Posted on July
19, 2016 by Yves Smith
Yves here. Note that Öncü’s
article is looking at events during the financial crisis that did (or didn’t)
produce liquidity crunches. One squeeze that is not on his list is
November-December 2007, and that is because it was not triggered by a
particular event. Liquidity in financial markets becomes thin at year end
because many investors try to minimize or halt trading after December 15 so
they can settle things up for the year without undue stress.
In 2007, trading conditions in
credit markets were becoming difficult in early November. At least part of the
reason was concern about structured investment vehicles, which had been buyers
of subprime debt and depended on short-term funding. Recall that Hank Paulson
spent weeks flailing around trying to orchestrate a private sector rescue plan,
which we correctly predicted would never get off the ground. The Fed announced
its first emergency program, the Term Auction Facility, on December 12.
Of course, another issue is
that is it not yet clear what Brexit means….but that was also true of some of
the events during the crisis.
By Sabri Öncü
(sabri.oncu@gmail.com), an economist based in Istanbul, Turkey. This article
was written on 2 July 2016 and first published in the Indian journal EPW on 16
July 2016
The Lehman moment is the
moment when Lehman Brothers—one of the largest investment banks in the United
States (US) at the time—collapsed. The collapse happened on 15 September 2008.
Almost nobody disagrees with that the Lehman moment has been the most important
moment in the ongoing global financial crisis that started in the summer of
2007, at least, up until the Brexit moment.
What is Brexit Moment?
The Brexit moment refers to
the 23 June 2016 referendum in the United Kingdom (UK) in which the Britons
voted on whether to remain in or to leave the European Union (EU). Its outcome
became official on 24 June 2016.
Naturally, there were two
sides. The “Bremain” side, supported remaining in the EU, and the “Brexit”
side, supported leaving the EU. The Brexit side beat the Bremain side 51.9% to
48.1% on 23 June, unexpectedly. The next day, the Brexit moment hit the global
financial markets leading to major drops in almost every equity market around
the globe. And since then, the internet has been flooded with unidentifiably
many articles analysing sociological, psychological, political, geopolitical,
economic, financial and other difficult-to-imagine aspects of Brexit.
This article comes from two of
those articles. There was one statement from each that struck me. The statement
from the first article, attributed to the Allianz Chief Economic Advisor
Mohamed El-Erian, is: “Brexit: Not a Lehman moment.” The statement from the
second article is: “Brexit is a Bear Stearns moment, not a Lehman moment.”
Prior to Lehman moment, there
were three other important moments. The first Bear Stearns moment (20 June
2007), BNP Paribas moment (9 August 2007) and the second Bear Stearns moment
(14 March 2008).
Shadow Banking
Simply put, shadow banks are
non-bank financial institutions which behave like banks. They borrow in
rollover debt markets, leverage themselves significantly, and lend and invest
in longer-term and illiquid assets. The difference between the two is that, unlike
banks, shadow banks cannot create deposits—that is, money. If we leave this
aside, then the two are more or less the same.
The significance of this is
that just as bank runs can occur on banks, shadow bank runs can occur on shadow
banks.
A bank run is rioting of the
bank’s depositors—the most important and largest section of the bank’s
short-term creditors—at the bank’s door to get their money out. A shadow bank
run is more or less the same. Except that, since shadow banks have no
depositors, it is their short-term creditors who riot at the door. This riot
takes place electronically at a virtual door. It is not visible, because it is
not physical.
The reason why those who
claimed Brexit was not a Lehman moment must have been that there was neither a
bank nor a shadow bank run at Brexit moment.
First Bear Stearns Moment
The signals of the first Bear
Stearns moment became noticeable early in 2007. Like Lehman, Bear Stearns was
one of the largest investment banks in the US at the time. When the real estate
bubble in the US started to burst in the first quarter of 2006, the subprime
mortgage market began to deteriorate.
The first casualty was two
highly levered Bear Stearns hedge funds. They were shadow banks speculating in
subprime mortgages by borrowing short-term funds in the repo market and
pledging their mortgages as collateral.
With the deterioration of the
subprime market in early 2007, creditors began asking these funds to post more
collateral by June 2007. When the funds failed to post more collateral, Merrill
Lynch seized $850 million of their assets and tried to auction them on 19 June
2007. When Merrill Lynch was able sell only about $100 million of these assets,
the illiquid nature and the declining value of subprime assets became evident.
The next day, these funds collapsed.
This is the first Bear Stearns
moment.
BNP Paribas Moment
Although the collapse of these
two funds did not freeze the repo market, it increased the fears of
counterparty risk and made the problem systemic.
Here, the key word is fear.
When fear hits financial markets, it spreads.
In early August 2007, a run
started on the assets of three special investment vehicles (SIVs) of BNP
Paribas. These SIVs were bankruptcy-remote entities financing their subprime
holdings through issuance of asset backed commercial paper (ABCP). On August 9,
BNP Paribas suspended redemptions from these SIVs when their ABCPs lost their
liquidity and became non-tradable. This caused the entire ABCP market to
freeze. When fears of counterparty risk spread through markets, all short-term
debt markets froze, only to open after central banks injected massive amounts
of liquidity (Acharya and Öncü, 2013).
This is the BNP Paribas
moment.
