Mehrling on Minsky
Financial instability abounds for markets both at home and abroad. Stocks and indices are demonstrating historic volatility, with the NASDAQ100 trading in astonishing intra-day ranges of 4% Monday, 5% Tuesday, 6% Wednesday, 8% yesterday, and 5% today. It is not, however, just tech stocks as the S&P Bank index traded in a 4% range Tuesday and 3% yesterday and today. From last Wednesday's lows, the Dow has surged 935 points, or 10%. Yet it took the NASDAQ100 only a few trading hours to rally 11% off yesterday's trading low. For the week, the Dow gained 4%, while the S&P500 declined about 1%. The Transports gained better than 2%, the Morgan Stanley Cyclical index 3%, and the Morgan Stanley Consumer index almost 4%. The Utilities dropped 2%. The small cap Russell 2000 and the S&P400 Mid-cap indices declined about 2%. The NASDAQ100 dropped 8%, the Morgan Stanley High Tech index 6%, and the Semiconductors 9%. The Street.com Internet index lost 5% and the NASDAQ Telecommunications index declined 8%. Even the Biotechs succumbed to selling, declining 2% for the week. The financial stocks outperformed, with a strong rally in the banking sector seeing a 4% gain for the S&P Bank index. The Bloomberg Wall Street index had a marginal gain for the week. Year-to-date, the New York Financial Index has gained 16%.
Conditions were unsettled in the credit market as well, although selling in Treasury securities helped take the edge off of the widening spread dilemma. For the week, 2-year and 5-year Treasury yields jumped 12 basis points, while the key 10-year note yield added 8 basis points to 5.71%. Long-bond yields increased 2 basis points. Mortgage-back yields increased 11 basis points to 7.45%, while agency securities outperformed with yields generally rising six basis points in the range of 6.6%. The benchmark 10-year dollar swap spread was unchanged at 114. There continues to be little good news in the battered junk bond market, with liquidity nonexistent and spreads continuing to widen for many issues. The dollar index ended the week unchanged after a virtual "meltup" early in the week gave way to selling into week's end. Many currencies have been under intense pressure, especially throughout the emerging markets and we continue to see a generally dislocated global currency marketplace.
Importantly, but certainly not surprising considering the environment, bank credit growth has come to a halt, with loan growth stagnating and security holdings actually down a notable $32 billion during the past five weeks (to $1.3 trillion). At the same time, broad money supply (M3) expanded $25 billion last week, with savings deposits increasing $20 billion and "repos" rising $5 billion. During the past 3 months, broad money has grown at a rate of 8.9%. For 12 months, M3 has expanded by 10.2%. The growth in broad money supply is unrelenting and money market instruments are major fuel for this historic monetary expansion. Since the end of June, money market fund assets have surged $120 billion, or at an annualized rate of 23%. For now, I assume the aggressive Wall Street-sponsored non-banks have "pedal to the metal," as the increasingly cautious (impaired?) banks are forced to think more about risk control. From recent earnings releases, we see the subprime credit card lender Providian increased managed receivables 34% year on year, and at American Express, lending receivables surged 33%. And with mortgage refinancings running at the most rapid pace since last December, there is a particularly convenient mechanism for the GSEs to aggressively expand system "money" and credit - "reliquefy."
We'll begin with a bit of "compare and contrast." First, an excerpt from Challenges for monetary policymakers, a speech given last week (October 19, 2000) by Alan Greenspan:
"Whether we choose to acknowledge it or not, all policy rests, at least implicitly, on a forecast of a future that we can know only in probabilistic terms. Even monetary policy rules that use recent economic outcomes or money supply growth rates presuppose that the underlying historical structure from which the rules are derived will remain unchanged in the future. But such a forecast is as uncertain as any. This uncertainty is particularly acute for rules based on money growth. To be sure, inflation is at root a monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of goods and services. But as technology continues to revolutionize our financial system, the identification of particular claims as money, near money, or a store of future value has become exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to output is the fundamental source of inflation, what specifically constitutes money is a notion that has, so far, eluded our analysis. We cope with this uncertainty by ensuring that money growth, by any reasonable definition, does not reach outside the limits of perceived prudence. But we have difficulty defining those limits with precision, and within any such limits, there remains significant scope for discretion in setting policy.
