Policy-Maker Perspective: Lehman Brothers Changed Everything
Anna Schwartz, co-author with Milton Friedman of A Monetary History of the United States, once claimed that "no financial crisis has occurred in the United States since 1933, and none has occurred in the United Kingdom since 1866." What is often classified as a crisis is actually a pseudo-crisis, and intervention by a lender of last resort is not justified.¹ This warning by one of the 20th century's leading monetary authorities has shaped policy since the beginning of the most recent crisis.

Pseudo-crises result from a decline in the price of banks' assets. Banks become undercapitalized, which can distress the broader economy as they reduce lending in an effort to replenish their capital base. Nevertheless, a pseudo-crisis does not justify intervention by a lender of last resort. Recapitalization should occur privately; else moral hazard seeps into the system and sows the seeds of the next crisis. Policy-makers should maintain a long-term time horizon and focus as much on penalizing stakeholders and curbing excessive risk-taking behavior as they should on restoring order. Real crises, on the other hand, operate through the liability side of the financial system's balance sheet, and pose problems beyond undercapitalization. A real financial crisis, according to Dr. Schwartz, can lead to "an unanticipated and undesired collapse in the stock of money, and such an unanticipated squeeze will cause a recession, perhaps a depression." In this case, a lender of last resort should intervene and break the vicious cycle, preventing systemic strains from spiraling out of control. Moral hazard concerns become trivial until order is reestablished. It is appropriate in these circumstances for the government's time horizon to compress to match the marketplace's short-term horizon.

The current financial crisis began with falling real estate prices and deteriorating asset quality, the classic trigger of a pseudo-crisis. Accordingly, monetary authorities provided only marginal support and allowed recapitalization (deleveraging) to run its course. Penalizing stakeholders for their excessive risk-taking behavior was a priority as authorities kept an eye on longer-term concerns, including eliminating as much moral hazard from the system as possible.

 

After Lehman Brothers collapsed in mid September, however, liabilities became impossible to roll over, and the world witnessed the first ever run on the global banking system; a real crisis according to even Dr. Schwartz' strict definition. Indeed, economic growth has ground to a halt in G7 economies along with a collapse in credit extension. This state, where illiquidity drives insolvency in a downward spiraling feedback loop, is truly destructive to the foundations of the capitalist system. Financial authorities across the globe were, from that moment forward, liberated from the constraints of moral hazard concerns or lingering pricing pressures. Policy-makers' response has been overwhelming and all indications suggest that their efforts will be unrelenting until strains in money markets have been reduced to negligible levels.

Systematic Response to Systemic Strains
The traditional "relationship-based" banking sector has declined in importance while the "shadow" banking sector has risen to a dominant position in the overall financial system during the past three decades. Relationship-based banking involves personal interaction between the borrower and the bank. Banks obtain detailed information from the borrower that may not be publically available, continue to monitor the borrower's risks and enforce the terms of loans through maturity. This sector is funded by retail deposits, which have remained relatively stable under the government support and supervision that was put in place following the last real financial crisis generations ago. The shadow banking sector, on the other hand, which grew in response to increases in the securitization business, is funded through money markets. Money market instruments, including repurchase agreements (repos) and commercial paper, have operated with minimal government support and supervision. It is the breakdown in this funding market that has caused such distress and risk aversion, not only in the shadow banking sector but throughout the entire global financial system.²

Central bankers and fiscal authorities are now scrambling to systematically address the two components of strains in money markets, the life-blood of the shadow banking system. The two components of strains are funding risk and counterparty risk, which could also be characterized as liquidity strains and solvency strains.

Together, these two strains have driven a wedge between LIBOR rates and government T-bills (Exhibit 1a & 1b). This measure, called the TED spread, is a proxy for the total financial strains in the shadow banking sector that result from both higher funding risk and higher counterparty risk; in other words, both a desire for the superior liquidity of government T-bills and greater trust in government's creditworthiness.³ It wasn't long after this spread widened that other money-market instruments became strained, including nonrecourse commercial paper and asset-backed paper (Exhibit 2).

