Diamond and Kashyap on the Recent Financial Upheavals

As an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers. What they told me was so interesting and insightful that I begged them to write their explanations down for a broader audience. They were kind enough to take the time to do so. In what follows, they discuss what has happened in the financial sector in the last few days, why it happened, and what it means for everyday people.

The F.A.Q.’s of Lehman and A.I.G.
By Douglas W. Diamond and Anil K. Kashyap
A Guest Post

For most of the last 20 years we have been studying banks, monetary policy, and financial crises. So for us the events of the last year have been especially fascinating.

The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. In talking with reporters and our noneconomist friends, we have been besieged with questions about several aspects of these events. Here are a few of the most frequently asked questions with our best answers.

1) What has happened that is so remarkable?

This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.

The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)

On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

2) Why did these things happen?

The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.

Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world: nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely.

In addition, other large financial firms — including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world — had guaranteed A.I.G.’s bonds by writing C.D.S. contracts.

Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.

3) Why did the Treasury and Fed let Lehman fail but rescue Bear Stearns, Fannie Mae, Freddie Mac, and A.I.G.?

We have already explained why Fannie, Freddie, and A.I.G. were supported. In March, Bear Stearns lost its access to credit in almost the same fashion as Lehman; yet Bear was rescued and Lehman was not.

Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear’s regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.

The second problem was that Bear’s counterparties in many transactions were not prepared for the sudden demise of Bear. A Bear bankruptcy might have triggered a wave of forced selling of collateral that Bear would have given its counterparties. Given the potential chaos that would have resulted from Bear Stearns filing for bankruptcy, the Fed had little choice but to engineer a rescue. In doing so, the Fed argued that the rescue was a rare, perhaps once-in-a-generation, event.

When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.

Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or “collateral damage” effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.

Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system — or both.

It was not surprising that they drew the line at helping Lehman. Based on all the publicly available information, this was clearly the right thing to do.

4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?

The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.

As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.

This is going to slow growth. We have not seen this much stress in the financial system since the Great Depression, so we do not have any recent history to rely upon in quantifying the magnitude of the slowdown. A recent educated guess by Jan Hatzius of Goldman Sachs suggests that G.D.P. growth will be just about 2 percentage points lower in 2008 and 2009. But as he explains, extrapolations of this sort are highly uncertain.

5) What does it mean for the Fed and Treasury going ahead?

A reasonable reading of the recent bailouts suggests a simple rule: if a firm is on the verge of collapse and its ties to the financial system will lead to a cascade of chaos, the firm will be saved. A bankruptcy will be permitted only if the failure can be contained.

Assuming the level of chaos is sufficiently high, this dichotomy is probably consistent with the mandate of the Federal Reserve. The rescue of A.I.G., however, raises some major challenges.

One is where to draw the line. A.I.G. was an insurance company, not a bank or a broker dealer, so the Fed had no special relationship with A.I.G. Presumably, if a very large airline or automaker had been involved in the C.D.S. market, the same reasoning that led to the rescue would apply.

A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.

Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?

Third, now that A.I.G. has been lent to, how will regulation have to be adjusted? Surely the Fed cannot be called upon to provide backstop financing whenever a large member of the financial system runs into trouble. How does it prevent a replay of this scenario, and can it be done without stifling innovation?

6) What does this mean for the markets going ahead?

Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome.

If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.

7) When will the turmoil end?

The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.

One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.

The fear of being the next Lehman ought to convince many of the large institutions that, despite however much they already raised, more is needed. It may be expensive to attract more equity financing, but the choice may be bankruptcy or sale. The decision by the Federal Reserve to not cut interest rates suggests the Fed also recognizes that the short-term interest rate is a very inefficient way to address this problem.


Kari

Does this mean the war will finally be over?

bobby benson

I`m native American, We were here before America we will be here after America.This bail out is The RICH stay rich ,the poor get poorer. then comes total collapse, martial law,then REVOLUTION. Is`nt this the way it started?