Evidence began to accumulate in the early and mid-1990s that prospective rates of return on capital were rising. This was implicit both in the marked rise in investments in high-tech equipment and in the updrift in estimates of the growth of long-term earnings by corporate management, which were reflected in the projections of securities analysts. Nevertheless, we could not be certain whether what we were observing was a short burst of productivity gains or a more sustained pickup in productivity growth. The view that we were experiencing a sustained pickup gained plausibility when productivity growth continued to increase as the expansion lengthened. But importantly, only after we could see evidence in other economic behaviors and in readings from asset markets that were consistent with accelerating productivity did we begin to develop confidence in our analysis."
Now, a bit of "contrast." While traveling in Australia in September, Dr. Steve Keen (a good mate and very gifted and iconoclast economist and writer!) from the University of Western Sydney was kind enough to provide me a paper written by Dr. Perry Mehrling from Barnard College titled "The Vision of Hyman P. Minsky." It was published in the Journal of Economic Behavior & Organization Vol. 39 (1999). At the time, Dr. Keen stated, "I think you will like it." Well, I loved it. It is an outstanding piece of research as Dr. Mehrling splendidly illuminates key aspects of the brilliant thinking of Hyman Minsky; a vision of the world of finance that could not be more pertinent to the present environment. It could also not be further from the thinking of our present central bankers and most of the economic community. Particularly now that we have entered a period of acute financial instability both domestically and internationally, it is most opportune to delve further into Minskian analysis.
Peter Mehrling's paper describes how Minsky was an "institutionalist" and, critically, how the economy was "monetary in character." The key is to focus on individual economic units - companies, individual households, financial institutions, governments and countries - and concentrate on monetary flows between the various units. Using a Minsky perspective, one would certainly ignore the current "New Era" fixation on new technologies, productivity and GDP growth, in favor of a rigorous analysis of money flows, credit creation and, particularly, the status of various debt structures. Importantly, money is the "most real thing" - "the veil of money is the very fabric of the modern economy." And as Dr. Mehrling points out, money is nothing more than a form of debt - someone else's liability. Indeed, the stability of the entire system hinges on the soundness of individual liabilities and the overall debt structure. This is a fragile arrangement, as it is subject to self-reinforcing - boom & bust - debt and institutional dynamics. "There is nothing underneath, as it were, holding it up." As we have discussed in previous commentaries, Minsky saw recurring cycles fostering a drift from "sound" to "Ponzi" finance, and inevitable collapse. Since Dr. Mehrling does such a wonderful job expounding Minsky thinking, better to let him do it in his own words. I've excerpted four paragraphs from his exceptional 23-page paper.
