Laboring in Obscurity Print E-mail
 
Laboring in Obscurity
It’s not uncommon for human beings, no matter our station in life to wonder if anybody notices our contributions. We work hard and produce our best work but question our ability to make a difference. It’s like the old riddle, “if a tree falls in the forest and there is no one there to hear it does it still make a sound?” Some of you may be familiar with the wise guy version, “if a man speaks in the forest and there is no woman present to hear him is he still wrong?” That high risk stab at humor may not make the final cut as my editor-in-chief also enjoys the title of spouse. Ah, the joy of living on the edge! In past commentaries we have written of the giants of economic theory. The names of Adam Smith, John Maynard Keynes, Joseph Schumpeter, Milton Friedman and even Karl Marx have received mention for their contributions to the development of economic thought. Today we will introduce another name, Hyman Minsky, whose Financial Instability Hypothesis could be very helpful in getting our arms around present economic and market conditions. Minsky was an American economist receiving a bachelors degree from the University of Chicago, a masters degree in public administration and a doctorate in economics from Harvard where he studied under Joseph Schumpeter. Minsky’s contemporaries labeled him a radical Keynesian for his ideas regarding the role of the Federal Reserve and other regulators in identifying and abating financial crisis. Despite being considered a thinking man’s economist, Minsky had many followers on Wall Street. You have likely not heard of Minsky unless you have a truly stifled social life or are a student of the economics game. His radical, outside the box thinking landed him at Washington University in St. Louis where he enlightened students in relative anonymity. Minsky’s Financial Instability Theory stems from the apparent contradiction that prolonged periods of financial stability lead eventually to financial instability and particularly to asset bubbles and increasingly speculative credit structures. For Minsky the speculative debt structures and bursting asset bubbles culminate in a credit crunch with lenders protecting their assets by freezing credit, even to worthy borrowers.
Stability Breeds Instability
  Minsky combined an astute reading of human nature gleaned from Keynes’ idea of “animal spirits” (greed), the idea of the herd mentality (lazy, dumb) and our propensity to speculate. Humans are subject to several flaws when it comes to investing. We are not prone to buy low and sell high. Instead we gravitate to assets that are rising in value and jump on the band wagon. We also look at current trends, especially bullish trends, and
extrapolate them into the future, as the star of Toy Story, Buzz Light-year would say,” to infinity and beyond!”
So how does stability breed instability and why is that idea important today? When we consider the flaws shared by most investors and then introduce the concepts of leverage and financial innovation we can see how brilliant and prescient Hyman Minsky was. The moment investors perceive smooth sailing for the foreseeable future they scheme ways to magnify their gains and income. Leverage is the first method that comes to mind for many. Minsky broke debt structures into three distinct types he called units. First he described  the hedge unit that involves an amortizing loan culminating with a fully paid balance at the end of a term. A traditional 15 or 30 year mortgage would be an example. Next Minsky described the speculative unit where the borrower engages in a loan agreement where he makes debt service payments but is not amortizing the principal. An interest only loan with a balloon payment at the end of the term is an example of speculative financing.  This borrower is speculating on a number of levels. He is betting that the value of his asset is appreciating or at least not declining. He is speculating that he can secure agreeable terms for a new loan with similar debt service costs and down payment. This borrower is secure in the belief that market conditions will continue to be favorable over the term of the loan. Minsky referred to the third and riskiest debt structure as a ponzi unit where the speculator does not have sufficient cash flow to cover even the debt service costs and does not amortize any principal. This speculator secures a loan at a reduced or even below market interest rate. The difference between reduced debt service charges and market rates is simply added on to principal due at the end of the term. An example would be a negative amortizing mortgage where the principal sum due increases over time and the final balloon payment is larger than the original loan amount.
How Does Minsky Play Today?
