The dominos are falling. It’s the modern version of a 1930’s bank run. Since everything is bigger (the leverage) and faster (the computers) these days, so is the downfall in financial prices and institutions.
The lead domino is an asset class becoming untenable. This time around it’s the subprime sovereigns of Europe, whereas three short years ago it was subprime mortgages. Then, as now, it was thought to be a small problem (if we count only Greece) of almost the same magnitude: $400 billion in subprime mortgages that was thought to be contained or walled off. From there you should get the general idea, as the subprime story should be fresh in your minds.
Since the most conservative and regulated institutions hold large proportions of sovereign bonds in their portfolios, the default of the bonds becomes their balance sheet insolvency. The next domino is the withdrawal of the funding from banks by those who lend to them on a short-term basis and suspect the banks’ solvency is compromised.
Since demand deposits, just as the name suggests, are payable on demand, they are the next domino. This funding source exits the banks because of the suspected insolvency. To replace the lost deposit funding, banks borrow overnight from other banks or from “repo” lenders on a collateralized basis. When these sources find lending to the suspect bank too risky, they stop lending and another domino falls.
This is the part when everyone says, “Oh, don’t worry; I’ll go to the central bank to replace the lost funding.” At this stage, the banks complain of “liquidity” drying up but in reality but what is driving their liquidity problem is the market sensing their insolvency problem. The liquidity then flows until the central bank hits the wall and another domino falls. The central bank has constraints, and when the collateral offered is no longer investment-grade as the ECB Treaty requires, then the ECB hits the wall and another domino falls.
Then, borrowing from other central banks (like those of the U.S., U.K., Switzerland and Japan) kicks in as it did three weeks ago. Because the Fed has over-extended its balance sheet, it recently took a pass on net economic stimulus, opting to buy assets financed by selling other assets so as not to further expand its already stretched balance sheet. Hence our central bank as lender of last resort is constrained, it can’t help the economy and another big domino falls.
When these sources no longer provide the liquidity necessary to support the right hand side of bank balance sheets, the bank’s stockholders start to leave in the form of selling bank stock. So the next domino falls. Then stockholders of the banks and other institutions around the world ask their management whether they lent to the hedge funds whose collateralized assets are falling in value. The answer is obviously yes; as we examine the worried look on the face of a very large celebrated hedge fund manager who is pondering what to sell next in order to pay off his leveraged loans and cash out his investors seeking liquidation of their stakes in the Paulson Funds.
So then hedge funds which are larger in aggregate than U.S. banks sell, sell, sell to pay off short-term funding as well as equity owners who want out. This compresses their balance sheets, and all kinds of assets unrelated to subprime sovereigns fall wickedly in price such as gold, and the equity and debt of successful emerging nations.
So another domino falls. This doesn’t diminish these assets’ long term worth, but it sure puts a dent into value believer’s portfolios for now.
The next dominos from there are just beginning to enter the public consciousness. Can this top-down shedding of assets and compressing balance sheets also take down the economy? Well, yes, as all financial institutions are seeking to liquidate assets to meet the demands of their funding sources. So the next businessman who walks into the bank asking to roll over his loan and add to the balance to finance some new opportunity is met with the news that the bank expects payment in full on or before the current loan’s term. This, too, is a big domino as the financial crisis takes down businesses and the economy.
I would like to think it’s over from there, but it is becoming increasingly clear that taking down wealth, taking down the economy, and shutting off business and employment opportunities can easily lead to revolutionary changes in government. This is a very big domino that has hit the streets in Europe and here as well. It will also lead to revolutionary changes in Europe’s governance and institutions. On this side of the pond, the Federal Reserve is likely to be taken to task for pumping up the asset bubble with easy money known as QE2. This could result in changes in the voting membership and control of the Open Market Committee that makes monetary policy decisions. The Fed could quite easily lose its cherished independence, which is perhaps the biggest domino of all.
Whether the financial meltdown goes into overdrive as in 2008 depends on whether systemically important (large) institutions are allowed to fail as with Lehman. That lesson is now clear and the intention is to not repeat that episode says Secretary Geithner. If the government doesn’t have the ability to recapitalize banks and the financial market can’t absorb the rush of additional asset sales from the liquidation of a Lehman sized institution, then the “too big to fails” will be left in suspended animation with an upside-down balance sheet (better known as zombie banking) and glossed over with cover-up accounting. Zombie banks liquidate bank assets slowly but make no loans. At least the liquidation is measured rather than instantaneous.
Of course, only knucklehead governments do not immediately replace fallen bank lenders with fresh entry into banking — a concept known as “good” and “bad” banking. But we have a knucklehead government that doesn’t permit bank entry, so viable banks to finance growing businesses are few and far between.
The financial implosion could end if the central bank really goes over- the-top and purchases stock, either common or preferred, in the commercial banks, restoring their solvency. Our government can’t afford to do this, given its fiscal limitations. There won’t be another TARP. Central bank financing was ultimately the key to making zombie banks in Japan whole again in 2003, after more than a decade of being zombies. We’ve done lots of over-the-top things with the printing press, but at least this one makes constructive sense and is likely the last silver bullet left in the Fed’s and the government’s arsenal. As for Europe, even if Greece is saved their banks need saving and their governments also can’t afford it.
What I have described is not an ordinary recession in which over-investment in some sector causes a lull in new investment and trickles down to slow the economy without taking down the financial system or blowing up the government’s balance sheet. This is, instead, a top down financial shrinkage that takes down institutions, wealth, market valuations, the economy, governments and governmental institutions. How far it goes in Europe and in the U.S. will be determined over the coming years. One thing for sure, this one will go into the history books. The only thing in question is will it be merely the history of prosperity and depression or will it also include the history of government evolution.