"In these (capitalist) economies, so (Minsky) seems to have thought, financial processes take on a life of their own, so that their logic effectively becomes the logic of finance. In Minsky's own early words: "Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist economy center around the impact of finance upon system behavior" (Minsky, 1967). This is the core insight that underlies all of Minsky's work, and distinguishes his work from that of other economists. According to Minsky, we need to understand finance not because it is an important part of our modern economy, but because it is the very heart and motive force of that economy." 139
"Generally speaking, the tendency is to move from robust finance to fragile finance - this is the Financial Instability Hypothesis - and this is so because in a world of uncertainly, especially endogenous uncertainty, expectations about the future have little objective foundation so that mistakes are inevitable. To be sure, economic units have their own understanding of how the economy works - they have a 'model of a model' as Minsky liked to say - that they use to form expectations about future cash flows. The important point is that any attempt to forecast which of the myriad possible futures will actually be realized come down to an attempt to forecast the forecast of one's fellow economic units. Concretely, the cash commitments of each unit depend on the cash commitments of every other unit. The whole web of interlocking commitments is like a bridge we spin collectively out into the unknown future toward shores not yet visible. Mere ideas about the future become realities as they become embedded in financial relations, but inevitable over time the reality embodied in the pattern of cash commitments diverges from the reality embodied in the pattern of cash flows. Inevitably our ideas about the future are wrong, even when we all agree, indeed especially when we all agree. Just so, widespread belief in the 1960's that economists had learned to tame economic fluctuation led units to the 'euphoric' view that future cash commitments were relatively unproblematic, and once this view became embedded in the structure of debt contracts, it became a constraint on future action. The bridge of commitments reaches far out into the future as units (understandably) mistake their common model of reality for reality itself. Robust finance gives way to fragile finance as 'margins of safety' are eroded and commitments leave less and less room for possible shortfalls of cash flow." 141 (305)
"In Minsky's vision, business cycle fluctuations of employment and income are mere surface manifestations of the deeper fluctuation in financial conditions along the scale from robust to fragile and back again. Like Schumpeter, Minsky understood fluctuation as the way in which the capitalist system grows, but for Minsky the underlying process was not absorption of technological change but rather the expansion and validation of financial commitments. What worried Minsky was the prospect that, left to its own devices, the financial system would operate to amplify rather than to absorb the naturally cyclical process of growth, as each commitment provides the support for others on the way up, and as default on some commitments undermines other commitments on the way down." (120)
"One might think that asset prices are the most obvious symptom (of financial conditions turning from one of balance to imbalance), but Minsky focused first on what he viewed as the more direct symptoms that appear in the mechanism of refinance. By definition, speculative financing arrangements require periodic refinance, at which point both borrowers and lenders get to take a second look at the balance between the borrower's future cash flows and future cash commitments in light of the changed financial conditions in the economy as a whole. Any evolution toward fragile finance is therefore bound to show up as increasing difficulty rolling over debts as they mature, difficulty that may manifest itself in various ways depending on the institutional framework, but which ultimately shows up as increased demand for bank lending because banks are the lenders of last resort to non-financial economic units. Significantly, banks are themselves speculative financing units that face their own problems of refinance both because of their extreme leverage and because of the short-term character of their liabilities. Thus, the ability of banks to help other units refinance depends on their ability to refinance their own positions. Problems of refinance generally are thus bound to show up as problems of bank refinance particularly. It follows that one way to track the state of financial conditions is to keep a close eye on the operation of the mechanism through which banks refinance their activities." (238)
Talk about "hitting the nail on the head!" "Any evolution toward fragile finance is therefore bound to show up as increasing difficulty rolling over debts as they mature…" We find this final paragraph fascinating, and believe it is critically pertinent to the increasingly hostile current environment. We have written extensively on the explosion in money market assets (short-term corporate debt obligations), with particular focus on asset-backed commercial paper and other sophisticated vehicles that have been used to finance this historic credit bubble. We've highlighted how the major money center banks have created hundreds of billions of "leveraged loans" (much of this very weak credits to finance the historic "telecommunications arms race") that were then syndicated throughout the system. We have also discussed how, through "structured finance," Wall Street had created an amazing alchemy for turning risky assets into "money." And, of course, we have discussed the vital role played by derivatives throughout this the entire crazy process to disguise risk, while in reality systemic risk grew exponentially.
The bottom line remains that enormous quantities of poor credit were created in an episode of "Ponzi Finance" that not even the great Hy Minsky could have envisioned. But to keep this scheme running requires unwavering confidence and a continuous feeding of speculative credit excess. Today, however, confidence is waning, investors are fleeing risky assets and financial market liquidity is faltering. Importantly, it appears that risky credits are increasingly losing access to the commercial paper market, with some borrowers apparently struggling to roll short-term debts. This is a big problem - the inkling of a severe liquidity crisis. First, this is bad news for bankers that have provided back-up lines of credit. Not surprisingly, it appears that nervous bankers are now scrambling to reassess their bank lines. This, then, comes as quite disturbing news for risk-averse commercial paper investors and money market fund managers, as they now scramble to assess which of their borrowers may lose their bank lines. So it becomes a dangerous game of "hot potato" - or who gets burned holding the bad paper. This is a much different game than it's been in awhile.
