Leverage and the lender of last resort

The wholesale dumping of bonds is the start of the disorderly - and critical - phase of the crisis
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ON FRIDAY, the global economic crisis reached a new dimension when the G7 government bond markets suddenly dropped by several full points amid a mad scramble for cash throughout the financial system. No longer were investors content to shift their assets towards the safety of government- guaranteed bonds.

In previous weeks, risky instruments such as emerging market debt, corporate bonds and equities had been progressively dumped in favour of bonds. Risk premiums were rising throughout the system as investors ran for cover. But, on the whole, the markets remained orderly.

That can no longer be said to be true. The 15 per cent collapse in the value of the dollar against the yen in the space of two days, swiftly followed by the wholesale dumping of the most secure assets in the entire financial spectrum, marks the onset of the disorderly - and critical - phase of the present crisis.

What on earth is going on? To most observers outside the financial markets, recent events have been opaque as well as alarming. But to any student of economic history, the story has in fact been following an extremely familiar path. Financial mania, excess leverage, distress, crash and then panic - it is a time-honoured pattern which should by now amaze us only because we remain so liable to repeat the herd-like behaviour of previous generations.

Next on stage an actor will appear who, for good or ill, must invariably play the key role at the denouement of these affairs. This actor - the best friend or worst enemy of those seeking to escape from a crisis of excess leverage - will be known as the lender of last resort.

Leverage is easy to understand, since most of us engage in exactly this process when we take out a mortgage. Assume for the sake of argument that we put up pounds 10,000 of our own money - equity - in order to persuade a bank to lend us pounds 90,000 on a house purchase worth pounds 100,000. We are now leveraged 10 times over. If the price of the house - our asset - rises by 10 per cent, we can now sell it for pounds 110,000, pay off the loan of pounds 90,000, and we are left with pounds 20,000. Magically, this is twice the amount we started with, even though the underlying asset has risen in price by only 10 per cent.

This simple story in fact illustrates something that most companies - and all financial companies - do as a matter of course. It is the bread and butter, for example, of the hedge funds and of certain trading business run by the banking sector. All these entities put up some of their own equity, and then borrow additional funds to acquire a much larger book of assets. Provided that these assets - shares, bonds, currencies and so on - rise in price, the returns on the equity base of these institutions will be truly spectacular. But if the assets start to fall in price, the losses can be equally large.

In the case of our humble mortgage, we can certainly get into trouble if house prices should decline, but at least we have borrowed the money over 25 years, and banks are not going to foreclose on us provided that we can keep paying the interest on the loan.

But, in the case of the hedge funds and other leveraged investors, the loans are typically very short in duration, so they need to be rolled over on a virtually continuous basis. If confidence in the health of a leveraged financial institution begins to sag, loans to this institution quickly dry up, and the only way they can be redeemed is to sell some assets. In the housing market, the equivalent is to sell the house to pay off the mortgage.

This is exactly what has happened in the past few weeks. Initially triggered by the debt default of Russia, some leveraged investors have suffered large losses, and loans to them have started to dry up. As a result, these leveraged funds have been forced to sell assets in order to remain solvent, and inevitably these forced sales have further reduced the prices of the assets themselves, thus causing mounting losses to reverberate through the entire system. Investors are perforce swapping financial assets for cash, because that is the only way that debts can be repaid. Asset prices must assuredly fall in this process - it has nothing to do with so-called economic fundamentals.

Sometimes, scrambles of this nature burn themselves out without doing too much damage to the health of the financial system, and without harming the economy at large. One such case was 1994, when a leveraged bubble in the European bond markets was reversed in a highly painful, but not catastrophic, manner.

At other times, such as in the aftermath of the 1929 crash, the process of deleveraging eventually cascades into generalised panic. Banks fail and the economy nosedives. Unfortunately, it is always very difficult to tell in the midst of a crisis whether the ending will be only unpleasant, or will prove to be an outright disaster. And that, of course, greatly complicates the task of the lender of last resort.

Enter the central banks. They have the power to print money, and therefore to provide liquidity to the financial system in limitless quantities. They can accordingly stop the meltdown, if they so choose, simply by injecting funds into those institutions which are short of cash.

With a flick of a central banking switch, the need to dump assets in order to pay off tomorrow's creditors can be eliminated from the system. The key factor in such moments of extreme duress is not the interest rate at which the central bank lends to the system - a quarter or half-point cut in rates is neither here nor there - but the fact that it stands ready to inject funds in unlimited quantities for a short period, even if it is at penal rates. Often, once this is done, confidence can return to the system, and disaster can be avoided.

This is exactly what happened following the 1987 stock market crash. As the graph shows, the loss of wealth in that episode was at one point equal to 19 per cent of OECD consumers' expenditure, which is almost exactly the same amount that has been lost in the past three months. But this loss was very temporary, as the US Federal Reserve under Alan Greenspan swiftly moved to flood the system with liquidity, preventing banking failure and panic. Within months confidence returned and monetary policy could be normalised.

So in 1987 the lender of last resort played its role admirably, and the whole episode resulted in not even the mildest of blips on the graphs for GDP and employment. Contrast this with 1929-30, when the lender of last resort - again the Federal Reserve - acted less decisively, and the resulting financial panic led to the Great Depression.

It is always difficult to judge when, and on what scale, the lender of last resort should act. Central banks are quite rightly reluctant to bail out private entities and save them from the consequences of their own folly. But, in extreme times, the wider danger of loss to innocent people elsewhere in the economy overrides this consideration. Such a time is now.