Tuesday, July 29, 2014

How to Start a Financial Crisis Part 3

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First, in the last three decades, low interest rates and increases in productivity are mostly responsible for record amounts of corporate balance sheet cash. That cash needs to go somewhere.

Second, banks devised a pawn-like scheme to take corporate balance sheet cash and use it to finance the purchase of higher-yielding securities, earning the difference in what they pay to borrow and what they earn on the purchase.

Third, the borrowed cash needed to be backed by AAA-rated collateral. To fulfill this need, Wall Street securitized packages of loans, thereby creating a new form of AAA-rated collateral.

This spawned the “shadow banking system”: corporations would lend money to banks through repo and commercial paper markets in exchange for a low interest rate and the banks would back these loans with securitized products. Even after Dodd-Frank, this system still remains largely unregulated.

Today, I’ll explain how the whole process led to higher asset prices through the creation of more credit.

Think of it like this: banks enter a pawn shop with a gold chain. The pawnbroker lends the banker $1000 at a 1% interest rate and keeps the gold chain as collateral. Banks take the $1000 and purchase another gold chain, and promptly return to the pawn shop to borrow another $1000. This process is repeated ad infinitum until all the cash on corporate balance sheets has been lent to finance the available supply of gold chains.

Suppose these gold chains weren’t your average run-of-the-mill gold chains. These gold chains have Mr T-like mystical powers and pay a 6% dividend to the owner. For every $1000 that the bank borrowed from the pawn shop at 1%, they earn a 5% return (the difference between what the bank borrows and what it receives). Each time the bank is due to pay the pawnbroker back the original $1000, he tells him to keep the gold chain and renews the agreement on the funds for 1%. Thus, borrowing money from the pawn shop to finance the purchase of higher yielding gold chains is a very lucrative endeavor.

So what happens to the market in gold chains? Well, if banks are using borrowed money to purchase gold chains, the price of gold chains is going to increase rapidly as demand outpaces supply. And the bankers can now take these gold chains with inflated valuations and use them to extract even more money from lenders.

However, the value of gold chains is increasing not as a function of buyers’ incomes, but through the introduction of more leverage from corporate balance sheets. As the leverage in the pawn system increases, so does the ratio between price and incomes. At some point, buyers’ incomes can no longer support the price of gold chains.

And this is precisely what happened to the housing markets in the early aughts as the price to income ratio of homes was boosted by the shadow banking market.

However, as the available supply of gold chains dissipated, bankers would sometimes deposit fool’s gold (subprime). The pawnbrokers started to worry about phony loans in early 2007, and began requiring more collateral to back their loans. Instead of lending at 100% of the collateral deposited, pawnbrokers would only issue funds equal to 90% of the value of the collateral. Slowly, this started to drain leverage from the system.

And as leverage fell, so did the value of the gold chains, which further arrested the flow of cash from corporate balance sheets. This vicious cycle repeated itself until the pawnbrokers decided that all gold chains were worthless and wanted their money back. Since the banks didn’t have the cash on hand, they needed to immediately liquidate gold chains into a market where there were no buyers. Lehman failed overnight, and the government was forced to respond by providing the banks with $1 trillion in capital.

The 2008 financial crisis was a run on the shadow banking market caused by a loss of confidence in the debt owed by banks. There were similarities to the bank runs of the 19th century, however, this time it was institutions that were lining up to retrieve their cash and not retail depositors.

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