Friday, March 5, 2010

Too big to fail or too silly to take serious?

Too Big to Fail

There is a great temptation to skip “too big to fail” (TBTF). There is so much fuzzy thinking, populist superstition, and down right nonsense circulating about TBTF that it’s hard to take it serious. At the most superficial level TBTF is ridiculous. The Roman Empire was big. It failed. More recently, the USSR was big. It failed. Fannie and Freddie were big. They failed.

Only politicians and academics can talk at length about something without ever saying what they’re talking about. TBTF means nothing without a definition. So the first point is to clarify what we’re talking about. In a narrow sense, TBTF means that someone has concluded size should determine whether an entity should be governed by the set of laws that cover bankruptcy. It should be pointed out in passing that it is the government that makes the laws. If TBTF is an issue, it raises questions about a government that can’t design laws that can be applied uniformly.

That said, on the Sunday before Lehman’s collapse, its balance sheet by most estimates had unrealized losses on illiquid assets of about $25 bil . Bankruptcy expanded the shortfall to about $150 bil at recent market prices. Bankruptcy increased the loss and acted as a vehicle for the “contagion”. For instance, Prime Reserve Fund “broke the buck” the next day. Prime Reserve’s action spread the liquidity run to other money market funds and crippled the money market and short-term corporate debt market. So, there is legitimacy to the concern.

Things get silly quickly, however. For example, in one current proposal, TBTF is defined as one of the 50 largest financial firms. Well, we all know that’s wrong. It’s one of the top 73, or is it 37, dyslexia strikes again. No wait! It’s the top 99 or maybe 9. Try to prove any of these numbers are wrong. You can’t. People forget that New Century and American Home Mortgage Investment, neither of which was big, were early bankruptcies and the entire collapse was well underway before any large US firms approached a critical state.

Remember we’re talking about systemic risk, the collapse of the economy, a great depression or hyperinflation, the end of the world as we know it. Just picking a number at random doesn’t make sense. Arguing “we don’t know the right number but something has to be done”, is advancing the notion ignorance is justification for action. But, we’re supposed to be talking about systemic risk. One begins to suspect TBTF has nothing to do with anything as important as systemic risk.

Further, no one has made a decent case for why the institutional structure of US financial industry is so important that it alone would reduce systemic risk. Remember GM, Chrysler, and GE were all deemed TBTF. Financial firms? Not really. Right now the concern has shifted to sovereign risk, Greece in particular. Are we to start identifying countries that are too big to fail? If we do, what are we going to do, invade’em?

Again, people are ignoring the fact that HSBC was the first, or at least a very early, large firm to take a hit for credit losses from housing loans. It’s not a US firm. Well before any large US firm collapsed or even approached a critical state, LIBOR and rate spreads for corporate debt were clearly indicating a financial crisis was under way.

Financial collapses have occurred under such diverse financial structures it seems unlikely TBTF among financial firms is relevant. Financial collapses have occurred under different government structures even different economic structures. They occurred in medieval times, and based on coinage and historical references, they seem to predate my historical familiarity. They’ve occurred in the US when we had many and much smaller financial firms (1907-09 and during the depression immediately come to mind, but the one that set off the depression of the late 1800’s was probably the worst). They’ve occurred in many foreign countries with very different structures ranging from more concentrated to very fragmented.

Well, doesn’t Lehman as outlined above support the idea of TBTF? Its failure magnified the pain. But, anyone who knows anyone who has gone through a bankruptcy knows every bankruptcy magnifies the pain. People don’t get paid. Expenses are cut. Trust is destroyed. That’s the nature of the beast big or small.

That doesn’t mean there’s nothing we can do. But here’s the issue. Think for a moment of Fannie and Freddie. In that case, they had different assets and liabilities, one was bigger than the other, but the same factors brought them both down. If there had been six of each, those same factors would have brought down all twelve little fannies and freddies. That’s the nature of common mode failure.