In normal times, both counterparty and funding risks are negligible. Banks generally have a high degree of confidence in their own ability to roll liabilities, and full trust in counterparties to repay such short-term loans. During the first phase of the financial crisis, which erupted in August 2007, funding risk and counterparty risk both increased. In the U.S., funding risk and counterparty risk had a more or less equivalent influence on overall financial strains (Exhibits 1a and 5a). In Europe, counterparty risk dominated while funding risk remained well contained (Exhibits 1b and 5b). This was consistent with the smaller shadow banking sector in Europe and the dominance there of relationship-based banking that is funded through the retail deposit market (Exhibit 3).⁴ For example, in 2004, securitization accounted for less than 5% of total mortgage lending in Germany and France. In contrast, 60% of total mortgage lending in the U.S. was through securitization.⁵ Relationship-based banking in Europe reduced the need for precautionary hoarding of cash since most funding continued to be satisfied by the more stable retail deposit market. Nevertheless, creditworthiness declined along with capital levels, and counterparty risk increased in Europe as well as in the U.S.

During the second phase of the financial crisis, which began with the failure of Lehman Brothers in mid September 2008, trust broke down completely, and both funding risk and counterparty risk soared across the globe. Investors scrambled to hoard as much cash as possible as a risk minimization measure, as a precaution against the inability to acquire funding. Lending also halted as a profit maximization measure. Counterparties could not be trusted as capital levels fell and everyone was a potential bankruptcy in waiting. This is the point when the crisis became real and policy-makers rushed to put an end to the vicious cycle.

No sooner did funding risk spike than it began to moderate (Exhibits 1 and 5). Early in the crisis, funding risk represented roughly 70% of total financial strains in both the U.S. and Europe. Today, funding risk is negligible in both markets for the first time in a year and a half.

Funding risk currently accounts for roughly 5% of overall financial strains in the U.S. The decline has resulted from the Fed's provision of liquidity through initiatives including the Term Auction Facility, Term Securities Lending Facility and Primary Dealer Credit Facility, as well the $29 billion loan extended to JPMorgan. Following the Lehman Brothers collapse, the Fed and Treasury announced the creation of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and established the Commercial Paper Funding Facility (CPFF) and the Money Market Investor Funding Facility. The FDIC also implemented its Temporary Liquidity Guarantee Program. Most importantly, the Fed began a quantitative easing program which has so far resulted in tripling the size of the Fed's balance sheet through ballooning bank reserves. Funding is now easily acquired by financial institutions. Funding strains have more recently eased for nonfinancial corporations as well thanks to the Fed's CPFF program (Exhibit 2 and 4).

As a component of overall financial strains, funding risk accounts for roughly 2% in Europe. The ECB has pumped hundreds of billions of euros into the banking system, including unlimited funds up to three- and six-month terms. Swap lines were established with the U.S. Federal Reserve to ensure an adequate supply of U.S. dollar funding within Europe. Individual member states expanded ECB guarantees through collateralized borrowing schemes, including €40 billion each by France and Italy, up to €200 billion by the Netherlands, and €400 billion by Germany. These initiatives essentially backstopped the funding needs of the respective countries' domestic banks. The Bank of England established three-month term auctions of £10 billion and the Special Liquidity Scheme, and recently began openly discussing its own plans for quantitative easing.

Authorities have successfully eliminated funding strains and the remaining strains in money markets are almost entirely driven by counterparty risk (Exhibits 1 and 5), which has begun to contract in the U.S. and Europe following measures that specifically address this type of strain. This reflects recapitalization efforts as well as fiscal stimulus, both of which lower the probability of default.

In the U.S., where counterparty risk currently accounts for roughly 95% of total strains, Congress passed the $700 billion TARP legislation, of which over $250 billion has already been deployed to replenish bank capital. The FDIC has shut down 27 insolvent institutions, including the giant Washington Mutual, and helped reallocate these institutions' assets and liabilities to safer hands. Most importantly, Fannie Mae and Freddie Mac were taken into conservatorship by the Treasury, ensuring ongoing lending for prime borrowers in the housing market. The most recent plan to channel up to $600 billion in funds to the mortgage market and set up what is essentially a $200 billion "government bank" to directly make loans to consumers should help to limit downside risks on asset prices (most importantly home prices) and to prop up creditworthiness. There is growing discussion that the next phase of TARP funds should be used to remove toxic, difficult-to-value assets from the banking system altogether.⁶ The uncertainty surrounding these assets has dissuaded private recapitalization efforts and been a major driver of counterparty risk. As TARP funds continue to be disbursed, and as revenues from ongoing operations are retained rather than paid out as dividends, leverage should continue to decline, and counterparty risks with it.

