A “Lehman Moment”
by Doug Noland
Posted June 17, 2011
ISN’T IT INCREDIBLE THAT THE FAILURE OF ONE FIRM, Lehman Brothers, almost brought down the global financial system? It is equally incredible that, less than three years later, a small country of 11 million has the world teetering on the edge of another systemic crisis. Today’s circumstance is a sad testament both to the instability of the international Credit “system” and to the lessons left unlearned from the previous crisis.
For about 15 months now my analysis has attempted to draw parallels between the initial subprime eruption and last year’s Greek debt crisis. Both were the initial cracks in major Bubbles (“Mortgage/Wall Street Finance” and “Global Government Finance”). These two weakest links – due to their role as the marginal borrower exploiting a period of system market excess – were extremely poor Credits. On the one hand, the systemic vulnerabilities associated with a potential bursting of major Bubbles elicited aggressive policy responses to the initial subprime and Greek tumults. On the other hand, policy had no constructive impact on the underlying quality of the debt – while significantly inciting market excesses (market price distortions, Credit and speculative excess, etc.) that exacerbated systemic fragilities.
There was heightened fear this week that the “Greek” crisis was evolving into Europe’s “Lehman Moment.” Recalling back to 2008, the Lehman collapse was the catalyst for a crisis of confidence throughout the expansive universe of “Wall Street” risk intermediation. Importantly, market confidence in the willingness and capacity for policymakers to backstop this multifarious system held steady virtually until the moment the Lehman bankruptcy was announced. The marketplace had appreciated the enormous risks associated with a potential crisis of confidence throughout the securitization and derivative marketplaces, yet assumed that policymakers would simply not tolerate a failure by one of the major players in this financial daisy chain. The global financial system almost imploded when this precarious “too big to fail” assumption was debunked.
I have posited that the global policy response to the 2008 crisis only expanded and solidified the market’s notion of “too big to fail.” Most in the marketplace believe that policymakers now recognize that allowing Lehman’s failure was a major policy blunder. The expectation today is that the EU, ECB, IMF, Germany, China and the Fed will not tolerate a Greek debt default. This faith had better not be misplaced.
While the Lehman failure proved the catalyst for the 2008 crisis, it was definitely not the root cause. The problem was instead the Trillions of unsound debt underpinning Trillions of leverage, Credit insurance, and sophisticated risk intermediation that, through “Wall Street alchemy”, had transformed really bad loans into seemingly appealing (“money-like”) debt instruments. As soon as the market began to back away from these structures (commencing with subprime concerns), the downside of a (Hyman Minsky) “Ponzi Finance” scheme was set in motion. And as the Bubble began to falter, the market increasingly valued huge amounts of debt based on the perception of a system backstop rather than on the fundamentals of the underlying debt instruments (largely, increasingly vulnerable mortgages).
If authorities had moved to save Lehman back in September of 2008, it would have bought some extra time – and would have changed little. Trillions of unsound debt, distorted asset and securities markets, and a severely maladjusted economic structure ensured a major crisis. It was only a matter of the timing and circumstances as to how the widening gulf between distorted market prices and the true underlying value of the debt was resolved. As we are witnessing with Greek, Portuguese and Irish debt (and CDS) prices, market troubles often manifest when unanticipated policy uncertainties force the marketplace to take a clearer look at the fundamentals underpinning a debt structure – only to grimace.
The problem today is not really Greece. A dysfunctional global Credit “system” has created tens of Trillions of unsound debt – and rapidly counting. Aggressive “activist” policymaking has been at the heart of this unprecedented Credit inflation, and the markets today fully expect policymakers to ensure this Bubble’s perpetuation. And, importantly, for better than two years now global fiscal and monetary policies have incited another huge round of global speculation and leveraging. This latest Bubble gained considerable momentum with last year’s European Greek bailout and implementation of the Fed’s QE2 program.
Policymaking gave a new – and egregiously profitable – lease on life to the “global leveraged speculating community.” Given up for dead in late-2008, hedge funds, proprietary trading desks and others have been able to exploit government-induced market distortions like never before. With confidence that massive fiscal and monetary stimulus would ensure economic expansion, abundant marketplace liquidity, and strong inflationary biases for global securities and commodities markets, the global “risk on” trade proliferated near and far. Re-risking and re-leveraging – through the creation of new market-based debt and attendant liquidity – fueled a self-reinforcing speculative boom. QE2 (and other central bank liquidity operations) coupled with re-leveraging dynamics bolstered the perception that the markets had commenced a cycle that would prosper in liquidity abundance for an extended period. Fragile underpinnings, especially in the U.S., seemed to ensure years of policy largess.
There is a big problem any time the leveraged speculating community begins to question core assumptions – certainly including the capacities of policymakers to sustain Credit booms, ensure liquid and continuous markets, and to contain Credit stress. Think of it this way: Enterprising market operators are incentivized into leveraged (“risk-on”) trades when they discern that policymaking is providing both a trading edge (generally an inflationary bias or predictable spread) in the marketplace and a favorable liquidity backstop availing an easy exit when necessary. I would argue that huge speculative positions have accumulated over the past two years on assumptions that are increasingly in doubt. This has quickly become a major market issue, and largely explains recent market action.