We continue to believe that the commercial paper market - a key source of monetary excess during this cycle - is a likely "hot spot" susceptible to serious trouble. As of last week, there was a total outstanding commercial paper of almost $1.6 trillion, having increased $190 billion (16% annualized rate) so far this year. By category, the financial sector has issued $1.25 trillion of commercial paper, with $122 billion (13% rate) new issuance so far this year. Non-financial commercial paper has expanded at a rate of 30% so far this year to $347 billion. There is $595 billion of Asset-backed Commercial Paper in the marketplace, up from $521 billion at the beginning of the year (17% growth rate) and $382 billion at the end of 1998. "Tier 2," or below-prime rated commercial paper, has expanded at an almost 70% rate so far this year to $130 billion. We would not be surprised if this extraordinary expansion was related to faltering liquidity in the junk bond market. This is an alarming amount of short-term borrowings for less than stellar credits, borrowers we would see as increasingly vulnerable in this environment. We see this as a weak link for the financial system.
Xerox, of course, has experienced trouble rolling its commercial paper. And, according to Bloomberg, Armstrong Holdings "failed to renew its $450 million one-year credit line as mounting asbestos-related claims led some banks to refuse to lend to the maker of vinyl flooring." Apparently some lenders backed away from Armstrong after Owens Corning filed for bankruptcy due to asbestos liabilities. There are 47 banks on the hook for $1.8 billion lent to Owens Corning. Quoting Bloomberg, "banks are also concerned that Armstrong might draw on a new backup credit line should the company be unable to tap the commercial paper market…Armstrong has used $350 million of its $900 million commercial paper." Yesterday, Moody's cut Armstrong Holdings commercial paper rating. The stock has lost about 75% of its value this month, falling to $ 3. At June 30th, Armstrong Holdings had total liabilities of $3.4 billion with shareholder equity of $694 million.
And with banks on the hook for loans, derivatives, bank lines, security holdings, and such, it is of little surprise that investors are increasingly nervous holding bank debt. This week, lower-rated bank and finance sector debt spreads widened as much as 14 basis points, while spreads for mortgage-backs and agency securities narrowed. No relief, however, for the beleaguered corporate debt market as spreads widened across the board between 2 and 8 basis points. It doesn't help that the list of problem corporate credits grows by the week.
Kudos to Dow Jones' Joe Niedzielski for his article "Chase Transfers $920M of Credit Risk With LANCE Deal." "Chase Manhattan Bank has become the latest global banking group to shed a portion of credit risk from its huge loan portfolio with the completion of a $920 million operation know as a synthetic securitization of commercial and industrial loans. These deals, a product of Wall Street financial engineering, have become increasingly popular in the past 12 months…In its latest deal, announced Monday, the credit risk on a $920 million portfolio of commercial and industrial loans was transferred to a special purpose vehicle, or trust, known as Leveraged Asset Notes for Credit Exposure, or LANCE 00-1…The transaction if further supported by the issuance of $46 million of credit-linked notes that were sold to investors. The notes were rated triple-B-minus by Fitch."
Basically, such a structure allows Chase to transfer credit risk from a pool of credits to "investors" willing to purchase lower-rated but higher-yielding securities. In many of these types of sophisticated structures, securities are largely immune from credit losses until "settlement" at the end of a designated term, such as three or five years. Such structures conveniently create securities that are both difficult to value and traded minimally. We worry that such securities are susceptible to abuse and hold potential to be destabilizing for the system down the road, like so many other securities and structures that have been created during this protracted credit-induced boom. Coincidently, just a few minutes after Mr. Niedzielski's article was posted, Bloomberg ran an article "Pension Changes for ABS, CMBS, Coming Soon, Morgan Stanley Says."