In Europe, where counterparty risk currently accounts for 97% of total strains, the government response has been scattered, but momentum is building behind robust countercyclical fiscal policy and outright bank recapitalization. Counterparty risk is falling as a result. The first wave of recapitalization took place in the U.K. where the Royal Bank of Scotland and HBOS/Lloyds were partly nationalized. A similar offer stands for Barclays should it fail to raise capital in the private sector. This followed earlier actions with Northern Rock and Bradford & Bingley. France announced it would allocate €14 billion for capital injections into the nation's six largest banks, with an additional €40 billion for smaller banks. Germany has pledged up to €80 billion for bank equity injections, and Chancellor Merkel recently threw her weight behind a new €200 billion European-wide fiscal stimulus package. Outside the Eurozone, Switzerland will finance the transfer of $60 billion worth of distressed assets from the balance sheet of UBS. With recapitalization efforts well under way and fiscal policy announcements coming in waves, counterparty risk is finally being directly addressed.

Conclusion
The market's reaction to the failure of Lehman Brothers highlights the overwhelming difficulties that policy-makers face in balancing both short- and long-term considerations. As Charles Kindleberger noted, "After a crash has occurred, it is important to wait long enough for the insolvent firms to fail, but not so long as to let the crisis spread to the solvent firms that need liquidity." The Fed and Treasury waited too long, and we cannot rule out further policy errors. We are concerned about the possibility of increasing trade barriers, the failure to remove reflationary monetary stimulus appropriately, and the over-encouragement of moral hazard. But any errors that may be forthcoming would have little impact on money-market funds directly. Governments have now underwritten the financial system and are focusing exclusively on short-term considerations. Long-term considerations have been put aside for the time being. With an exclusive focus on the short-term, the timing of policy intervention becomes less an art and more of a science. We expect strains to continue to diminish as risks are systematically addressed with progressively more precise tools. Funding risk is now negligible, and counterparty risk should continue to fall as recapitalization efforts proceed. In fact, in a sign of budding confidence, money has begun to flow back into prime funds. Since the end of October, prime fund balances have increased nearly 11%, or roughly $185 billion.⁷

Footnotes

1. "Real and Pseudo-Financial Crises", 1986, in Wood, editor, Financial Crises and World Banking Policy.
   
2. The IMF describes relationship-based banking as "transactions between two parties—such as a bank and a corporate borrower—primarily rely on information the lender has about the borrower that is not available publicly. Mechanisms for enforcement of contracts rely more heavily on the lender's direct influence on the borrower and/or the lender's monopolistic power in the market." They describe the shadow banking sector, which they label "arm's length-based transactions" as "highly dependent on publicly available information and on the enforcement of contracts through formal and standard legal mechanisms and procedures applicable to unrelated parties. There is a strong role for price signals and open competition among lenders."
   
3. In reality, the two components are interrelated. When assets are sold below their intrinsic value at "fire-sale prices" in an effort to meet liquidity obligations, solvency deteriorates. And as solvency deteriorates, risk aversion increases and the desire to hoard cash increases. This is the vicious cycle that kicked off in September when funding risk and counterparty risk spun out of control.
   
4. The reaction by depositors today is similar to the Japanese reaction in that country's financial crisis in the early 1990s. Funding risk never increased due to depositors' belief that the government would stand by to guarantee their deposits.
   
5. IMF, World Economic Outlook 2007, "How do Financial Systems Affect Economic Cycles", Chapter 4, page 8.
   
6. Ben S. Bernanke, 2009, "The Crisis and the Policy Response", speech delivered at the London School of Economics, January 13, 2009
   
7. ICI, Crane Data