The Financial Instability Hypothesis posits that the longer markets and expectations remain stable the more speculative investors and lenders become. Further, the investors and lenders progress from the hedge to the speculative to the ponzi unit as market stability persists. It would be easy to assume that Minsky might have formulated his theory after observing the ballooning bubble in the housing market and the evolution of creative lending practices that produced the subprime mortgage mess of recent years. The truth of it is that Minsky passed away in 1996 at the age of 77. What a shame that we cannot hear his analysis of the current situation. Not only has Minsky proven on the mark about asset and credit bubbles but the subsequent credit crunch as well. In examining the Minsky progression from the mundane to the exotic one can certainly understand the motives of the speculator who sees green grass and blue skies forever. As investors jump on the wagon in increasing numbers the law of supply and demand naturally pushes prices higher. The rising prices attract more buyers and the price spiral takes on a life of its own. The affects on the housing market have been plain to see. But what about the lender who accompanied investors on the journey from hedge to ponzi unit? It is clear that one of two things must have occurred. Either the lender must have crossed over the table from the side of dispassionate and prudent lender to join interests with the speculator or the lender must have found a way to absolve his institution of the financial risk associated with default. As we have written in the past both suppositions are correct. Many lenders saw rising prices in residential real estate as a sure bet and figured defaults would remain low. If a homeowner did default the lender would receive an appreciated asset and an eventual profit. Securitization allowed many lenders to sell off their mortgage debt and keep the healthy servicing fees and repeat the process. It is the process of securitization that takes Minsky’s ideas to a frightening new level. 
Ponzi Units on Steroids
Let’s transition from the housing market to the securities market. In sports steroids pump up performance. In the investment world it’s leverage. The derivatives markets introduced an insane degree of leverage to an insanely overheated asset class- housing. The danger of default inherent in the speculative and ponzi unit financing became magnified many times over by 10, 15 and 20 to 1 leverage. What resulted was an asset class fraught with risk magnified by leverage obscured by faulty financial models and conflicted ratings companies. A Minsky Moment was fast approaching.
The Complacent Herd
When stability reigns supreme investors presume increasing powers of prediction. They become confident of future outcomes. As is human nature they up the ante, borrowing more and more to enhance returns on a sure thing. Minsky’s theory would hold true beyond the housing market and move into the derivatives market. The same law of supply and demand that drove home prices higher would work its magic on the derivatives market. Prices soared on everything from mortgage backed securities to junk bonds. Yield spreads narrowed to resemble those of Treasury securities erasing the reward investors receive for taking risk. With diminishing returns on traditional securities the financial wizards of Wall Street went to work. With proper marketing and packaging and a little help from the ratings companies high risk loans became low risk securities. The herd loved these new fangled high yield low risk investments. The demand was so great that Wall Street could barely keep up. The cry went out for more mortgages, the raw material for these magical new investments. Wall Street, enamored with the remarkable stream of new revenue became blind to the risk. Wall Street funded mortgage loans to keep the pipeline full and churned out billions in Collateralized Debt Obligations. Some firms like Merrill Lynch even bought a mortgage broker to assure a steady flow of raw materials. Like the old Willie Nelson song, “Blue skies smiling at me. Nothing but blue skies do I see”. Investors enjoyed the ride.
A Piece of the Pie
In the modern economy there is little distinction between bank, broker, insurance company and hedge fund. All participated in the fee bonanza created by the booming real estate market and the offshoot derivatives market. As Merrill knew, to keep the good times rolling funding for mortgages and levered investments was the key to big profits. Big banks wanted in on the mortgage craze. Securitizing loans freed capital for revolving loans and secured high fees but there had to be more. There was one hurdle that had to be jumped. For every mortgage a bank retains on its books it must make a capital reserve against possible loss. What Merrill understood and the banks were quick to learn was that nothing boosts returns so assuredly as cutting costs. Cutting out the middle man maxed fee retention for Mother Merrill. The banks had a different idea. They found a way to invest in the mortgage boom without having to make
Ponzi Units on Steroids
Let’s transition from the housing market to the securities market. In sports steroids pump up performance. In the investment world it’s leverage. The derivatives markets introduced an insane degree of leverage to an insanely overheated asset class- housing. The danger of default inherent in the speculative and ponzi unit financing became magnified many times over by 10, 15 and 20 to 1 leverage. What resulted was an asset class fraught with risk magnified by leverage obscured by faulty financial models and conflicted ratings companies. A Minsky Moment was fast approaching.
