September 4th, 2014 | By Nick SargenRemarks delivered at the Bretton Woods 2014 Conference: The Founders and Future hosted by the Center for Financial Stability on September 4, 2014.
Thank you for the opportunity to address this topic. It has been an area of interest for me since the 1970s, when I worked on developing an early warning system for detecting debt problems of developing countries at the U.S. Treasury and the Federal Reserve. Thereafter, I worked with financial institutions that had considerable exposures to domestic and foreign markets. My perspective is that of an investment professional whose job is to assess opportunities and risks.
I will begin by saying the task of identifying financial crises is not easy for investors. If it were, they would be fewer and less severe. For investors to do a better job in the future, they will have to overcome the following obstacles:
(1) Lack of adequate and timely information on exposures of borrowers and lenders. The financial system appears as a "black box" for investors, and while regulatory bodies have the authority to peer inside this box, their track record of identifying potential problems has been poor.
(2) Lack of a conceptual framework for thinking about financial crises. Until recently, they were considered to be episodic rather than systematic, and with the principal exception of the Bank for International Settlements (BIS), economists did not focus on the credit cycle and its determinants.
(3) Lack of economic policies to promote financial stability. Investors take their cue of what matters from policymakers; consequently, if policymakers appear unconcerned about financial stability, they will be similarly inclined.
To illustrate these points it is useful to consider the LDC debt crisis of the 1980s, which at the time was the worst crisis in the post-war era. The circumstances entailed a substantial increase in the external indebtedness of developing countries, especially those in Latin America, during the first and second oil shocks. When domestic loan demand slowed, multinational banks found they could earn higher margins by lending to sovereign entities, and they took comfort from rising commodity prices and the ability to pass along interest rate and currency risks to the borrowers. Also, the recycling of "petro dollars" through the international banks had proceeded smoothly.
Officials at the U.S. Treasury and Federal Reserve, nonetheless, recognized the importance of monitoring the situation, considering these countries lacked access to international credit previously; hence, the need for an early warning system. One of the main impediments was that external debt data for developing countries was incomplete – only long-term debt of the public sector was available and the information was two years old. When conditions worsened for the borrowers in the early 1980s as interest rates and the dollar surged, lenders responded by shortening the maturity of the loans being rolled over, typically to a year or less. These loans, however, were not captured in the official statistics. When Mexico announced it had run out of foreign exchange reserves in August of 1982, it set off a chain reaction in which Argentina, Brazil and other countries in the region followed suit, as the roll-over process ground to an abrupt halt.
Amid these developments, it soon became apparent what was at stake. Namely, the leading multinational banks had exposures to troubled Latin American countries that exceeded their capital. To stave off a global banking crisis, a coordinated plan was developed by the G-7 industrial countries in conjunction with the IMF, whereby they would offer assistance to the troubled countries provided they adhered to IMF "conditionality" programs. For their part, the multinational banks were responsible for rolling over existing loans to these countries, and they effectively formed a cartel to put pressure on smaller regional banks to maintain their commitments. This program of "managed lending" (along with forbearance by regulatory institutions) bought time for the banks to rebuild capital and the LDCs to undertake adjustment programs. Nonetheless, while the coordinated policy easing in the industrial countries contributed to a rally in financial markets and global recovery by 1983, it was not until the end of the decade that developing countries regained access to international capital markets via the creation of Brady bonds.
Looking back on this experience some 30 years later, what stands out is that investors and policymakers had focused their attention on the possibility of individual countries defaulting, but they did not consider the systemic risk entailed if banks collectively cut back on their lending to all borrowers. I committed this mistake, as well. The early warning system I developed in the 1970s accurately predicted a wave of defaults for Latin America, but I thought the model was misspecified and opted to ignore the results! The main lesson from this experience is that if one is not expecting something to happen, one will not discover it until it is too late.
Considering the numerous crises since then, one may ask why investors and policymakers were so unprepared for what happened in 2007-09. One explanation is that they were lulled into complacency by the tranquil markets during 2004-06. This is consistent with Hyman Minsky's thesis that calm markets are breeding grounds for financial instability.