Yasuko Sasaki

I had E-mailed Steve a while ago, asking him about all that financial mess, and i wondered why the response took this long but now i know
thanks Steve.

charles

Not that hard to figure out since it looks like they are scrambling to figure a way to make a profit off of this too, and off of oil speculation, and who knows what else. A crisis of morality in the midst of decadent free marketeering at the expense of everyone but the profiteers. So it does happen to impact everyone and we have to jump in with corporate welfare cadallac dollars courtesy of good ole grandpa Reagan. First Savings & Loan bailouts and now its come to this. George Will is deathy afraid gov't might impact business negatively while we all overlooks just how much business has been allowed to impact us negatively. With pollution and with dollars, and with increased healthcare costs and with wars for cost-plus profit!

Wayne Hey

We citizens are too blame, we took the loans wanted more square footage and more garages. Driving up prices and sucking up imports. Laying off our brothers and sisters, off shoring who cares, I just got another new loan. All the while causing the least along us to be priced completely out of the market.Causing, pushing homelessness further into our communities.

As for the American dream some economist suggest we have too many home owners causing our workforce to not be fluid enough to be able to move to new areas of employment and need.Home works as anchor.I think many Michigan resident would leave too new work elsewhere if they could just sell their homes.American Dream a phrase made up by realestate folks.
This above is now starting to happen with food and water.Speculation.
The Government's fix just more of the same borrow on decreasing capital. The US is loosing value just look at our road and bridges underground infrastructure decade old in many cases.No maintenance rundown all lose of value.

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Mukundan

Gentlemen,
Thank you for the comprehensive article. I view the cash flow chain bottom-up as business activity to people (service providers) to mortgage payments to banks/institutions (that lend the mortgages). The current problem is at the start of the chain with the economy not picking up. The solutions including the latest $700 billion proposal prevents the failure of top of the chain institutions, through long-term debt ($2400/person) to the economy and people, further burdening the already hit economy and people.
Is there a way to prevent a run on the institutions& financial system and not have the govt accept cost of bad mortgages. Remember, the bad mortgages are going to continue unless the economy picks up.
Maybe, if there is no short term cash flow for lehman, they should immediately create some cash from selling assets. Similiarly for AIG. Separately, there has to be a framework for prevention of run downs on institutions. This sort of govt backing is going to burden the economy with long term debt. There is no benefit to the joe on the street who will face the same problems.

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Gary Kern

What I got from the article - the Federal Government took the business risk out of the Fannie Mae and Freddie Mac. With the Federal government as a sugar daddy silent partner, market place competition died. Those who ran these programs cooked the books, while both side of the political world got their cut and looked the other way.

Character and ethic matter and judging from last week's events both are in short supply and neither will be fixed by this bail out.

Big government and big business; we, the American people, have put all of our eggs into one basket; this is a socialist basket not a capitalism basket. Those who still believe the out dated concept of our founding fathers; that government derives it power from the will of the people need to wake up and smell the coffee. It is time throw the nay sawyers (conservative idealist) out and get on board with the rest of us and help build our new country "Utopia". In Utopia there are no risks. We will tax the rich distribute the wealth, everyone will be a king. Happy days are here again.

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james wilson

More simply put, the democracy is out of control; because it is to large, too self-important, and not a proper Republic any longer.
The only way to make certain government does not abuse its power is not to grant it in the first place--Tom Deweese
Powers once assumed are never relinquished. bureaucracies, once created, never die--Charles Reese

leo from atlanta

Okay article. After the fact and just okay.
It would have been great if it had the courage to be written beforehand. The guys who wrote this knew what was happenning looong ago. They are disingenuous in atributing the why of when action was taken.

Back in August of 2007 the public got its first glimpse of us as a nation having a bad debt to cash ratio. Housing prices stuttered and we closed our eyes. Decisive action was needed, but wasnt taken because the public would have never tolerated what was necessary to be done.

So we waited. We waited some more. We waited until the pain was shared by enough of the population in equity prices that we were collectively scared.

