Chapter 16. Credit
“Directors noted that the rapid growth in recent years of credit derivative and structured credit markets had facilitated the dispersion of credit risk by banks to a broader, more diverse group of investors, making the financial system more resilient and stable. However, directors observed that these markets had grown rapidly in a relatively benign environment and had not been fully tested.”
IMF Global Financial Stability Report, 2006
The credit market boom of the mid-2000s, especially in sub-prime mortgages, sparked a scandal of historic proportions. Derivatives enabled investors to spread credit risk and gave the impression that the risk of default throughout the economy had reduced. In fact, they made funding artificially cheap for speculative investments worldwide.
In September 2005, the New York Federal Reserve summoned 14 international bankers to its headquarters for their first meeting since the LTCM crisis seven years earlier. This time, conditions were calm, but the Fed saw risks on the horizon. The bankers were the leading dealers of new instruments known as credit default swaps and the message to them was blunt: “Clean up your act or we will do it for you.”
The Fed’s alarm, we now know, was prescient. It wanted to take action because credit derivatives had grown faster than the banks could process them. Even the paperwork was a mess. More than any other innovation, they fostered the belief that investors now knew how to tame risk. But as with any new technology, they carried risks of their own.1 Further, they stripped banks of their most important role, assessing the risk of default, and turned it over to the markets. Sure enough, soon after the Fed’s meeting the synchronized bubble entered its most destructive stage, fueled in large part by credit.
In concept, credit default swaps are simple. Take this example. A bank has a relationship with General Motors, which wants an extra $1 billion loan. The bank wants to maintain its relationship, but feels uncomfortable about being so exposed to one company. A rival bank has had a similar request from Ford, and has the same dilemma.
The solution is for the banks to “swap” half of their exposure so that each is on the hook for loans of $500 million to each company. Now if one of the car companies gets into trouble, the banks will bear the exposure to it equally. Both maintain their relationships but have a more prudent spread of risks. The car companies benefit because the banks are stronger and more able to offer financing in the future.
Such a transaction is simpler to describe than to execute, as the legal structures are very complicated. But once lawyers and financiers hit on a workable template, the idea took off and swiftly developed. Rather than swapping exposure to two different lenders, investors could swap corporate exposure for exposure to the U.S. government, which was deemed almost riskless. In such a transaction, the holder of the loan buys their way out of that risk, while a large bank or insurer assumes it. In effect, it is an easily obtained form of insurance.
The price of the transaction thus shows the risk that the loan will default. If $1 of General Motors risk is swapped for 95 cents of Treasury bond risk for a period of five years, then that puts the risk of a GM default within the next five years at 5 percent. As the deals were standardized, they were collated, and dealers could track default risk on their screens minute by minute.
As in any market, default risk prices grew prone to overshooting in either direction. While greed was in the ascendant, it was very easy to insure against default—and cheap insurance encouraged investors to buy too much debt. If fear took the upper hand, the supply of debt could dry up suddenly.
Default risks could be swapped more than once. As big banks busily swapped the same risks time and again, they created mind-boggling figures. In 2001, the first year anyone tried to measure the burgeoning phenomenon, the total amount of debt that had been “swapped” came to about $650 billion, according to the International Swaps and Derivatives Association. In the second half of 2007, it peaked at $62 trillion—greater than the gross domestic product of the world at the time.2
As with the booms in BRICs and commodities, the innovation came when it was possible to buy cheap. Low interest rates in the United States—imposed in the wake of the dot-com bust—made credit transactions possible that would not have made sense at higher rates.
And rates stayed low. Greenspan and the Federal Reserve raised rates repeatedly, with their target rate reaching 5.25 percent in the summer of 2006. But the Fed can only directly move short-term rates. The more important rate for the credit markets that financed longer-term transactions was the yield paid on ten-year treasury bonds. This set their implicit “risk-free” rate. If treasury yields went up, then the yields on riskier credit would have to rise too, even if the risk of default was unchanged.
But bond yields refused to rise, enabling the credit boom to carry on for years. Alan Greenspan called this a “conundrum.” The most likely answer lies in the demand for bonds. China, with other Asian countries, was building foreign reserves, buying dollars and parking them in U.S. treasury bonds. In 2000, China had $157 billion in foreign reserves; by 2009 it had more than $2 trillion—a huge weight of money pushing treasury yields down.
With baseline interest rates low, the ability to isolate and trade default risk lent itself to new transactions. Without lending to a company, bankers could create a “synthetic” investment that mimicked such a loan, its value rising and falling with the risk of default. This levered the system all the more. If a company defaulted, the total cost to investors might be higher than the amount of debt that had defaulted, because many had deliberately chosen to take on a risk that mimicked that default.
