Financial crises have a certain family resemblance to each other, but not an identical pattern. The present crisis is one of the banking industry itself, and its most disturbing symptom is the reluctance of leading banks, which have been dealing with each other for decades if not centuries, to continue to lend each other money.
They have a reason for their caution. All the banks have investments in derivatives in their own balance sheets. Non-one knows who holds how much of what derivative. They suspect that some other banks have big losses on collateralised loan obligations, of CLOs, but they do not know how big there exposures are.
The problem has two aspects. At every stage there is a lack of transparency. The banks are not open about their CLO holdings. There are thought to be about $2,000 billion of CLOs in existence which include subprime mortgages as part of the ultimate security. Only about $200 billion can be located. That leaves $1,800 billion of CLOs somewhere in the banking system, but nobody know where.
Banks are supposed to “mark to market” when taking their assets. But it is very difficult to mark CLOs to market. Different CLOs have different loans as their base – no two packages are likely to be identical. There is therefore no standard brand for CLOs, in the way that there normally is for stocks and bonds.
“Mark to market” is a difficult concept to apply when there is no market. In recent weeks, bankers have tended to regard all CLOs as more or less contaminated. Even CLOs based on high grade loans have been discounted; CLOs based on subprime loans have in some cases become unsaleable.
No doubt there will be a point at which confidence will recover. There will be a discount, but at least it will be possible to sell CLOs at a price. This process may already be happening. Some hedge funds are raising money to buy distressed CLOs at knockdown prices. That is a rational speculation. If the speculators have the funds, they will provide a floor to the market, and those banks which have a surplus of low grade CLOs will be able to calculate their losses. But that stage has not yet been reached. There is no firm basis for valuing CLOs, and certainly there is no good basis for assessing their future value. This problem can be eased, but not solved, by flooding world markets with central bank money.
The outside observer is bound to think that the banking system must be very weak if banks will not lend to each other. After all, banks do know their own circumstances, even if they cannot know those of other banks. There must be many institutions, including hedge funds, which are much poorer then they were three months ago.
If banks are not lending to each other, they are unlikely to be lending freely to other institutions, such a private equity funds or hedge funds. Nor will they be lending freely to non-financial clients. That is the ultimate fear.
In 1907, a hundred years ago, there was a Wall Street panic which destroyed many financial institutions. J.P. Morgan and a few other leading bankers stopped the run on the banks. There was no subsequent industrial crash. In 1929, the Wall Street crash undermined confidence and created a global slump. The Fed, the E.C.B., the Bank of Japan, the Bank of China, the Bank of England, are all determined that should not happen again. We all hope that they prove right in their judgments. I am pretty sure they will – we shall live to look back on 2007 as a panic not a crash.
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