Thinking the unthinkable

The credit crunch has now become a full-blown systemic banking crisis. Financial institutions that were previously thought immune from failure are now crashing. Eighteen months ago, who would have thought that Bear Stearns and Northern Rock would be no more; that Freddie Mac and Fannie Mae would be nationalized and that Lehman brothers would be on the verge of total collapse. Moreover, you don’t have to look too far beyond Lehman to see other vulnerable institutions. The unthinkable has suddenly become the plausible.

There is worse to come. Other institutions are going to tumble and fail. Lehman, Freddie and Fannie are not the end; they are but the prelude. We have only just raised the curtain on this sorry opera.

How do we know this to be true? We have to start by understanding a rarely mentioned and shocking fact about the failures recorded so far. In the greater scheme of things, the sub prime shock was only a modest blip. Yet somehow, it finished off Bear Stearns, and Lehman. Default rates on US mortgages are still in single digits. Although US house prices have fallen by about 25 percent, even foreclosed properties still have some value. When you do the arithmetic; the losses are really not that great. Nevertheless, Freddie Mac and Fannie Mae found these losses too much to bear.

So why are financial institutions collapsing so quickly? It is a lack of bank capital. Every prudent bank should keep a buffer to absorb losses. Roughly speaking, this buffer is the difference between total bank assets, which are basically loans, and total liabilities, which are deposits and loans from other financial institutions. Banks on both sides of the Atlantic minimized this difference; their capital. They reduced their buffer because holding capital meant reduced profits. Banks reduced their safety zone down to the absolute minimum. When the sub prime losses began to arrive, bank balance sheets could not cope. The buffer was too slim.

This is one of the reasons why the Fed and the US treasury are finding it so hard to save Lehman. In principle, Lehman is on sale for $3.5 billion. Based on past valuations, this is a ridiculously low price. Yet why can’t Lehman find a buyer? Other banks simply don’t have the resources to pick up this bargain. True, Lehman has some potentially worthless mortgage debt on its books. However, these losses could be easily absorbed if the buyer had a sufficient capital buffer.

So if banks do not have sufficient capital to absorb modest losses, imagine what would happen if loan default rates really begin to rise. Unemployment on both sides of the Atlantic remains comparatively low. However, both economies are slowing and the unemployment rate is about to pick up. As it does, households default rates are going to begin to rise. However, the banks are already in the danger zone. They are having a hard time absorbing existing losses, and a further round of defaults will send many over the cliff.

Of course, this was all foreseeable. It was all completely understood by central banks, financial regulators and the commercial banks. Yet knowing something and acting on that information are two quite distinct things. People often prefer to ignore unpleasant facts that require distasteful policy responses. Invariably, it was easier to hope for the best. As US and UK banking systems slide into an ever deeper crisis, the unthinkable reality of bankruptcy was the highly plausible consequence of keeping too little capital. It was more a case of not thinking about some obvious dangers rather than imagining the unthinkable.