhile, the conspiracy theorists say, "Some secret group is causing all this financial turmoil," and can't figure out why the likely suspects seem so disarrayed. Both groups believe the world is a giant machine, and just by turning this or that dial, or squirting a little oil here or there, or replacing the engineer, we can put everything right again.

Whether it's perpetual motion machines or Ponzi schemes, fools have their dreams.

Long-Term Capital Management

John "Liar's Poker" Meriwether's Long-Term Capital Management (LTCM) was down 44 percent in August 1998. The former Salomon bond trader had as partners option gurus (and Nobel-prize winners) Robert Merton and Myron Scholes helping him run the fund, along with other trading stars who even took out personal loans to increase their own exposure to the firm. Three LTCM partners took out personal loans of $34 million from the hapless Credit Lyonnais to plow back into LTCM (Credit Lyonnais proving once again the Dylan dictum that just when you think you've lost everything, you find you can always lose a little more).

As for the three partners, finance theory says don't invest in the stock of the company where you work. For the obvious reason that if the company falls on hard times, the stock will likely be taking a hit just as you are being fired. But True Masters of the Universe don't bother with such trivial notions of diversification. They prefer a Texas Hedge: go long two call options and buy the underlying asset.

UBS (the largest European bank, which resulted from the merger earlier this year of Union Bank of Switzerland and Swiss Bank Corporation) had a realized loss of $705 million due to its exposure to LTCM and fired its chairman. The bank had a policy of not making loans to entities with leverage (the ratio of assets to capital) greater than 30. But its own private estimate of LTCM's leverage was 250, yet it loaned them a lot of money anyway. (LTCM had not one, but two Nobel prize winners as partners.) The 250 number may be too high, but what it means is that for each $1 in capital, LTCM put the equivalent of $250 at risk, through a combination of borrowed money and derivatives. Clearly UBS had faith in LTCM, as did the Bank of Italy, and many New York firms such as Chase and Goldman Sachs. LTCM had profits of 43 percent in 1995 and 41 percent in 1996.

At the beginning of 1998, LTCM had $4.7 billion in capital. LTCM has dozens of trading strategies, none of which is public information. But it is clear they like to deal in bond credit spreads. They had several bets that credit spreads were going to narrow. So they were long commercial-mortgage backed bonds and junk bonds, and short US Treasuries. They also expected credit spread narrowing in Europe because of the interest rate convergence required for the introduction of the Euro. Hence LTCM was long Italian government bonds, and short German government bonds. The fund had a bad month in June, when the fund was down 10 percent. But in July the IMF saved Russia. And as of mid-August LTCM still had $3.7 billion in capital. Then Russia defaulted, and credit spreads widened greatly. US Treasuries soared in price, as did German government bonds, and lesser credits took a dive. So did LTCM. The fund was down 44 percent in August, and its capital had dropped to $600 million by mid-September. The final straw in September seems to have been the unraveling of a stock bet that the merger of Ciena and Tellabs would go through.

Warren Buffet offered to buy LTCM, and its alleged $600 million in capital, for $250 million (showing that Buffet didn't believe the $600 million figure), with a plan to recapitalize the firm with $4 billion or so. But Buffet's offer had a catch: Meriwether would get fired. Buffet was turned down. The Fed rounded up some of the current bank lenders to LTCM, who kept Meriwether on and agreed to recapitalize the fund themselves on Sept. 23.

The US Congress afterward held hearing whether hedge funds should be regulated (just which genius are they going to get to do this job?--maybe Merton and Scholes are out looking for work?). Many people were upset because LTCM was "bailed out" without anyone being punished. But what is easily overlooked, however, is that LTCM was bailed out because of regulation. The Federal Reserve convened a consortium of banks who provided the infusion of capital. (LTCM partner David Mullins Jr., a former Vice-Chairman of the Federal Reserve Board, knew just who to call.) The banks could hardly refuse to show up, for they are, after all, regulated by the Fed. So they poured another $3.65 billion of capital into the LTCM capital destruction machine. And why not? It was only depositors' money, and those deposits are insured. The risk of repaying bank depositors is carried by the FDIC. So why not invest in a hedge fund which is leveraged 250 to 1 (or is it only 100 to 1)? If LTCM is lucky, the bank will make a lot of money. If LTCM is unlucky, the FDIC pays the piper. The system is good. It's win-win for the banks.

The International Lender of Last Resort

Alan Greenspan says that what is happening in international financial markets is unlike anything he has seen in 50 years.

So what is he going to do about the credit crunch? Not much, I expect. In traditional central banking theory, the lender of last resort--the Federal Reserve, in this case--is supposed to halt the run out of relatively illiquid financial assets, and real assets (commodities, goods) and into money. How? By making more money available. One deals with the drying up of liquidity by creating more. But how does one do that without exacerbating the current problem, or simply creating future inflation? Who should get money, and why? Doesn't postponing liquidation of assets postpone resolution of the crisis?

But . . . moving along. Lenders of last resort-- whatever their supposed merits--respond necessarily to domestic considerations. So suddenly we are now witnessing a rash of proposals for an "international" lender of last resort, which will act from global motives, and not be bound by petty domestic considerations.

The international lender of last resort is a deus ex machina that will somehow operate outside the world financial system to save the system from crisis. (For if the international lender of last resort is part of the system, then in what sense can it itself be exempt from crisis?)

Policy makers, who haven't a clue as to how to deal with the world financial crisis, are now being given a "solution" by economists--or whatever it is that people at the US Treasury call themselves--who are equally clueless, but who have seized on "international lender of last resort" as a counterfactual offering to policy makers: "Oh, what we need is an international lender of last resort." Since we don't have such a lender, the suggestion is nonfalsifiable, much like those historical arguments which say, for example: "If only Napoleon hadn't invaded Russia, then blah, blah, blah [make up whatever story you want to, because since Napoleon did invade Russia, history can't refute what you say]."

Where would an international lender of last resort come from, with no world government, no world central bank, and no universally recognized system of laws? And who wants any of these, anyway?

The analogy is with a domestic lender of last resort, such as the Federal Reserve. Now, there is no evidence that the Fed has prevented any financial crises--or, net net, prevented any more crises than it has generated. But all that doesn't matter: the very "experts" consulted are from the US Treasury, the Federal Reserve, the IMF, the World Bank--and they (surprise) uniformly see the need for a greater role for themselves and for people like them.

Many see the IMF evolving into just that "international lender of last resort" role. Then the new mega-IMF can do for the global economy what the IMF recently did for Indonesia and Russia.

Meanwhile, the credit crunch continues.

-30-

October 11, 1998

This article appeared in Laissez Faire City Times, Vol 2, No. 33.

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