The Complacent Herd
When stability reigns supreme investors presume increasing powers of prediction. They become confident of future outcomes. As is human nature they up the ante, borrowing more and more to enhance returns on a sure thing. Minsky’s theory would hold true beyond the housing market and move into the derivatives market. The same law of supply and demand that drove home prices higher would work its magic on the derivatives market. Prices soared on everything from mortgage backed securities to junk bonds. Yield spreads narrowed to resemble those of Treasury securities erasing the reward investors receive for taking risk. With diminishing returns on traditional securities the financial wizards of Wall Street went to work. With proper marketing and packaging and a little help from the ratings companies high risk loans became low risk securities. The herd loved these new fangled high yield low risk investments. The demand was so great that Wall Street could barely keep up. The cry went out for more mortgages, the raw material for these magical new investments. Wall Street, enamored with the remarkable stream of new revenue became blind to the risk. Wall Street funded mortgage loans to keep the pipeline full and churned out billions in Collateralized Debt Obligations. Some firms like Merrill Lynch even bought a mortgage broker to assure a steady flow of raw materials. Like the old Willie Nelson song, “Blue skies smiling at me. Nothing but blue skies do I see”. Investors enjoyed the ride.
A Piece of the Pie
In the modern economy there is little distinction between bank, broker, insurance company and hedge fund. All participated in the fee bonanza created by the booming real estate market and the offshoot derivatives market. As Merrill knew, to keep the good times rolling funding for mortgages and levered investments was the key to big profits. Big banks wanted in on the mortgage craze. Securitizing loans freed capital for revolving loans and secured high fees but there had to be more. There was one hurdle that had to be jumped. For every mortgage a bank retains on its books it must make a capital reserve against possible loss. What Merrill understood and the banks were quick to learn was that nothing boosts returns so assuredly as cutting costs. Cutting out the middle man maxed fee retention for Mother Merrill. The banks had a different idea. They found a way to invest in the mortgage boom without having to make
 the capital reserve or account for any market fluctuations on their balance sheets.  The linked goals of  funding the beast and cutting costs led to the explosion of off balance sheet entities called conduits or SIVs. With costs controlled the next step was to fund the investment in mortgage derivatives. Commercial paper was a tried and true fund raiser for corporate America. Money market funds were already big buyers of the short term low risk paper. With the blessing of the ratings companies Asset Backed Commercial Paper issuance exploded and secured the funding SIVs needed to get their piece of the mortgage pie. ABCP pumped up yields for hungry investors oblivious to the risk. Soon money market investors were snapping up yet another magical investment that paid above market rates.
Bear Stearns Leaking Like a SIV
 The first cloud on the horizon appeared early in 2007 when Europe’s largest bank HSBC took a multi-billion dollar hit on risky mortgages. The word subprime was introduced to the investment lexicon. In June more clouds appeared. Venerable fixed income house Bear Stearns closed two hedge funds that failed under the weight of leverage and subprime loans. The bandwagon was loaded and the happy herd failed to head the warnings flaring up around them. Losses began to mount at brokerage firms and banks. Mortgage brokers began to fail at an alarming rate. Mortgage default rates exceeded the most pessimistic forecasts and financial models became as irrelevant as credit ratings. Heads rolled. CEOs were canned at Merrill, UBS, Bear and Citigroup. Sophisticated investors found it hard to ignore the lightening strikes hitting so close to the wagon and began to bail. Bank losses pushed SIVs onto the front page. The housing market was crashing and the game unraveling. When the connection was finally made between ABCP and mortgage derivatives the smart money fled and the daisy chain of financing was severed. The funding source dried up and the banks found themselves in deep trouble. Without short term funding liquidations of derivatives was the next step. Market values were near collapse. New sources of funding had to be found or losses would be huge.