95% of the people who invest in the market, both home and public equities dont spend a whole lot of time paying attention. They allow themselves to be part of the herd. All you had to do was spend 30 minutes each week looking at the net money flow out of financial instituitions to know they were headed for the toilet months ahead of their demise. Do the math, its easy these days. Whose fault is that ?

Like it or not, the health of main street is linked to the ability of the banking system to move money. This is not a vacuum system folks.
Be careful cutting off your nose to spite your face. If we werent so collectively ignorant of this fact we would have taken action far sooner.
It just costs more now. And yes, certain leaders should have paid dearly with their pockets. They still should.

So what next ? This is the discussion that means more. Put on your thinking cap. Keep it simple.

What about the next couple of months ?

Like someone who falls off a horse, we'll have to retest this week's low. Its human nature. DON'T invest in equities till you see this low held.

Longer term ?

Money will be more expensive to come by.
In other words, cash will be worth more.
The economy will slow to a crawl and jobs will be hard to come by.
Commodities will decrease in price because we wont be using them as much.
And what about the dollar that the 'public' laments will become the new peso ?

Think it through.
Go back in history and see what happens to the dollar when its hard to come by cash.

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Ralph H, Malick

Having lived through the last depression or rather survived rather than lived, I do not feel the least bit sorry for speculators and those with greed as their objective for all have had a hand in bringing this problem down on us.....its really called STUPIDITY for you never get something for
nothing, that is basic so I guess with all this white hair on top I feel like an old worn out prostitute that is too worn out to fight anymore.
Thanks.

Pranav

Ok. Great Article. Provides amazing clarity. But think about it. Essentially, its the pessimism on part of lenders and fake balance sheets made by many firms that has led to all this. The solution, well many big shots haven't been able to find out and obviously so can't I. But what I can tell is that essentially its money that has stirred up the entire world. C'mon guys, I think we have been giving undue importance to this aspect of life for many years now, which is why all the pessimism. Lets get out of this trouble for now and learn a lesson for future. Money is just one of those things we accumulate and let go once we are through with our physical existence. So it can't be THE thing to be concerned for. After coming out of this trouble, its time to rethink, our priorities and act suitably. Let's rise above all this and strive for achieving better things than just the stability of the materialistic world.

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Walldill

Thanks to Martin and John, posts 304 and 342. Finally some coherency ! Like John said: "In effect, like our government, fannie and freddie were borrowing just to finance old debt. When no one would lend, mostly because they couldn't (their funds were illiquid) they faced default."

Bottom line - like Fannie and Freddie, when no one would lend, our government... faced default.

Alan Hall

Great job of examining the trees. You missed the forest. Not a word about psychology.

Frank

"Where does the money come from for these 'bailouts'?"

In the case of action taken by the Federal Reserve Bank, (http://en.wikipedia.org/wiki/Federal_Reserve) the money is obtained from the 'federal reserve'; e.g., the reserve balances that private banks keep at their local Federal Reserve Bank. No taxpayer money is involved, hence no Congressional action is required. The loans made by the Fed used in the 'bailouts' of Bears-Stern and AIG were NOT MADE with taxpayers' money (as erroneously reported in a number of news articles and opinion columns).

Any actions taken by the US Treasury, however, do involve taxpayers' money. So any costs incurred by the Freddy Mac or Fannie May conservatorship, or by Paulsen's RTC-like plan, will require Congressionally-appropriated funds (e.g., taxpayers' dollars).

OBTW, in response to comment 366, the Federal Reserve DOES NOT make money. The US Treasury does. The Fed just distributes the money for the Treasury Department.

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ajwak1

and now not only does Paulson look stupid, but Diamond and Kashyap look just as silly. About time for them to admit they were wrong.

esmiles

AIG: private profits, socialized losses.
Here's an interesting answer to the question, is Paulson wrong? http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf
Found this on Greg Mankiw's blog last night.

Thank you for the excellent explanation!

Tess

I don't think the answer to the second question really explained "why it happened". There were a host of events that had taken place prior to the firms' failure to retain financing. And still, why did this happen?

