Boats in the Desert

@CharlieLongren

There are two sayings that guide my approach to learning about complex systems. The first is ‘you will not truly understand a subject until you try to teach it.’ The second saying is, ‘if you can not explain something simply, it is probably because you do not understand it yourself.’ Everything that I write is my attempt at teaching interesting ideas, as part of an even greater endeavor to learn and understand those ideas myself. In this paper, we will try to understand how the hell a boat ends up in the middle of a desert.

Banking in the Shadows: Part 4

TLDR: The Great Recession was caused by the collapse of the Eurodollar system. The world has not recovered from the collapse of the Eurodollar, and therefore we have not returned to the economic growth and prosperity that was experienced up until the turn of the century.

After Bretton Woods and the subsequent break of the US dollar’s peg to gold, banks began to create their own liquidity by employing off balance sheet accounting tricks in foreign and domestic markets. As a result, foreign and domestic dollar markets became extremely interconnected. Further, the Eurodollar system of money creation proliferated because of government regulation like the Basel Accords, which resulted in banks focusing on balance sheet expansion while relying less on effective capital allocation. This shadow banking Eurodollar system was working until August 2007, when the system fell apart and started what is now called the Great Recession.

There are three misconceptions about the Great Recession. The first misconception is that the great recession was caused by the US real estate market. This narrative has become ubiquitous in financial education. However, the US real estate market alone was not nearly large enough to cause the type of economic destruction that occurred in the years 2007 through 2010. Even defaults in the large packages of mortgage backed securities that were being bought and sold prior to the 2008 economic crises would not have been enough to cripple the global economy. A better explanation of the crisis is that the Eurodollar system broke down. Mortgages were only a part of that system.

Most people who have read about the 2008 financial crisis or who have watched movies like The Big Short, understand that large financial institutions were packaging large amounts of risky mortgages together in order to change their risk profile and make them “safer.” What I have recently come to understand is that most of the large tranches (portions) of AAA rated mortgage backed security(mbs) packages were in fact safe. There was little risk of default. The reason they wreaked so much havoc was the financial games being played with them.

In ‘We Found The Missing Money,’ I explained that from the 1970s to the early 2000s banks became increasingly dependent on the Eurodollar system for liquidity and financing. Specifically, the repo markets allowed banks to create dollars out of thin air by exchanging pristine collateral with each other. They would enter repurchase agreements and use those repo accounts to pay their bills. The banks were essentially using liabilities like liquid assets. The AAA rated mbs packages were considered pristine collateral; meaning the owners of the mortgage backed securities could sell or lend them to banks in money markets and repo markets. Globally, banks traded mbs packages and used them to create liquidity in the same way they used US Treasury securities. To make matters more entangled, the banks who originally sold the AAA rated mbs packages were so confident in the system that they agreed to act as a liquidity backstop. They gave the purchasers of the mbs packages free insurance, promising to be the buyers of last resort.

Although the so-called pristine collateral was considered low risk, bankers knew there was still some modicum amount of risk inherent in the securities. They sought to offload that risk with the use of credit default swaps, which were sold by companies like AIG. AIG also saw the collateral as riskless, so they wanted to take advantage of what seemed to be a zero risk opportunity to increase profits. They insured the default risk of the collateral used throughout the Eurodollar system. One of the problems with AIG’s models was that they equated extremely low risk with there being no risk. As the Eurodollar system grew uncontrollably in the shadows, so did AIG’s level of risk. Like many companies and banks in the financial crisis, AIG’s balance sheet looked healthy because most of their true liabilities were off balance sheet existing in the shadows of traditional banking in the Eurodollar system.

The real reason for the great recession was the fragility of the Eurodollar system. The mortgage market may have been one of the first dominoes to fall, but it was not the cause. When there was a sizable change in the perceived risk of an underlying asset in the Eurodollar system, the entire system would come crumbling down. That is exactly what happened in late 2007. The mortgage market had grown out of control and the perceived risk of (even AAA rated) mortgage backed securities grew. Therefore most mbs packages were no longer considered pristine collateral. This brings us to the second misconception about the Great Recession.

Many people still believe that the Great Recession was a credit crisis, when in fact it was a liquidity crisis. The bankers who were putting together mbs packages, forming credit default contracts, and taking full advantage of repo transactions were correct about the risk of default in the underlying assets. When the US government bailed out companies like AIG, the government actually made a profit on the securities that were purchased. The bankers were roughly right about the credit risk. Credit risk had been the primary risk factor prior to the expansion of the Eurodollar system. But, the spawn of the Eurodollar system was a reaction to the need for liquidity rather than the need for credit. Therefore, the inherent risk in the system was liquidity risk. This fact is where bankers were precisely wrong.

After the AAA rated mortgage backed securities were no longer considered pristine collateral, banks had to turn to other securities for their financing needs. As a result the demand sky rocketed for other forms of collateral and balance sheet assets. Since the repo markets are extremely short term, the counterparties in repo transactions were less concerned with the risk of default in the underlying assets and more concerned with day to day volatility (liquidity) of the underlying. This caused the prices of other forms of collateral to become more volatile and therefore less useful in repo transactions. Even treasury bonds, where risk of default was near zero, could not be used as pristine collateral because they were exhibiting large amounts of volatility. The money creation system that banks had become reliant on for financing began to implode.

This was the equivalent of a bank run, except “instead of physical cash banks were hoarding balance sheet capacity.” Balance sheet capacity could no longer be created out of thin air. Up until this point, the banks had been creating their own liquidity, but now they had to seek it externally. They turned to ABS commercial paper until the liquidity in that market dried up. They looked for unsecured interbank financing, but most banks were in the same boat. No one could lend what they did not have. Finally, banks turned to federal home loan banks advances because there were no other places to find liquid assets. Eventually, there was no liquidity left. The waters that bankers believed would always be stable became violent and turbulent. Many banks that were previously sailing beneath clear skies and above calm waters found themselves on boats in the middle of the desert: unable to move: not a drop of water in sight.

The last misconception about the Great Recession was that it ended. The world financial system never recovered from the collapse of the Eurodollar system. Federal Reserve banks across the world have been printing money in hopes of providing the economy with an ample amount of liquidity, but even their best efforts have not been able to match the money creation that occurred with the Eurodollar system. In real terms, banks have not been able to reach the amount of balance sheet capacity that they had in 2008 at the height of the Eurodollar system. On balance, economic growth globally has been stagnant. What is worse is that policy makers remain blissfully unaware of the real issue, so they can never be relied on to fix it.

The world is broken and only one thing can save us...