Article published in Revue Sociétal no. 65 – Q3 2009
Financial crisis follows financial crisis, each one originating and playing out in fundamentally similar ways, while also displaying some unique characteristics. Every financial crisis takes at least one of the three classic forms that have been regularly observed from the 19th century to the present day. They often take the three forms in turn or simultaneously. The following analysis is inspired by the work of Michel Aglietta and economists from the Bank of International Settlements.
The first form of any banking crisis, past or present – we could even say it is the oldest form of crisis – is the speculative crisis. How is it that assets (shares, property, gold, etc.) can become the subject of speculative bubbles? It is because their prices, unlike those of reproducible industrial or commercial goods or services, do not depend on their cost price, or what economists call their marginal cost. That is why they can diverge so significantly from their manufacturing cost.
The price of a financial asset is ultimately a function of the confidence that people have in the promise of future earnings it could yield, a promise made by the issuer. But determining the price also requires each player to anticipate how much confidence others will have in that promise. Everyone is thinking along the same lines.
As long as information is not readily shared (between the lender and the borrower, the shareholder and management, or between market players themselves) and the future remains highly uncertain, these informational asymmetries and this fundamental uncertainty drives players to imitate one another. Under these circumstances, it is very difficult to ascertain the intrinsic value of the asset in question and thus to bet on it. In this case, the market is dictated by others, as it is a pure product of the majority opinion that emerges. Players imitate each other rationally in an effort to anticipate and play on market trends, and this process is entirely self-referential. That is how strong, long-lasting speculative bubbles arise. These bubbles end by bursting suddenly when the majority opinion swings in the opposite direction, in an even more dramatic fashion than during the previous phase.
The market is a pure product of the majority opinion that emerges.
The second form, a credit crisis, occurs when a long period of growth causes everyone (banks and borrowers) to gradually forget the possibility of a crisis and to believe that there is no limit to the expansion. During this euphoric phase, lenders dangerously lower their sensitivity to risk and leveraging (the ratio of debt to wealth or income for households or net assets for companies) reaches levels that any objective observer would consider inadvisable. And this phenomenon is further amplified when lenders stop evaluating borrower solvability on the basis of their likely future earnings and begin using the metric of the expected value of the financed assets (especially shares or property) or of those that are used for collateral. During this phase they also accept margins that will not cover the future cost of risk for the credit in order to compete with others. The financial situation of these economic actors proves to be extremely exposed when the reversal occurs. Then, when the crisis finally arrives, lenders (banks and markets) have an extreme change of heart in terms of their willingness to take on risk, and they run to the opposite extreme in terms of volume and margins, until a credit crunch occurs, further worsening the economic crisis that caused it.
The third classic form of crisis: a liquidity crisis. During the dramatic events of financial crises, a contagious sort of distrust takes hold. This is typical of the financial and banking crises we know today. For some banks, this distrust leads their customers to withdraw their money in what experts call a bank run, causing the bank to fail.
It can also cause banks to slow down or even stop lending to each other altogether, fearing a chain reaction of failures. This illiquidity in the market for interbank financing – unless central banks intervene as lenders of last resort – produces the very failures they feared. There are other forms of illiquidity that can occur. Some financial markets go from being liquid one day to illiquid the next, due to the fact that the idea of market liquidity is again highly self-referential, as an analysis by André Orléan shows. A market is only liquid if the players think it is. If they begin to doubt its liquidity, all the players will try to sell so they can exit the market, and by doing so they cause the illiquidity problem from within. In the current crisis, the most emblematic case is the market for ABS (asset-backed securities).
A market is only liquid if the players think it is.
One Thing Leads to Another
These types of crises often intersect and join forces to create an extremely serious situation. For instance, credit can expand too rapidly, through abnormally high growth in the prices for the assets being used as collateral for these loans. This makes asset prices balloon, as additional purchases are made possible by these easily obtained loans. That is when a self-fulfilling and potentially long-lasting phenomenon takes hold with markets that are unable to return by themselves to « normal » levels. By the same token, the liquidity crisis may be caused by a sudden panic about the value of the bank bonds and financial assets
held by financial institutions. Looking for liquidity, banks invest less in the economy and attempt to sell off their assets. In turn, this fans the flames of the speculative crisis and the credit crisis. The devastating crisis that began in earnest in 2007 is, like previous crises, a combination of all three of these forms. It first began as a speculative housing bubble, especially in the United States, the United Kingdom and Spain. Then it became a credit crisis caused by a dangerous rise in household debt levels in these same countries and overleveraged investment banks, LBOs and hedge funds. And finally it turned into a liquidity crisis in securitisation and interbank financing markets resulting from the after-effects of the Lehman Brothers bankruptcy. Each crisis aggravated the others in a self-perpetuating cycle.
What makes the current crisis unique is the rapid development in the last few years of securitised debt instruments.
Through securitisation, credit institutions were able to transfer debt instruments for individuals, companies and even municipalities off their balance sheets. These instruments were then haphazardly combined into bundles into that were themselves overleveraged; these were then sold to other banks, to insurers and to investment funds, in short, to anyone and everyone. Securitisation helped increase the financing of the global economy, as it enabled banks to grant more loans than they would have been able to if the loans had remained on their balance sheets. But this technique led the banks who used it the most (notably in the United States) to significantly lower their standards for selecting and monitoring borrowers and to provide loans to agents that were increasingly insolvent, because once they were securitised the loans no longer posed a threat to the banks. That is how the number of subprime loans proliferated, which further amplified the credit crisis that hit after the housing bubble burst. Unregulated securitisation significantly aggravated the credit and liquidity crises. The fact that the loans were so difficult to track and the practice of bundling good and bad loans into the same securities, along with the opacity and complexity of the securitised instruments (CDOs made of CDOs, etc.), expanded the scope of the crisis as well. As the players involved no longer had any confidence in the quality of these kinds of investments, or even in their own understanding of them, liquidity was suddenly brought to a halt. Fears about the assets held on bank and insurer balance sheets caused a liquidity crisis in one fell swoop, especially for interbank lending, on a level that many had thought would never be seen again. Governments found themselves faced with the increasingly difficult task of solving these problems. The first lesson to take away from this has to do with the unregulated boom in securitisation and the role this mechanism should play for banking in the future.
Ratings agencies also played a huge role, as they gave the highest rating (AAA) to tranches of these instruments based on mathematical models that used poorly understood restrictive assumptions and solely analysed past series. This rating proved to be essentially worthless as the crisis unfolded. These ratings, which did not cover the liquidity risk, led many investors, including banks, to falsely reassure themselves about the quality of their financial assets, without thinking too deeply about how an AAA-rated investment could offer such a high rate of return. Reforms are needed to ensure that these agencies can re-establish objectivity in their work and the credibility that they need to survive. The combination of the three classic forms of financial crises and the unique features of the current crisis explain the extreme gravity of the situation, involving distressed banks, panicked investors, an ongoing credit crunch and a severe economic crisis. Only strong measures from public authorities, at a time when players have no faith in anyone else, have been able to begin to relax the interbank market and prevent the entire financial system from imploding. Now is the time to act to counter the economic consequences of the financial and banking crisis and to prevent us from finding ourselves in a similarly dire situation again in the near future.
Professor of Financial Economy at HEC, Bank Director