"Changes to the rules limiting pension fund investments in commercial mortgage bonds and asset-backed securities may come at the end this month or early next month, according to Morgan Stanley Dean Witter & Co. The changes were proposed to ERISA, or the Employee Retirement Income Security Act, and were entered into the Federal Registry for a 45-day comment period, which ended last week…
Once the Labor Department publishes the rule changes, they become effective, Morgan Stanley wrote. The changes in the their original form would allow pension plans to buy bonds rated as low as "BBB-'" backed by pools of residential and commercial mortgages and auto, manufactured-housing and home-equity loans, a market estimated at $100 billion. Pension funds are currently limited to investing in AAA-rated mortgage and asset-backed securities."
Interestingly, only a few minutes later another headline pops up on my Bloomberg screen: "Labor Department Expects Little Delay in Pension-Plan Changes."
The Labor Department expects to publish and enact proposed changes that would allow private pension plans to buy lower-rated asset-backed debt either next week or the week after, a Labor Department official said. The changes were proposed to ERISA, or the Employee Retirement Income Security Act, and were entered into the Federal Registry for a 45-day comment period, which ended last week. The Labor Department received three comments, none of which were ``earth-shattering'' or likely to give rise to any changes in the original proposal, said Ivan Strasfeld, director of exemptions at the Department of Labor.
The proposal will allow purchases of bonds rated as low as ``BBB-'' backed by mortgage, auto, manufactured housing and home-equity loans, of which there are about $100 billion outstanding. They were originally seen as too risky, though investors now say lower-rated asset-backed securities have proven to be at least as safe as the stocks and junk bonds pension plans can buy.
All I can say, is "I don't like the smell of this." First, there is Chase Manhattan (and certainly the other aggressive lenders/securities firms/derivative players) working diligently to create sophisticated structures and securities that transfer the risk of their ill-advised lending onto the marketplace (let's not forget the Orange County bankruptcy fiasco caused directly by positions in GSE structured notes sold to a county official with insufficient skills to appreciate the great risk!!!). At the same time, the Labor Department is quietly working to change the rules allowing pension money to purchase risky securities. Again, this just doesn't look right, and this will be an absolute outrage if institutions now try to offload credit risk onto the unsuspecting. While it is quite likely too late in the game to protect the American taxpayer from risky lending by the GSEs, can we at least keep ERISA pensions free from high-risk securities?
Going forward, it is certainly our expectation that the government-sponsored enterprises will take extraordinary measures to perpetuate the current bubble. We also expect, in an environment fraught with increasingly tumultuous financial markets, that Wall Street will "circle the wagons" and work diligently to support the GSEs, their "liquidity backdrop." Today, the stock of Fannie Mae traded to a record high and Freddie Mac is not far behind. The message is loud and clear, "Fannie and Freddie, get out and buy securities, lend aggressively, and expand your assets!" We read with curiosity the sanguine comments from one major Street firm: "We favor Strong Buy-rated Fannie Mae and Freddie Mac as the best defensive stocks in our sector in the face of a slowing economy. Not only are their mortgage portfolios insulated from credit risk by layers of private mortgage insurance. But also widening spreads, which might accompany uncertainly over the economy, would allow them to accelerate portfolio growth."
This week, Bloomberg ran an article "Fannie Mae Sitting Pretty Atop Mortgage Mountain - for Now," where it quoted Franklin Raines, "our strategy is to take both credit and interest-rate risk on more of the loans we touch, given our superior risk management experience and expertise." Also quoted, a senior analyst at Moody's stating that Fannie Mae "is a well run, low-risk" company. "They're a world-class financial institution."
