The programs of the Presiden2al Candidates Conference of the University of Miami
PROGRAMS : DEALING WITH CREDIT
CRUNCH AND BAIL OUTS
Ricardo V. Lago October 8th, 2008
Moderator : Prof .Manuel Santos, James L. Knight Chair in Economics at the School of Business Administra?on PANELISTS Carlos Asilis , Financial Adviser Ricardo V. Lago, former Senior Official of the
European Bank for Reconstruction and Development; Prof. Christopher Cotton, an Assistant Professor of Economics.
COMMENTS CAUSES OF THE CRISIS AND POLICIES TO DEAL
WITH IT THE PROBLEM OF HIGH LEVERAGE DO WE NEED MORE REGULATION ? THE ATTITUDE OF THE PRESIDENTIAL CANDIDATES ARE WE HEADING FOR A 1929‐TYPE OF DEPRESSION
Co>on , Asilis , Lago , Santos
THE CAUSES OF THE CRISIS WAS IT TOO MUCH CREDIT ? WAS IT AN UNSUSTAINABLE HOUSING FINANCE
MODEL IN THE US ?
WAS IT TOO HIGH LEVERAGE RATIOS ? WERE THE REGULATORS ASLEEP AT THE HELM ? THE ANSWER IS : ALL OF THE ABOVE .
ILLIQUIDITY OR INSOLVENCY ? I CALCULATE THE SIZE OF THE WORLD BANKING SYSTEM AT
AT LEAST US$ 100 TRILLION OR 200% OF WORLD’S GDP
FURTHER , I CALCULATE CONSOLIDATED BANKS BOOK VALUE
EQUITY AT AT LEAST US$ 5 TRILLION
MY HUNCH IS THAT THE MARKET VALUE OF CONSOLIDATED
BANKS EQUITY IS PROBABLY NEGATIVE
BEWARE THAT TRUE SOLVENCY IS FORWARD LOOKING ,
AND IS DEPENDENT ON MULTIPLE EQULIBRIA
THEREFORE , THE CURRENT ILLIQUIDITY IS GROUNDED ON A
PROBLEM OF INSOLVENCY
WARREN BUFFETT’s COLORFUL ILLUSTRATON You don't know who is swimming
naked, until the tide goes out, and “ right now, Wall Street is a nudist beach” ( Interview in CNBC , August 22,2008)
SOLUTION :BANK RECAPITALIZATON
RECAPITALIZING THE BANKS ALL OVER THE WORLD
WOULD COST NO LESS THAN US$ OR 5 TRILLION OR ABOUT 10% OF THE WORLD GDP
THE USA’s SHARE WOULD BE ABOUT US$1.5
TRILLION ( THE EXPENSE OF THE US TREASURY SO FAR IS ABOUT US$ 1 TRILLION ) SO THE US IS AHEAD IN THE GAME
BANK RECAPITALIZATION CAN BE EFFECTED BY
EITHER INJECTING EQUITY IN THE BANKS OR BUYING OUT THE TOXIC ASSETS FROM BANKS AT ABOVE TODAY’S MARKET PRICES
THE ACTIONS OF THE FED AND THE TREASURY THE SHADOW OF 1929 and of Japan 1992 –to date
IT IS IMPERATIVE TO STOP THE DE‐LEVERAGING OF FINANCIAL
INSTITUTIONS TO AVOID A 1929 ‐TYPE DEPRESSION
THE FED IS DOING THE RIGHT THING : MASSIVE INJECTIONS
OF LIQUIDITY .IT BUYS PRECIOUS TIME BUT DOES NOT SOLVE THE PROBLEM
THE TREASURY IS ALSO GOING TO DO THE THE RIGHT THINK :
THE STATE AS PROVIDER OF LIQUIDITY OF LAST RESORT TO AVOID LIQUIDATION (EXCEPT LEHMAN BROS)
RUNNING AGAINST THE CLOCK :
THE 700 BILLION QUESTION IS WHETHER THE TREASURY WILL BE ABLE TO RECAPITALIZE THE BANKS FAST ENOUGH .
LET ME FOCUS NOW ON HIGH LEVERAGE QQQQ
HOW DOES HIGH LEVERAGE WORK? GOOD TIMES ‐If the economy keeps growing , you
multiply by 30 the profits you make on each dollar of capital .
HARD TIMES ‐When the inevitable economic downswing
comes , you blow away the equity position by a wide margin .
Key asymmetry and inequity : in good times profits are
privatized , in hard times creditors ( and sometimes shareholders) are bailed out : losses are socialized.
LTCM’s COLLAPSE : THE POSTMAN ’s FIRST RING Leverage ratio : 26 times on balance sheet , more
than 100 times off‐balance sheet Long Term Capital Management was a hedge‐ fund that collapsed in 1998 and had to be bailed out to prevent widespread effects on creditors . LTCM had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. In addition , it had off‐balance sheet derivative positions with a notional value of approximately $1.25 trillion .