In Search of Blue Skies
When skies darken what better place to go than the Sunshine State. It was time to reload the wagon. The housing boom was over and financial distress was mounting in the money markets. Liquidity was drying up and borrowing costs were skyrocketing. All pyramid schemes rely on the “greater fool” theory. When you are sitting at the poker table and you don’t know who the sucker is, its you. Joe Mason, a former US Treasury official and finance professor at Drexel University put it this way when speaking of our friends on Wall Street,” when they couldn’t sell it (high risk securities) to more sophisticated investors they found less-sophisticated investors like local government investment pools”. Wall Street excels at putting lipstick on the pig and moving it from their sty to yours. The continuing saga of the Florida investment pool will be full of heavy losses, law suites and intrigue. To lesser degrees it is being replicated in Montana,
 Washington and Connecticut. Lehman Brothers will be a focal point of any investigation in the Florida pool meltdown. It sold nearly $20 billion in securities to the decimated pool. Bloomberg magazine reported in its February 2008 issue that Lehman CEO Richard Fuld received a $35 million dollar stock award for the firm’s record income in 2007.
The Minsky Moment Arrives
When cash flows can longer support the levered high risk debt structures and the last fool has been bilked lenders sober up and freeze credit. That is the Minsky moment. It arrived in 2007 when banks refused to lend, even to each other. SIV losses were forcing bad loans and investments back on to the bank balance sheets. Billion dollar losses are now common place. More are sure to come. Each loss requires a capital reserve and leaves less money to lend. Some estimate credit will be reduced by as much as $2-$4 trillion in the aftermath of the Minsky moment. The finance based global economy is in for a test. Credit is the life blood of the modern economy.
The Role of the Fed
The Federal Reserve has contributed in several ways to the increasing credit risk in the housing and derivatives markets. The Greenspan Put made risk taking more palatable. Knowing that a bailout in the form of cheap liquidity was sure to follow any serious market correction made risk takers more brazen. The Fed broadcast its intentions regarding future policy. Greenspan kept interest rates far too low for far too long in his ironic attempt to avoid asset deflation after the dot com bubble burst. Consumption continued because homeowners tapped into new found wealth in their spiraling home prices. Now that asset is deflating at an alarming rate. In 1994 the Fed was empowered to scrutinize lending practices to keep banks sound. Libertarian Greenspan turned away from the role of regulator insisting regulation is a poor substitute for free market discipline. Greenspan also felt that policy should not be used to curb asset bubbles as they inflated stating that the Fed could not spot a bubble before it popped. Again he deferred to the invisible hand of Adam Smith. In an interesting contradiction Mr. Greenspan had little trouble using monetary policy to support falling asset prices, particularly stocks. Now the Bernanke Fed will try to fill the void left by constricted credit and weakened banks with lower rates and increased money supply. President Bush, hardly a Keynesian is touting tax rebates to consumers and cuts for corporations to help the moment pass.
The Financial Fallout
The Minsky Moment will leave behind a credit contagion and collateral damage that has spread from housing into retail, banking and insurance. It may find its way into the municipal bond market. MBIA, the nation’s largest insurer of municipal bonds strayed into the world of mortgage derivatives insuring billions of dollars in mortgage tainted securities. At the time of this writing MBIA’s stock has lost 80% of its value since October. AMBAC is in the same boat. The lure of fees and perpetual blue skies pulled these firms from their knitting with disastrous results. MBIA has slashed it’s dividend in half and is seeking billions in capital to stave off a credit downgrade. 
As a guarantor of municipal debt failure to maintain AAA status could damage the company’s future, hurt bond prices and raise borrowing costs for muni bond issuers across the country. Spotting both weakness and opportunity Warren Buffet’s Berkshire Hathaway will soon enter the muni insurance market further pressuring existing insurers. A recession is an increasing probability in 2008. The Fed will cut its target rate and flood liquidity into the banking system. The yield curve will continue to steepen. Fiscal policy will stimulate consumption and investment. Somewhere Hyman Minsky is smiling down on this mess. If we extract the important lessons from 2007 the late professor will not have toiled in vane.