While there is some merit to this argument, it is not the full story. My rendering is that the crisis was very complex, and in order to anticipate it investors and policymakers had to make judgment calls on three key issues:
As Chief Investment Officer for a financial institution, I had concerns about the first two issues, which were widely debated at the time. However, I was uncertain about the third issue, because the process of securitization made it difficult to know how exposed financial institutions were to the housing sector and mortgage-backed securities (MBS). The reason being the originators of mortgages typically sold them to financial institutions that repackaged them and dispersed them to investors. The rationale was mortgage-backed securities were safe instruments because they were collateralized and risks were pooled. Accordingly, they typically received AAA ratings. While the underwriting standards on MBS had deteriorated to make mortgages more affordable for subprime borrowers, our firm invested only in those securities whose collateral met our own credit standards. It was not until after the publication of the Financial Crisis Inquiry Report in January 2011 that it became apparent many of the securities being sold in the mid 2000s did not adhere to the stated guidelines in the underwriting documents. These misrepresentations, in turn, contributed to the severity of the crisis, because the value of these securities plummeted and failed to recover when financial markets rallied.
Meanwhile, in positioning our own portfolios, our firm took a defensive posture. We did not have significant exposure to sub-prime mortgages and structured products; the duration of our assets and liabilities was properly matched; and our capital adequacy was among the highest of any financial institution. Therefore, management believed we could withstand an economic downturn reasonably well. Only when the crisis was far along did investors learn how exposed some of the leading financial institutions were to structured products and real estate, the extent of the mismatches in the duration of their assets and liabilities, and the high degree of leverage they deployed with assets up to 30-40 times capital for the leading investment banks.
As the crisis unfolded in 2008, investors were confronted with ongoing surprises, including precipitous declines in prices for mortgage-backed securities and both debt and equity of financial institutions. When the corporate bond market became increasingly illiquid, our firm created a dashboard of market indicators so we could identify how risks had shifted and try to understand the reasons. But it was hard to stay ahead of the rapid-moving markets. In the wake of Lehman's collapse, for example, worries about counterparty risk became paramount and the soundness of money market funds were questioned. As confidence in the international financial system plummeted, prices of virtually all asset classes except cash, gold, and treasuries fell precipitously. At the low in late 2008, the market value of our investment grade bond portfolio was trading at 85 cents on the dollar.
Fortunately, the story has a happy ending. Investors had to decide whether the forces at play would lead to a financial collapse, which markets were pricing in, or whether policy makers finally understood the gravity of the situation and were prepared to do whatever it took to restore investor confidence. Ultimately, we thought the latter outcome was the more likely, and we were rewarded for staying the course and acquiring assets at fire sale prices.
Looking back on this experience what stands out is the incredibly challenging environment investors faced. Virtually no one could have anticipated the twists and turns in financial markets from 2007 until present. Throughout this period, investors have had to adapt to an environment in which markets have been in disequilibrium or in which central banks have intervened in capital markets extensively. One of my tag lines is that those educated in principles of modern portfolio theory and efficient markets must be wondering what guidelines, if any, there are for investing during and after a bubble has burst.
Looking ahead, I have mixed feelings about our ability to avoid future crises, because the challenges are considerable. The good news is there is a low likelihood of a repeat any time soon given the severity of the crisis and the high risk aversion among retail investors. Also, there is a better understanding today about systemic risks and inter-connectedness in the financial system and the need to reduce leverage. The adoption of a macro-prudential approach to regulation is certainly a welcome, albeit untested, development.
At the same time, it is not evident that economic agents will modify their behavior that gives rise to financial crises:
For these reasons, I do not harbor false hopes that future crises are easily avoidable. However, I am encouraged by research at the BIS and by Bob Aliber in pointing out factors contributing to financial crises and asset bubbles. I hope the economics profession will take up the challenge of understanding the process of credit creation better, as it holds the key to assessing potential booms and busts in asset markets.