By the middle of the decade, when the Fed called in the bankers, greed was ascendant. Market prices implied not only that risks had been shared, but also that default risk across the entire economy had been reduced. A mathematical way to do this is to look at the yields paid on corporate bonds compared to treasury bonds and then work out what level of defaults would be needed to bring the total amount they pay to investors down to the same level.
Jim Reid, an analyst at Deutsche Bank in London, calculated that by 2007, “single-B” junk bonds were so expensive that they could only make money compared to Treasuries if they went on to have a lower default over the following five years than had been seen at any time over the previous three decades. As many at that time feared a recession, which would raise defaults, these prices made no sense.
Further, the technology for corporate credit was soon also applied to mortgages. By providing cheap insurance, it made it possible to invest in mortgages for subprime borrowers with poor credit histories. Such people are bad credit risks by definition, but diversification could help. Lend to enough subprime borrowers and a lot will repay—and if you can insure easily through the market, the lowered risk might be worth taking. Then factor in the housing market—even if the borrower defaults, lenders get to repossess the house, and house prices were rising. Then came another layer of alchemy: bundling many different mortgages into packages known as collateralized debt obligations (CDOs) and then slicing each bundle into so-called “tranches.” For example, investors might buy a tranche representing 10 percent of the mortgage pool, which would bear the first losses. So if the default rate for the entire pool were as high as 10 percent, this tranche would be wiped out. These tranches offer risky investments.
But a tranche representing the last 50 percent of the mortgage pool to default looked very safe. Providing only that the default rate for the whole pool did not exceed 50 percent, a huge number even for subprime mortgages, its investors would be repaid in full. Such “super-senior” debt could get triple-A ratings, allowing banks to hold on to it under their newly permissive regulations at no cost. They could sell the riskier tranches, hold on to the safer ones, and use the money they had generated to go out and buy more loans. As with junk bonds and emerging markets before them, there was “safety in numbers.”
And investors believed that they were truly safe. Market prices allowed a clear measure of default risk, which could be measured with the ABX index, introduced by Markit, where 100 implied a zero default rate, and 0 implied a total default. In early 2007, on the eve of financial catastrophe, the ABX index of subprime mortgages stood above 95, implying that less than 5 percent of subprime mortgages would default.
With hindsight, this episode can already be seen as one of the greatest scandals in U.S. history. Many lenders and borrowers behaved disgracefully, and regulators should never have allowed them to do so. But it was financial innovation that enabled them. The agents who made loans had been separated from the principals who bore the risk of those loans, and banks’ decline gave them an incentive to behave badly. The sum effect was to give debtors—whether smaller companies or subprime homeowners—credit at prices far cheaper than ever before.
That cheap credit fed into other markets and inflated them. House prices shot up in the United States and in countries like the UK and Spain. While house prices—lenders’ collateral—were rising, subprime lending seemed easy to justify, so more lending led to still higher prices. The cheap credit also drove the stock market.
Companies can finance themselves by either debt or equity. Usually equity, in which their investors are entitled to a share of earnings, is cheaper for them. In other words, usually earnings as a proportion of the price of the shares they issue are lower than interest payments as a proportion of the debt they issue.
But now, debt was cheaper for companies than equity, so corporate managers could boost their market value by borrowing money to buy up their own shares. This reduced the supply of shares in circulation and thus pushed up the value of each remaining share for shareholders. By the spring of 2007, U.S. companies were spending $3 billion each day doing this, according to the research group TrimTabs. Activist investors poured their energy into forcing companies to take on more debt or to pay out big dividends.
Money also poured into private equity funds, the new name for what in Michael Milken’s era had been called corporate raiders. Nine of the ten biggest leveraged buy-outs in U.S. history happened in 2006. In Europe, where stocks had traditionally traded at lower multiples to earnings, equity finance was more expensive for companies, and this financial engineering made even more sense.
Thus credit and stock markets grew interlinked. Stock market growth rested on cheap credit, not any underlying growth, and Western companies were under pressure to borrow rather than to invest in growth opportunities. Again, it was unclear which markets were driving up which others—they had become a mutually reinforcing cycle.
It is easy to see, therefore, why the Fed tried to scare the big banks behind all this activity. Fatefully, however, the bankers got their act together just enough to satisfy their supervisors. “These institutions have taken this thing seriously, as have their regulators,” said Gerald Corrigan, the former New York Fed governor charged with breathing down the banks’ necks, in late 2006. “So far so good in terms of damage control.”3 But Corrigan carefully did not declare victory, which was just as well. A few months later, the extent of the interconnections between markets, and of the overconfidence they had fueled, would be made brutally obvious. The correlated and fearful rise of markets was ready to turn into a synchronized sell-off.
In Summary
• Credit default swaps started as a risk-management tool but enabled the systemic underpricing of credit. This made financing cheaper and pushed up prices of assets across the world.
• Critically, credit derivatives enabled funds to flow toward subprime mortgage borrowers. This blew up the synchronized bubble to unsustainable proportions.