Presidential Programs : Dealing with Credit Crunch and Bail-Outs

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