The BNP Paribas moment is what
started the ongoing global financial crisis. The reason why most people do not
know about BNP Paribas moment is that it effected the US markets mostly. Lehman
moment is better known, because it globalised the crisis.
Second Bear Stearns Moment
It is all about fears and,
beginning late Monday, 10 March 2008, fears spread about liquidity problems at
Bear Stearns, freezing the repo markets in which Bear Stearns was funding its
illiquid assets.
This happened on 13 March
2008. Then, on Friday, 14 March 2008, on the second Bears Stearns moment came.
On 14 March, the Federal
Reserve Bank of New York agreed to provide a $25 billion loan to Bear Stearns
to save it, sending the signal to markets that Bear Stearns was dead. Failing
to save Bear Stearns on Friday, the Federal Reserve Bank of New York arranged a
costly marriage between Bear Stearns and JP Morgan Chase on Sunday, 15 March
2008, about two years after which Bear Stearns name went into oblivion.
This is the second Bear
Stearns moment which laid the ground for Lehman moment.
Fear Indices
There are many fear indices in
the global financial markets and I will compare the above described four
moments—namely, the two Bear Stearns, BNP Paribas and Lehman moments—with the
Brexit moment based on two indices— VIX and the TED Spread.
Their main significance is
that they are publicly available and daily data for these indices go way before
the onset of the ongoing global financial crisis.
A third index I will touch
upon is SKEW, but unfortunately, its daily history I was able to obtain starts
only after 2010.
VIX: VIX is the ticker symbol
for the Chicago Board Options Exchange Volatility Index, a measure of the
30-day volatility of S&P 500 index options. It is constructed using the
implied volatilities of a wide range of S&P 500 index call and put options,
and meant to be a forward looking measure of volatility. It was introduced by
Whaley, a Vanderbilt University finance professor, and had gone through several
modifications since its introduction in 1993. Often referred to as the fear
index, it has been considered by many to be the world’s premier barometer of
investor sentiment and market volatility.
TED Spread: The TED spread was
born after Chicago Mercantile Exchange developed and introduced the Eurodollar
futures contract in December 1981. When first defined, and traded, the TED
spread was the difference between the interest rates for the 3-month Eurodollar
futures and 3-month Treasury bill futures contracts. Indeed, ED is the ticker
symbol of the Eurodollar futures contract. These days, the TED spread is the
spread between the 3-month LIBOR and 3-month US Treasury bill rate. The TED
spread is viewed as another fear index, because many view it as a measure of
the perceived difference between the safety of lending to other banks and the
safety of lending to the default risk free US Treasury by the banks of concern.
A big jump in it indicates funding liquidity freezes, that is, “bank runs”, in
money and credit markets.
SKEW: SKEW is the ticker
symbol for the Chicago Board Options Exchange Skew Index, a measure of tail
risk—that is, the risk of extreme events such as major crashes in equity
markets. SKEW is calculated from a wide range of (out-of-the-money) S&P 500
index options and considered by many as the real fear index. Historically, it
fluctuates between 100 and 130 and its historical maximum is 151. Its values
beyond 130 usually indicates increased risk avoidance in financial markets.
Comparison of the Moments
Let me now compare the five
moments based on VIX and the TED Spread as percent changes from a day earlier
in the table below.
The very first conclusion from
the table may be that Brexit moment is neither any of the two Bear Stearns
moments nor the BNP Paribas moment nor the Lehman moment. It is a new moment.
While based on VIX, the Brexit moment is the worst (given its impact on the
global equity markets, this is expected), based on the TED Spread, the Lehman
moment is the worst and the Brexit moment is just an ordinary event (given that
the UK is neither a bank nor a shadow bank, this is expected also).
Two other observations are as
follows. The first is that from 23 June to 30 June, the TED Spread jumped about
17.7%, which may indicate some funding liquidity issues. The second is that
SKEW reached its all-time high of 151 on 28 June, which may indicate increased
risk avoidance and market expectation of an extreme event, that is, growing
fears.
Apart from all of these, most
European banks are zombies. Since 23 June, the Italian bank shares crashed more
than 20% and the Italian banks are dying one by one these days. Furthermore,
the International Monetary Fund called Deutsche Bank (the largest German bank)
the riskiest financial institution in the world as a potential source of
external shocks to the financial system on 30 June. With few exceptions, the
government interest rates are falling in almost every country, and even the
long term Japanese, German and Swiss interest rates are in the negative
territory. True, the world equity markets recovered their losses after the
Brexit moment. But, this was because of the expected coordinated interventions
by the world’s major central banks, which they fulfilled.
Now, what should we conclude
from all of these?
La Sagrada Familia
One of my favourite albums of
all times is Gaudi album by Alan Parson’s Project. One of its song is La Sagrada
Familia. Here is a part of the lyrics.
Who knows where the road may
lead us, only a fool would say
Who knows what’s been lost
along the way
Look for the promised land in
all of the dreams we share
How will we know when we are
there? How will we know?
Only a fool would say
Reference
V.V. Acharya and T.S. Öncü
(2013), “A Proposal for the Resolution of Systemically Important Assets and
Liabilities: The Case of the Repo Market,” International Journal of Central
Banking, January, pp. 291-349
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