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US structured finance

In traditional models, it is the job of central banks to moderate credit cycles. By that measure, there is little to say that is favourable about the work of the US Federal Reserve System between April 1998 and October 2002. For nearly six years before 1998, conditions slowly improved, going from unnerving through cool to Goldilocks on the chart. Almost everyone claims credit for that virtuous cycle. The horrible period from 1998 to 2002, however, remains unclaimed.

What began in April of 1998 is not the Fed's fault. Mechanisms that supported the so-called Goldilocks era fell apart for other reasons. What happened for the next four years can be described in words John Maynard Keynes used to describe the Great Depression:

"We have involved ourselves in a colossal muddle, having blundered at the controls of a marvelous machine the workings of which we do not understand."

Traditional central bankers may not understand (some simply will not accept) the model that created the Goldilocks era in US finance. Central banks play an important role, but credit markets that sustained the Goldilocks economy do not rely on banks.

Markets that created stability in US finance from 1992 to 1998 rely on: (1) SEC Rule 3a-7 (1992); (2) US legal and market reforms over the preceding 60 years; and (3) mathematical certainty of riskless arbitrage transactions in which corporate debts are transparently bundled and traded in free markets. In those markets, central banks maintain the ability to affect funding costs, but not the ability to allocate credit or its cost.

Done properly, arbitrage transactions create: (1) a rising flood of liquidity to douse any flight to quality and (2) contractions of liquidity that prevent market overheating. These effects produced the not too hot-not too cold US credit conditions of 1992 to 1998.

Disruptions of those markets, and recent re-emergence, explain both the decline of 1998 to 2002 and the return of the Goldilocks economy by the end of 2003.

Just how close the US came to repeating the Great Depression can be seen if you block out the period on the chart after September 30 2002. Imagine how businessmen felt at that time. It's easy to understand why seasoned bankers, lawyers, businessmen, economists and policy pundits in the US were "packin' the money in a pillow and headin' for the hills".

Yet, on October 9 2002, we declared: "Let the Recovery Begin!"

What caused the slide toward oblivion and what changed the course of history on October 9 2002? The slide began when SEC rules triggered the Hedge Fund Crisis of 1998. The crises that occurred in 2000 and 2002 were, in many ways, repeats of the 1998 crisis.

In April 2003, The American Banker published a chart showing that 25 large US bank and thrift holding companies contracted business loans by more than 16% in the year ended September 30 2002. Seven of the 25 accounted for nearly 95% of the group's contraction. Milton Friedman once estimated that a 30% contraction in lending, over several years, caused the Great Depression.

From their perspective, lenders were simply reacting to market conditions. As they dumped loans, however, there were few buyers. The result was a catastrophic cliff of rising risk premiums during the middle of 2002.

In May of 2002, Federal Reserve chairman Alan Greenspan warned:

"Concentration of market making [at only a half dozen banks] has the potential to create concentration of credit risks."

Credit, however, was not the only risk in concentration of market making. In a small circle of market makers, the rising price of credit creates a feedback loop where increased funding costs trigger higher risk premiums. Prices rose so quickly during the summer of 2002 that concentration of market making nearly drove the US economy into the same colossal muddle Keynes saw in 1933.

By October 2002 the Financial Accounting Standards Board (FASB) made clear its intention that single-obligor/multi-seller conduits used by a few institutions to gain unique, and perhaps dominant, access to short-term funding for corporate loans would need to be consolidated. Next, on October 9, an EITF meeting gave assurance that true sale entities (multiple-obligor/single-seller conduits used to create liquidity for traders of assets) would survive challenges based on a phony premise that re-issuing debt was not allowed for qualifying special purpose entities under FASB Statement 140.

As a result, two of three issues that fostered instability during the period between 1998 and 2002 were resolved, pending final rules that assure this result. The last issue, restraints created by the SEC's 1998 amendments to Rule 2a-7, still needs to be resolved to assure long-term stability, but ending two of three barriers to recovery was enough to turn the tide of US economic history.

Market makers that had gained control of US credit markets did not go away quietly, however. As 2002 ended, The American Banker reported:

"Smarting from record loan losses, the nation's top-ranked syndicated lenders . . . have toughened terms and raised fees on corporate loans."

The situation looked similar to Japan in the mid-1990s. Borrowers needed liquidity and debt service cost relief. Lenders, however, had no appetite for risk. The traditional bank funding model, on which most of the world's financial systems are built, appeared frozen in a liquidity trap, in Japan and in the US at the end of 2002.

The situation in both countries, however, was not as appeared to most observers.

Two years earlier, confronting a clash of old systems and new problems in Japan, a famous Japanese reorganization lawyer, Shozo Miyake, declared: "Sometimes different circumstances require different solutions." With that, groups led by outstanding Japanese reorganization specialists began a process that has now broken the logjam of Japanese financial restructurings.

The head of the Bank of Japan, Toshihiko Fukui, recently announced that the Bank is buying asset-backed securities supported by corporate debt, and will support the market's US-style development. This overcomes the inability or unwillingness of Japanese banks to take corporate lending risk. The US miracle of credit market disintermediation is beginning to bloom in Japan, fostering recovery from more than a decade of despair.

In the US, when loopholes and barriers to market making were cut off, a miracle happened. With competitors freed to grow, 7% risk premiums looked very attractive, not only to new funding sources, but to those that had been dumping loans and raising rates to their own detriment.

The vicious credit cycle of 2002, therefore, suddenly reversed. Since October 9 2002, risk spreads have fallen about 6%. Sustained by accommodative monetary and fiscal policies, credit conditions went from cataclysmic to Goldilocks in less than 14 months.

Everyone gains from this. Record losses have become record recoveries. Record loan loss reserve increases have become record reserve reductions. Investors that were driving businesses into bankruptcy are refinancing at lower rates to bring businesses out of bankruptcy. Fee income is rising to meet margin reductions.

There is no mystery behind the US recovery. A 6% reduction of spread creates savings of about $180 billion a year in funding costs of affected firms. At a 20-1 price-earnings multiple, that represents a $3.6 trillion increase in projected equity value.

Pundits that projected a depression by 2003 underestimated the breathtaking magic of truly free and transparent markets. Properly align greed with virtuous purpose, and there is no limit to what free societies, free markets, free people and free enterprise can achieve. It is those who seek to manipulate and control market forces, using loopholes and barriers, that endanger the world's economic future, including their own.

This is the last of a series of articles on the debacles that affected US markets after April 1998. We close with renewed hope that the US has now, finally, learned what must be done to "free the free-enterprise system".

 Credit conditions for growth firms

Frederick Feldkamp

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