Why did the money markets nearly seize up last week? Will the central banks manage to restore calm? And what about Ninja mortgages, conduits, margin calls and commercial paper? How do they fit into the story?
There are still many unanswered questions. But here is Breakingviews’ attempt to unravel the main puzzles.
Why did the ECB and Fed flood the money with liquidity last week?
Inter-bank lending was seizing up. Overnight interest rates shot up above the level the central banks were targeting. They spiked to 4.6% in Europe versus an official rate of 4%, and 6% in the US versus an official rate of 5.25%.
Why was inter-bank lending seizing up?
Fear. Banks didn’t know who was credit-worthy. They didn’t want to end up l
osing money by popping it into an unsound institution.
Malay Karmakar / Mint
What triggered this panic?
It has been building for weeks. But the final straw was the fear that the banks may be on the hook for tens of billions of dollars of emergency back-up loans needed to bail out the commercial paper (CP) market. Most of these loans were put in place on the assumption they would never be called upon. The problem is that investors in the CP market seem to have gone on a buyers’ strike. Suddenly, the banks faced demands to pony up those loans.
Why did CP buyers go on strike?
A lot of the CP was used to finance asset-backed securities. Some of these were for subprime mortgages in the US. “Subprime” is a euphemism. It really means high-risk. Many mortgages awarded last year were particularly junky: They were given to people with no income, no jobs, no assets (so-called Ninja mortgages). CP is only as safe as the house it was secured against—and in many cases, this turned out to be not very safe at all.
Why would anybody make a Ninja mortgage?
Banks thought they were protected for two reasons. First, US house prices were rising (they aren’t now). So, if worst came to worst, the lenders could just grab the house, sell it and recoup their loan. Second, the banks didn’t hang onto the loans. They just packaged the loans up and sold them off to somebody else, taking a cut. The risk was cleverly sliced and diced—like a Sushi master carving up a tuna—allowing many of the securities to be dressed up as triple-A credits.
But haven’t we known about subprime problems for months?
Yes. They have been exposed by falling house prices. One consequence: If you grabbed a delinquent’s home, the collateral might not be good enough to pay back the loan.
So why was there a credit crunch right now?
Because of the game of pass-the-parcel, it has not been clear who is holding the toxic paper. In the past month, though, we’ve had blow-ups in different parts of the world that have rammed home how widespread the problem is. Three, in particular, have spooked the markets: Bear Stearns in the US, IKB in Germany and BNP Paribas in France. What’s more, another important market—lending to leveraged buyouts (LBOs)— has frozen.
When is triple-A not triple-A? What happened with Bear Stearns?
The US investment bank sponsored two hedge funds partly invested in subprime paper. Most of the cash came from outside investors. They were then leveraged up by borrowing from other banks. When the subprime crisis hit, investors tried to take out their cash, but Bear closed the funds. The lenders also demanded more collateral—a so-called margin call—and asked Bear to pump in cash itself. Initially, it refused. But the investment bank was eventually prevailed upon to provide a $1.6 billion credit line to the least risky fund. The creditors seized the assets of the other fund.
Why did this unnerve the market?
It suggested Bear had liquidity problems. It also rammed home how triple-A ratings couldn’t be relied on and undermined confidence in the whole “mark-to-model” method for valuing asset-backed securities.
Explain again how junk mortgages get triple-A ratings.
The likely-to-go-bad loans are popped into pools with lots of other mortgages. Then the risks and returns on these pools are divided into tranches. The riskiest slices are called “equity”. Whenever a mortgage in the pool runs into difficulties, the equity tranche takes the first hit. It’s only if all the equity gets wiped out that the next tranche steps up to the plate and has to take a hit. It’s a bit like lines of soldiers in an old-fashioned battle. Those at the back don’t tend to get killed unless those in front are massacred first. The last ones in the line of fire are the triple-A tranche.
Well, for an asset that is frequently traded, financial institutions (such as banks, hedge funds) value it by looking at the market price. That’s called mark-to-market. But some of these mortgage-security tranches are not traded—or only infrequently. So they are valued by reference to mathematical models that estimate how many mortgages are going to go sour. It’s a bit like calculating how many soldiers in the back row are going to get killed by analysing old battles in the Napoleonic Wars.
What’s wrong with this?
It ignores liquidity. It’s all very well to have an asset that is theoretically worth, say, 95% of what you originally paid for it. But if you have to sell it in a hurry, because you are subject to a margin call, it’s only worth as much as somebody is prepared to pay.
What has the LBO bubble got to do with this?
Although it is a different market, it was buoyed by the same loose attitude to lending that led to dodgy mortgages— and the financing techniques were similar. What’s more, the market for supplying credit to LBOs got gummed up just after Bear’s funds ran into difficulties. Since some of the same players were involved, there was a double hit to confidence.
