This is Part 1 of a series from Lombard Street titled "Last Spin Of The Wheel For Europe's Banks." As the title indicates, Lombard Street is hardly bullish on Europe's chances to avoid a fate that was described earlier by the IIF, only this time instead of just €1 trillion which would be the cost of a Greek disorderly default, the final tally will be many orders of magnitude higher and will also drag down the ECB, and the world with it.
Computer models versus looking at the facts
In 1974, Hyman Minsky explained the unfolding of credit cycles with his Financial Instability Hypothesis. It identifies three types of debt financing: hedge (borrowers can pay principal and interest from income, so risk is minimal); speculative (borrowers can pay interest from income, but need liquid financial markets to refinance the principal at maturity, so defaults rise when liquidity is impaired); and Ponzi (borrowers can’t pay either interest or principal out of income, so need the price of the asset to rise to service their debts and defaults soar when asset prices stop rising). Confidence rises over a prolonged period of prosperity, so a capitalist economy moves from hedge finance dominating its financial structure to increasing domination by speculative and Ponzi finance.
Financial markets and the economy are relatively stable when hedge financing dominates, but become ever more unstable as the proportions of speculative and Ponzi finance rise. The rising instability causes cycles of increasing severity until fear takes over and financial markets suffer a self-reinforcing spiral downward. Banks are the core of the financial system, so Minsky correctly says bank balance sheets deteriorate until inability to service liabilities causes a ‘Minsky Moment’ – a debt crisis that forces bloated asset prices down to levels that are appropriate to the real economy of production and income.
The questionable lending practices and the banking business models that caused the 2007–08 banking crisis and Great Recession certainly fit Minsky’s definition of Ponzi finance. That ‘Minsky Moment’ was a major turning point in global financial and economic history. It began the correction of all the imbalances that have accrued since the last major turning point – the huge monetary stimulation in response to the Penn Central non-bailout in 1970. (It changed the focus of most central banks from guarding against inflation to protecting banks from everything.)
Many analysts ignore financial debt when computing debt to GDP ratios – odd because financial debt is always a factor in financial crises. Financial debt in the US has fallen 20% from its high at the end of 2008, but is up 10% in Europe, shifting the locus of the banking crisis to Europe, where the quality of sovereign debt has fallen as financial debt has risen. Moreover, bankers on both sides of the Atlantic are continuing two serious errors that were major factors causing the last banking crisis;
- putting more reliance on computer models than common sense and
- failing to purge their balance sheets of failing assets due to inadequate net tangible equity to absorb the losses.
Contrary to the hype, computer models are very fallible. As predicted in February 2007, they greatly underestimated financial risk by failing to incorporate obvious correlations as well as being responsible for rating securities based on home equity loans and sub-prime mortgages AAA. Reliance on computer models also explains the failure to spot turning points. Only external shocks divert models from moving towards the equilibrium position, so all forecasts tend to be straight lines. Computer models don’t, and probably never will, identify turning points.
Failure to adequately price complex financial instruments, especially CDOs was a major factor in the 2007–08 subprime crisis. Securitisation effectively hedged the specific factors leading to default, such as personal illness, but failed completely to address the risks common to the entire securitized pool, such as an economic downturn and rising unemployment. Investors in the Euro Area (EA) mispriced sovereign debt for a prolonged period of time, but for a different reason – the false assumption that a common monetary policy plus the political promise that no country in the region could default reducedidiosyncratic sovereign risk within the euro. This assumption led to higher risk EA economies borrowing at low rates for a decade, thereby building up excessive debts and external obligations (see chart 1). For example, 10-year government bond spreads over Bunds for Spain and Italy heading into the currency union and until the financial crisis were very depressed (see chart 2).
In addition, models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly. No such people exist or ever have existed. Desires and fears, i.e. emotions, drive all human activity. They are neither rational nor linear, so can’t be modelled. However, they do fluctuate within given parameters most of the time, so the resulting behaviours can be modelled as long as the emotions stay neatly within the parameters and historical relationships continue. This is a big ask and gives rise to another three problems that bedevil model predictions. First, extreme events pop up far more frequently than mathematical theory predicts. Second, models can’t predict when an extreme event will occur. Third, they can’t give any reliable information on an extreme event – even after it has occurred – so the models still can’t incorporate the effects on economies and financial markets of the reversal from the ever increasing leverage of the past to the present deleverage.
Emotions exceeding known parameters cause extreme events, such as stock market booms and busts. They are self-reinforcing spirals upward and especially downward that, once established, keep diverging from equilibrium until the driving forces fade or stronger counter forces reverse them. Ever-increasing desires for accumulating ever greater wealth faster and faster ignited a credit bubble that spiralled upwards until it burst in 2007 from a lack of new borrowers. The multi decade credit bubble and its bursting were extreme events. No model recognized the credit bubble or its collapse and no model is giving any indication of the plethora of problems now brewing in Europe.
