I’m currently reading a book about the life of Jesse Livermore. Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit. He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.
What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks. Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market. Remember, in those days, margin loans required only 10% initial equity, not the 50% required today. A modest move down in the stock market could create a self-reinforcing panic.
All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet). In both cases you had a mix of:
- High leverage
- Short lending terms with long-term assets (stocks) as collateral.
- Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
- Inflated asset values on the stock collateral.
- Inadequate loan underwriting standards at many trusts and banks
- Inadequate solvency standards for regulated financials.
- A culture of greed ruled the day.
Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today. The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.
In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.
Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.
I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any? Leave a comment.
Subprime lending is returning also, though not in housing yet…
I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis. Since risky borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era. There would be some art to this. A raw leverage ratio, or fixed charges ratio in the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough. The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)
In a highly leveraged situation with chains of lending, confidence becomes crucial. Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!” The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death. Confidence only deserves to exist among balance sheets that are conservative.
That’s all for now. Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.