AND WHO MODELLED RISK AT LTCM ? Two of the principals were :
Myron Scholes and Robert Merton Two academics who shared the Nobel Price of
Economics in 1997 ( the year prior to the collapse ) Precisely for their work on the pricing of options
ROBERT LUCAS They forgot the work of the Nobel Prize Winner two
years earlier in 1995 Robert Lucas’ evaluation critique :
“you cannot predict on the basis of historical data , particularly when there are important policy changes”
THE FOUR FLAWS OF LTCM VERY HIGH LEVERAGE
OFF BALANCE SHEET OPERATIONS ABUSE OF DERIVATIVES RISK MODELLING : PARAMETERS
ESTIMATED WITH HISTORICAL DATA
FIVE YEARS LATER :
WARREN BUFFET’S REMINDER Derivatives are “financial weapons of mass destruction that could harm not only sellers and buyers but the whole economic system “ (Warren Buffett’s Annual letter to shareholders , 2003 )
“History always repeats itself twice: first time as tragedy, second time as farce” Karl Marx
THE POSTMAN’s SECOND RING : Black September 2008 Leverage ratios of failed banks :
Fannie Mae and Freddie Mac 60 Lehman Bros : higher than 31 AIG : higher than 20
ISDA®
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC. NEWS RELEASE For Immediate Release, Wednesday, September 24, 2008 ISDA Mid‐Year 2008 Market Survey Shows Credit Derivatives at $54.6 Trillion
ABOUT ISDA ISDA was chartered in 1985, and today has
approximately 850 member institutions from 56 countries on six continents. Most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over‐the‐counter derivatives .
INTERNATIONAL SWAP AND DERIVATIVES ASSOCIATION ‐ ISDA ( June 2008) NOTIONAL AMOUNTS OUTSTANDING CREDIT DERIVATIVES US$ 55 trillion INTEREST RATE DERIVATIVES US$ 465 trillion EQUITY DERIVATIVES US$ 12 trillion TOTAL AMOUNTS OUTSTANDING US$ 532 trillion GROSS CREDIT EXPOSURE US$ 13 trillion
HOW HIGH ARE THESE FIGURES :COMPARISON TO GDP TOTAL AMOUNTS OUTSTANDING US$ 532 trillion OR ABOUT 10 TIMES THE WORLD’s GDP OUTSTANDING IN CREDIT SWAPS US$ 55 trillion OR ABOUT EQUIVALENT TO THE WORLD’s GDP GROSS CREDIT EXPOSURE US$ 13 trillion OR EQUIVALENT TO THE USA’s GDP
DO CREDIT DEFAULT SWAPS TRADE IN AN ORGANIZED EXCHANGE ? FORMAL EXCHANGE .No , they don’t . Today , the
Chicago Mercantile Exchange announced , it is launching an electronic trading and clearing platform . REGULATION .How well are they regulated / supervised ?.In general , they are not . BIS .The Bank for International Settlements (BIS) collects both notional amounts and market values in derivatives . NEED FOR A FORMAL EXCHANGE
REGULATION
ONE OF THE PROBLEMS IS THAT REGULATION IS
SCATTERED AMONG SEVERAL INSTITUTIONS : SECRURITIES COMMISSION , FED , COMPTROLLER OF THE CURRENCY , FDIC DO WE NEED MORE REGULATION ?
‐THE ISSUE IS NOT NEW REGULATIONS ‐THE REGULATORS DID NOT DO THEIR JOB ‐THE FED WAS TOO LAX ON CREDIT GROWTH – ‐THE SECURITIES COMMISION AND OTHERS COULD HAVE FORCED BANK ON LEVERAGE RATIOS , INCREASED PROVISIONS , ETC ‐ UNIFY REGULATORY AGENCIES LIKE IN THE UK
THE CANDIDATES REACTION TO THE CRISIS : IN GENERAL DISAPPOINTING
COMPLAINTS ABOUT GREED IN WALL STREET COMPLAINTS ABOUT CORRUPTION IN WASHINGTON A RIGHT MOVE : JOINT SUPPORT FOR THE BAIL OUT
PACKAGE OBAMA MORE OF A STATEMAN IN : THE CORAL GABLES PRESS CONFERENCE McCAIN :FUNDAMENTALS ARE RIGHT ! BUT CANDIDATES STICK TO THEIR GUNS :
OBAMA ON THE MIDDLE CLASS TAX REDUCTION McCAIN ON THE “LAFFER CURVE” :LOWER INCOME
TAXES AND CORPORATE TAXES PROCTECTIONISM IS A SERIOUS PROBLEM : REMEMBER SMOOT‐HOWLEY TARIFF ACT OF 1930 RISK OF BEGGAR MY NEIGHBOOR ACTIONS
THE CANDIDATES SHOULD HAVE PUT ASIDE THEIR PETTY CASH GIVE‐AWAYS AND FOCUS ON THE REAL PROBLEMS : ‐ SHORT TERM :CAUSES OF THE CRISIS AND HOW TO FIX IT ‐ LONG TERM :THE UNFOLDING BUDGET TIME BOMB .
ARE WE HEADING FOR A 1929‐TYPE DEPRESSION ?
NO , BUT …WELL IT DEPENDS….. THE SHORT ANSWER IS : NO WE HAVE LEARNT FROM THE POLICY MISTAKES OF 1929 THE ENGINES OF INTERNATIONAL GROWTH ARE
INTACT : THE INTERNET AND CHINA
WELL….. IT WILL DEPEND ON THE LEADERSHIP AND
UNDERSTANDING OF THE ISSUES OF THE NEW PRESIDENT
WILL ALSO DEPEND ON RESPONSE BY OTHER
COUNTRIES : THE EU SO FAR DISAPPOINTING
THE END