Fannie is definitely not alone in endeavoring to aggressively expand risk-taking. Yesterday, Freddie Mac announced three new products further promoting "flexible mortgage funding," including "the new Freddie Mac 100 Mortgage is a 100 percent loan to value mortgage that is consistent with the company's vision that high LTV mortgages can be originated successfully while maintaining high credit standards. This product gives borrowers with excellent credit histories the ability to purchase homes they can afford sooner without making downpayments. This is an attractive option for borrowers who want to maintain their investments without depleting them to purchase a home." "Another new Freddie Mac product is the Alternative Stated Income Mortgage that makes it easier for self-employed borrowers to get a loan with no documentation of their income amount. The Alternative State Income Mortgage is for self-employed borrowers with high credit quality and large down payments. These reduced documentation loans only require the borrower to provide the amount and source of income on the loan application. Pay stubs, tax returns and other written verification are not required." These are most unwise moves by Freddie Mac, particularly at this stage of the credit cycle. But then again, to continue to aggressively grow assets these institutions, as we are witnessing, must further lower lending standards. This is specifically how lenders destroy themselves.
There was an encouraging announcement today out of Washington: "Armando Falcon, Jr., Director of the Office of Federal Housing Enterprise Oversight (OFHEO), financial safety and soundness regulator of Fannie Mae and Freddie Mac (the Enterprises), sent a notice to the Federal Register soliciting public comments for an OFHEO study on the systemic risk that will examine the risks that Fannie Mae and Freddie Mac pose to the financial system and U.S. housing finance markets, in particular…Send written comments to Robert S. Seiler, Jr. Manager of Policy Analysis, Office of Federal Housing Enterprise Oversight, 1700 G. Street, N.W. Fourth Floor, Washington D.C. 20552. Written comments may also be sent by electronic mail to email@example.com." From today's release, "financial firms that have large amounts of liabilities or other financial obligations pose risks to other financial market participants. Default by a large financial firm affects their counterparties directly (by imposing losses on them) and may effect other financial firms indirectly (by lending markets to increase their financing cost, reduced their access to credit, or lower the market values of their assets)…The pace at which the enterprises are growing and their increasingly central role in the mortgage and financial markets raise the issue of whether, if either enterprise experienced severe financial distress or failed, the functioning of the financial system in general, or of U.S. housing finance markets in particular, could be disrupted to such an extent that the U.S. or international economies would be adversely affected. Financial difficulties at Fannie Mae or Freddie Mac could be caused by disruptions at other financial firms."
In conclusion, well, it was certainly another tumultuous week. The unfolding financial crisis lurched forward once again, this time encompassing emerging debt markets and risk assets generally. This was another critical development. In particular, the Argentine bond market was hit with acute illiquidity, while emerging bond market spreads widened sharply across the board. Concurrently, global currency markets are in almost complete disarray. This is, unfortunately, exactly what one would expect from a very fragile global financial system with weak underpinnings and, at the same time, dominated by enormous leverage and speculative positions. There is, however, no doubt that this crisis has reached the point where extreme measures likely have and will continue to be taken to maintain market liquidity and stem unfolding financial dislocation. Yet, such measures in themselves create fuel that only exacerbates the very volatile and acutely unstable financial environment. We see no reason to expect any diminution from extreme volatility and financial instability. Importantly, the "Ponzi Finance" credit structure that has for years been (over) financing the great global technology bubble is coming undone, with profound ramifications for the entire system. Here are some Amazon links to explore more of the work of Perry Mehrling Debt, Crisis, and Recovery : The 1930s and the 1990s (Columbia University Seminar) The Money Interest and the Public Interest : American Monetary Thought, 1920-1970 (Harvard Economic Studies, 162) Dr. Keen and Dr. Mehrling were also contributors for the forthcoming Financial Keynesianism and Market Instability : The Economic Legacy of Hyman Minsky, Volume I by R. Bellofiore(Editor), Piero Ferri(Editor). Hardcover (February 2001)