The markets must now face the reality that policymakers don’t, by any stretch, have the Greek crisis contained. Last year’s big “fix” is now appreciated as a mere little band-aid. What appeared an incredible sum for the one-time bailout of an inconsequential economy is increasingly recognized as the tip of the iceberg for huge structural problems at Europe’s periphery and beyond. The markets are beginning the process of recalibrating the potential costs – including financial, economic and social, along with myriad unknowable attendant risks – associated with festering Credit and market crises. The results are frightening.
My basic premise is that the sophisticated leveraged speculators have been operating as the marginal source of liquidity – fueling a highly speculative run throughout global risk markets. These players now appreciate that assumptions underlying their bullish positioning in various markets are now in jeopardy. No longer do the policymaking, liquidity and economic backdrops support their aggressive risk-taking posture. This essentially ends the latest cycle of speculative excess, as prospects would appear to dictate more self-reinforcing pressure to de-risk and de-leverage.
A speculative marketplace cannot easily accommodate a move by the marginal liquidity provider to unwind leveraged positions. This challenge becomes only more formidable when a meaningful segment of the speculating community would prefer to reverse long exposure and go short various risk markets. Others will move aggressively to hedge long exposures in the derivatives markets. It is exactly these types of dynamics that transforms what seemed to be highly liquid markets quite abruptly into illiquid problems.
It has been part of my bear thesis that the “moon and stars” have been lining up for a bout of de-risking and de-leveraging right as QE2 was wrapping up. Market cracks have been forming for months now – emerging market equities, commodities and gold stocks, the banks and the depleting energy sector come to mind. Hedge fund returns have been unimpressive, which equates to a lot of positions and leverage in potentially weak hands. And, importantly, the U.S. economy has performed dismally in the face of massive stimulus. Much of the marketplace has been caught poorly positioned. Still, many of the bullish persuasion are comparing the current soft-patch to last year’s, missing the critical difference that recent weakness commenced in the midst of strong equities markets, booming debt issuance and $20bn or so of weekly quantitative easing.
It is certainly not a clear line from Athens to the U.S. markets and economy. And it’s not an easy task to explain how financial conditions in our system have come to a large degree to be dictated by global market forces. But to appreciate the gravity of the situation one must first recognize the underlying fragility of our financial and economic systems.
If this were a sound recovery – fueled by balanced growth, strong capital investment and financed largely by relatively stable bank finance – I’d be a lot less worried. But we’re instead in a quite shaky recovery incited by massive fiscal and monetary stimulus – which spurred excessive risk-taking, speculation and general financial excess. Real economic adjustment was put on hold; the system has been set up for disappointment. And with bank lending stagnant, the vast majority of system credit creation is coming these days from the issuance of marketable debt. The markets had already moved to impose austerity on the municipal bond arena, and it appears the booming corporate debt marketplace is now facing an abrupt shift in the liquidity backdrop.
“Extend and pretend” and “kicking the can down the road” are now bandied about when discussing the policy approach to the Greek crisis. Virtually everyone believes that policymakers will – heroically in the final hour – come together, end the brinksmanship and craft a policy response that avoids even a technical default. German Chancellor Merkel peeked into the abyss and saw the light – just as the markets presume politicians and central bankers will do. There will be no “significant” contribution (aka losses) to bondholders, with Ms. Merkel agreeing instead to a voluntary participation from private creditors.
The problem is the market has no appetite for Greek debt – and it doesn’t want the debt of Ireland or Portugal either. And it wouldn’t take all that much for the marketplace to take a cautious approach to debt altogether. At this point, there’s little that can be done to make this problematic periphery debt appealing to the marketplace. Meanwhile, the Greek populace has taken a lot of pain – and will be told to endure worse – without seeing any positive results. The whole process has lost important credibility, which could mark an important inflection point for the markets.
Global markets have enjoyed a bountiful year of policy-induced gains. Policymakers, once again, emboldened those believing that governments can solve debt problems and easily intervene to bolster financial markets. This backdrop has, at the same time, provided quite an opportunity for market participants to hedge risk in Credit default swap (CDS) and myriad other derivatives markets. At the end of the day, the flurry of hedging and speculating that arose when subprime heated up in ’07 embedded risk exposures that came back to haunt the system with Lehman’s collapse. And, I’ll wager, many of the institutions at the heart of today’s booming global risk-intermediation and derivatives markets (including CDS) are heavily exposed to Greek and periphery debt.
Expanding debt impairment is becoming a major problem; there’s no apparent default mechanism that wouldn’t imperil many of the world’s major financial institutions; and the tentacles of this potential crisis reach far out across the global system. “Extend and pretend” is the new normal, as global markets become a politicians’ and policymaking confidence game. Europe – and the world’s – new “Lehman Moment” commences when the markets question the soundness of the global derivatives marketplace.