‘We’re about halfway through the credit crisis’

The financial media and “we told you so” experts have gone to town over the last few months with various explanations of what caused the current credit crisis. They have the benefit of hindsight, of course.

Charles R Morris, a lawyer and a former banker, was among the few to have put a number to the crisis much earlier. In his book, The Trillion Dollar Meltdown —Easy Money, High Rollers, And the Great Credit Crash, released in March this year, he estimated the total defaults and write-downs because of the crisis in the United States to run to a little over $1 trillion.

He has since revised the figure upwards, to $2 trillion, Morris tells Vivek Kaul of DNA Money. Excerpts from an interview:

How much do you hold the low interest rate environment in the US responsible for the current mess?
It was the critical enabler. The reliably falling funding rate took much of the risk out of building big short-term funded trading books at the investment banks, which greatly expanded the leverage and fee opportunities for building and distributing structured finance instruments.

Of six banks at the end of 2007 (Merrill, Citi, JPM, Bear, Lehman, and GS), their combined trading book was $2.1 trillion, up $519 billion in just one year, funded by some $350 billion in new short-term borrowing.

To what extent was securitisation responsible for the current mess?
The principle of securitisation is fine. Collateralised mortgage obligations worked well for most of the previous 20 years (with a frothy detour in 1992-94). Securitising subprime stuff is just crazy.

They jumped to the very risky stuff because prime mortgage rates were so low, they didn’t have the yield firepower that their customers wanted.

Hedge funds are sitting on credit default swaps estimated to be worth nearly $15 trillion.
What do you see happening once claims on credit default swaps start landing up on their doorsteps?
Bill Gross’ estimate of last year that the total losses may be in the $200 billion range still seems plausible to me. I suspect people have already written off a large chunk of losses with respect to the failure of the monolines (monolines are publicly traded companies that write insurance protecting purchasers against principal losses on securities) as counterparties. Merrill accepted a discharge payment that embodied a substantial loss, but it’s hard to track through their financials. Most of the notional values are netted, and nobody knows what the net exposures of the hedge funds are.

In your book, you don’t seem to come across as a great fan of Alan Greenspan. How was he responsible for the current financial crisis?
AG pretty much admitted his culpability recently, although rather grudgingly. One of the wisest financial editors I know told me that she thought ‘everybody got it’ suddenly in the last 6 weeks or so. Lehman really concentrated minds.

Do you think the $700 billion US rescue package will be enough?
Notice that the Fed has expanded its balance sheet by $800 billion just since mid-September, that’s in addition to the $700 billion. 

There has been news going around that a lot of borrowers are now using credit cards to repay their home mortgages, their home equity loans as well as their credit card loans. Given this, do you see defaults increasing in the days to come?
I have heard that many times but can’t personally verify it. I think we are about half way through the overall credit crisis, and probably two-thirds through the housing debacle.

The next big trees to fall will be corporate debt and leveraged loans. Commercial mortgage-backed securities have been taking big losses for several months now.

Home equity loans seemed to have been driving much of the US consumption. Now with home prices falling, do you see that slowing down?
It’s completely disappeared. Home equity borrowing, not reinvested in housing, supplied more than 6% of Americans’ disposable personal income in 2000-2007. That’s now all gone. And that’s why we can’t avoid a major recession that will reverberate through the entire world.

(The latest figures put out by the US Commerce Department confirm that, what with the GDP contracting by 0.3% in the third quarter. One reason for the contraction is that home equity borrowing is dead.

Home equity is essentially the difference between the market value of the house and the portion of the home loan taken to buy it, which is still to be repaid. So let us say the current market value of a house is $400,000 and the home loan to be repaid is $300,000, the home equity works out $100,000. Borrowing against this home equity of $100,000 is possible and that loan is known as a home equity loan. As home prices kept going up, Americans took a lot of home equity loans and that drove consumption in the US economy. With home prices falling, that is not possible anymore)

The trillion-dollar estimate in your book must have been made around a year back. Have you made a fresh estimate?
The paperback to be published early in 2009 is titled the Two Trillion Dollar Meltdown. Economist Nouriel Roubini thinks it will be $3 trillion. Who knows?
($2 trillion works out to Rs 1,00,00,000 crore, assuming one dollar to be Rs 50. This is nearly twice India’s annual gross domestic product.)

Sovereign wealth funds have been sitting on a lot of cash. Do you see them coming to the rescue of the US financial system?
They have started to, but I think have been scared off.

You recently wrote in the Business Week that there is a need to “shrink the hypertrophied financial sector.” Why do you say that?
The expansion has been driven pretty much by the expansion of balance sheets. Wringing out all that stuff, plus the overall deleveraging of consumers, will mean
a big reduction in the financial sector.

How could you see all of this coming?
I wrote a book called Money Greed and Risk, published in 1999, that analysed selected financial crises from three centuries. The constant tale was a very useful financial innovation, like the bill of exchange, or the private railroad bond that spread like wildfire because it was so useful.

The early innovators made, and deserved, huge paydays. So legions of imitators piled in, pushing the limits to the absurd until there was a big crash. When the dust settled, everybody figured out what the rules were and the innovation became an established part of the financial landscape (Look at junk bonds as a recent example.)

I did work with some structured instruments and credit derivatives in the late 90s and early 2000s, and watched them develop, waiting for the crash — more as a historian than anything else. But they never crashed — just ballooned bigger and bigger. I realised it was because of the continuing fall in rates. So I sold my apartment and started writing the book.

Lots of people saw it coming, by the way. And a lot of them started short funds in 2003 or so. They all got murdered. Is John Paulson a hedge fund genius for accurately predicting the subprime crash? No, he’s just one of a long line of short sellers who made that bet, and who happened to be there when it actually happened.

k_vivek@dnaindia.net