The Bear Sterns’ mortgage funds which led to Bear Sterns’ collapse, WAMU, IndyMac, certainly Fannie and Freddie, and many other failures early in the crisis were clearly common mode failures. They could have all been one organization or a hundred times as many organizations; it didn’t mater. Size actually reduced the number of events, but it neither increased nor reduced the severity of the fallout. In common mode failures, the number of back ups doesn’t help if they all are sensitive to the same risk.

Risk dispersion (as in, we’ve sliced these pools of loans up and spread them all over the place) was very much in style going into the crisis. Much of the TBTF thinking is just a continuation of the same logic that led to the financial engineering that preceded the crisis. TBTF will have about the same impact as financial engineering: none. If anything it will do the same damage by taking a given level of risk and dispersing it so that no single entity has enough of a stake to limit the total risk to the system.

If Lehman had been six smaller firms, each with one sixth of the assets and liabilities, the same factor that brought down Lehman would have brought down all six little Lehmans. Bear Sterns, a smaller firm with a similar profile, didn’t last as long as Lehman. But, Lehman shouldn’t be described as just another common mode failure. It doesn’t fit the common mode model as cleanly. Yes, investments in mortgages and mortgage backed instruments contributed to Lehman’s failure just as they had for the failure listed before. Yet, Lehman illustrates a different risk, but, again, one not addressed be TBTF.

To understand how Lehman fits in, one needs to take into account some aspects of the shadow banking system. Lehman illustrates the point because most people view it as a clear example, but AIG or Bear Sterns could serve equally well as examples. In the commercial banking system, people are aware of the maturity mismatch. Banks take deposits that can flow out virtually on call, on depositors’ requests. They lend for longer terms for mortgages, car loans, business loans, etc. Commercial banks represent a small portion of the maturity mismatch in a healthy economy. For Lehman (or Bear Sterns and AIG), other short-run, or on demand, sources played the same role as deposits do in commercial banks.

By the time Bear Sterns and Lehman failed, a very broad common mode failure of institutions with leveraged exposure to consumer debt had become a cascade failure that had the potential to take down any institution with a maturity mismatch. As each method of borrowing short to lend long collapsed, market participants trying to borrow were forced to another method. But, participants on the other side were doing the same thing; each failure to be able to secure short term loans was taken as additional evidence that for lenders it was important to shorten maturity. Eventually this got to the point of not lending at all on one side of the market and eliminating the need for short term borrowing on the other side. At its most extreme businesses would not borrow even if it meant cutting capital expenditure, inventory purchases, and even payrolls. On the other side of the market, actually paying, that is taking negative returns, to maintain liquidity was acceptable.

For noncommercial banks the equivalent of a bank run can be measured fairly directly by rates in the repo market and other very short term funding sources. To illustrate the market-wide, not firm-specific nature of the cascade by using LIBOR overnight rates, when Bear Sterns failed, the rate, which had normally been about 10 to 15, was in the 80s. When Lehman failed, it was above 100. Clearly, Bear Sterns and Lehman weren’t the only firms in trouble.

The risk was already systemic. While LIBOR is useful because it quantifies the phenomena, nothing illustrates the point better than the fact that the stocks and credit default swaps of the entire financial sector were moving together. The entire sector could not all be long the same asset class (although an amazing number were). What they shared in common was a maturity mismatch. In this respect, the current questioning of the book of business at Goldman is particularly interesting. They were buying and selling offsetting positions. Yet, they were at risk of a run. That can be said regardless of whether they were long or short any specific asset type.

Once the issue of a cascade failure is raised, it naturally raises the issue of too connected to fail and too systemically important to fail. Lehman is sometimes used to illustrate these concepts because it was clearly the vehicle that most directly transmitted the problems into the money market and thereby the commercial paper market. But once a liquidity run starts, the run itself is the transition mechanism. Under those conditions having many small players, especially small and unconnected players, actually exacerbates the problem. Each is likely to be the victim of its own limited liquidity. Having a big enough and liquid enough institution to meet the demand for liquidity is what stops the run. That’s the philosophy behind central banks.

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