How does LBO financing work?
Initially, the debt is supplied by banks. But the banks don’t plan to hang onto the loans. They syndicate them onto others in the market, taking a fee in the process. It’s another game of pass-the-parcel.
How did the LBO market blow-up?
The banks got stuck with a number of loans that they wanted to syndicate. The game of pass-the-parcel didn’t play out how they intended with two big deals, in particular: Chrysler and Alliance Boots. With an estimated $50 billion or so of LBO loans now stuck on their balance sheets and another $200 billion-plus in the pipeline, banks are reluctant to make any more. There is also a knock-on effect on the equity market as LBOs have been one of the factors boosting share prices.
How does IKB fit into this?
The German bank set up an off-balance sheet “conduit” called Rhineland Funding, which invested in asset-backed securities, including some that owned bits of sub-prime mortgages. It funded itself with CP—a huge $19 billion worth. The problem was that banks that had provided CP back-up credit lines were worried that the CP market would seize up as soon as investors realized how exposed Rhineland was to dodgy assets. The banks would then be called on to step into the breach. One of the banks, Deutsche Bank, blew the whistle and alerted the German regulators. The result was the CP market did indeed freeze up, causing problems for other entities funding themselves in the market.
Why was this any different from Bear?
There were two new worries. First, the virus was not contained in the US: it had crossed the Atlantic. Second, Rhineland’s troubles focused attention on risks in the CP market, which had previously been considered a virtually risk-free investment.
How can lending to a conduit like Rhineland be considered risk-free?
Well, it wouldn’t be if it weren’t for two other factors: back-up loans and credit enhancement packages. Back-up loans mean banks will provide liquidity if the CP market fails. What’s more, to get a triple-A rating, the sponsors (like IKB) put in “credit enhancement” contracts, which mean they take the first hit if there are any losses.
But doesn’t this mean the risk just rebounds on the banks?
That’s what’s dawning on the market. And that’s why a problem that started with dodgy mortgages in the US risks infecting the heart of the banking system.
And what went wrong with BNP Paribas?
It had three money market funds with assets of €1.5 billion. Around 35% was invested in instruments with exposure to the sub-prime market. When it found it couldn’t get a value for these assets, it suspended redemptions.
Isn’t that the same story again?
The variation this time was the BNP’s funds were “money market” funds, which are supposed to be even less risky than conduits, let alone hedge funds. Money market funds are viewed as pretty much the same as cash. Investors expect to be able to pull their cash out whenever they need it. Being told that they couldn’t was a bombshell.
Is there worse to come?
Possibly. There are two main ways trouble could spread: via hedge funds or banks.
Why hedge funds?
Many hedge funds engage in herding behaviour. A lot are momentum players, following recent trends. They also typically employ lashings of leverage. When markets are rising, this triple cocktail tends to accentuate the upward spiral. When they fall, it can spread trouble.
When asset prices fall, investors want to take out their capital. The hedge fund then has to sell assets—driving prices down further. The banks that lend them money then ask them to cut their leverage by making a margin call—as they did with Bear Stearns. That forces them to sell yet more assets. Other hedge funds that have been herding into the same trades come under pressure to sell—giving the vicious spiral a further twist.
And the banks?
They are exposed to credit market woes in four main ways: via trading losses on credit instruments they are holding on their own books; via CP back-up loans; via stuck loans to mega LBOs; and through lending to hedge funds. What’s more, investment banks’ equities businesses may suffer if stock markets fall. And their advisory businesses could enter the doldrums if the M&A boom—of which the LBO bubble has been the most vibrant feature—comes to an end.
So how does this bank exposure spread contagion?
If the banks get hit on multiple fronts, they will become more risk averse across the board. They won’t just stop funding LBOs and subprime debt. They could become less keen to fund hedge funds, conduits and other special purpose vehicles. That could have a further knock-on effect. Worse, even financially sound companies may start to find it hard to roll over existing debt programmes or raise new finance.
Central banks ride to the rescue. Did it do the trick?
Well, it certainly managed to drive overnight interest rates down to the official levels. But the fact that the central banks felt they had to inject liquidity two days in a row suggests that the inter-bank market hasn’t yet returned to normality.
What will happen next?
The central banks will hope that, after a few more days, confidence returns and they can step out of the picture. Many central bankers think that a short sharp shock is just what’s needed after the loose lending attitudes of recent years. And they’re not too worried because the economic fundamentals are strong. Such a correction is probably the most likely scenario. But there’s a risk that, if more cockroaches crawl out of the innards of the financial system, panic will set off again.