In the scheme of things, a mortgage is a small layout/payout for banks compared to other incomes that an investment bank generates such as advising fees, corporate or sovereign loans, middle market lending, securities. Therefore mortgages are bundled into MBS to allow it to have big enough face value for investments banks to accept as a financial instrument.

The investment banks knew that MBS were not huge deals for them, unlike an IPO offering, resources were not diverted to look at them closely. Mortgage brokers knew that they were simply making small sums here and there, couldn't have possibly impacted long standing, financially affluent investment banks, so they kept on feeding them to the banks. Plus, the government seemed to have encouraged it.

With the housing boom and quick profits, would anyone would've listened if someone had told them that this was not viable?

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GS Chandy

Please check my message No. 370 - you have lost most of it!!!

What on on earth happened?

-- GSC

Christopher Scott

Over the last few weeks we have seen the socialisation of vast quantities of the debt of the richest people and organizations on the planet. In one way or another these phenomenally rich people and organisations are being absolved of the consequences of their actions and inactions.

In this context a whole series of situations in our world have become truly grotesque:

- the continued existence of the debt of the worlds poorest countries is now a true obscenity and must be eliminated. I suggest the debt of the 100 poorest countries be written off immediately, and that the debt of all but the richest 50 be reduced proportionately. Perhaps someone would like to put numbers to these debts in order to put them in context with the billions and trillions that are being thrown around at the moment. If there is to be any semblance of justice in this situation the poorest countries must also be absolved of the consequences of their actions and inactions.

- AIDS treatment is desperately needed in many parts of the world. It is an obscenity that this is denied to hundreds of thousands of people for want of the financial wherewithal, either personal, or of their country, to pay for this. Ways must be found to provide free AIDS treatment to anyone who needs it, anywhere in the world, now.

- Haiti (specifically, and probably many other places around the world) is currently in a desperate situation because of devastating natural disasters. The cost of providing all the funds, food, and equipment necessary for some semblance of normality to be restored must be absolutely trivial in the context of the debts being absolved at the moment. The necessary funds should be provided immediately.

Perhaps others would like to add to this list. I am certain that there are many other similar situations around the world which are quite simply morally and ethically grotesque in the current context. All such situations were already unacceptable before the current crisis; now, their continued existence is quite simply surreal.

How to pay for all this? Nothing in this crisis happened by accident. Every step along the way was taken as the result of the individual decisions and actions, indecisions and inactions, of thousands of managers and regulators in the US and around the world. Many of those positions were probably within in a hairs breadth of criminal. Some were possibly truly criminal. Words and phrases such as 'breach of trust', 'withholding of information', 'misrepresentation', and 'deception' come to mind. How many of those involved were encouraging, or doing nothing to prevent, the less well informed from becoming part of this financial merry-go-round, while in full knowledge of the fact that their companies were practically bust, or that the bubble was unsustainable. Crime is what a society judges to be crime in a given context. In the current context much of this behaviour must now be seen as criminal.

At the very least there is a need for a Congressional Commission, or probably better a UN Commission, as this crisis is global, to unravel this tangled knot of decisions and actions, indecisions and inactions, in order to try and understand what happened and who was responsible for pushing the situation forward into crisis. If crimes are discovered they must be treated as such. They must not be absolved along with the debts. Punishment should be exemplary and financial, in the form of community service writ large. The individuals and organisations found guilty should be obliged to assume full responsibility for resolving, with both work and their own financial resources, some part of the global problems listed above.

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jim

When the stock manipulation only affected the average guy IE to shoot the price of oil and gasoline through the roof or to loose ones house due to interest manipulation this administrations answer was to let the market run its course. No need for the government to get involved. Now when the big boys begin to get hurt the government need to do every thing possible to stem the loses. The person who has lost his house, his job and sees his family hungry,does not see how saving these companies can now make a difference to him. These free market people sure move fast when their money and their friends money is on the line. No amount is to much for the people to spend. I guess the plan is right on track.