The Lehman Brothers bankruptcy is perceived of as the 9/11 of the financial crisis, the moment where liquidity problems that had been bubbling since late 2006 turned into a full-fledged panic and then economic collapse. The question American elites are pondering is, will a Eurozone break-up, or even Greece leaving the Euro, cause another such moment? Ben Bernanke has argued that Greece leaving wouldn’t, since domestic banks have reduced their exposure to problem countries. Paul Krugman agrees, and in a recent interview on Bloomberg, laid out his case.
Question: How interdependent right now, how linked is Europe to the United States?
Paul Krugman: The sheer, the trade linkage, the thing people think well we export to Europe, that’s a lot smaller than people imagine. We only sell 2% of our GDP to Europe, so even a serious European recession, it hurts, obviously, it’s not a good thing, but it’s not that big a deal. The real concern for this side of the Atlantic is financial. Do we see a blowup in European financial markets that spreads worldwide the way ours did? And you know it’s, maybe I ate the wrong thing for breakfast or something, but I’m fairly optimistic that that won’t happen…. Between Mario Draghi and Ben Bernanke, that they can throw enough money at the banking system to keep this thing from being a financial meltdown. I can believe that and believe at the same time that Greece is going to be out of the Euro fairly soon and that there’s a risk that the whole Euro will break up. I don’t think we’re looking at a Lehman style event, which means the impact on the US economy will be fairly limited. Famous last words, knock on wood.
Yet, a key dynamic in the Lehman situation was ignorance – no one quite knew how bad the problem really was. Similarly, no one knows how bad this Eurozone problem will get, or what the linkages are to American banks. It’s possible the linkages are very very significant. Remember that Bloomberg story from last November, in which JP Morgan and Goldman disclosed to shareholders they have sold credit protection on $5 trillion of global debt? They wouldn’t disclose many details, but that’s a fairly large amount of credit protection.
A few days after Krugman’s Bloomberg interview, we began to learn a bit more about what JP Morgan is betting on, that led to a few billion dollars in losses (so far). And it has a direct bearing on the transmission of Eurozone problems to the US.
The unit, the chief investment office (CIO), has been the biggest buyer of European mortgage-backed bonds and other complex debt securities such as collateralised loan obligations in all markets for three years, more than a dozen senior traders and credit experts have told the Financial Times.
So, apparently, aside from trillions in sold credit protection on global debt, the biggest American bank by revenue and profit is deep into speculative investments on European housing bonds. What could possibly go wrong? What’s interesting about JP Morgan’s losing bet in a relatively placid environment is how shocked people on Wall Street and in DC were. This is worrisome, because it implies that market actors simply do not know that there are still severe risks in the banking system, just as they did not understand shadow banking vulnerabilities in 2007-2008. They believed Bernanke’s PR about the “great moderation”, that financial risk had been diversified and effectively managed away.
The cult of personality around Dimon is similar a testament to elite ignorance of possible risks in the banking system. The Dimon story is that JP Morgan escaped the subprime debacle because of the CEO’s wonderful risk-management skills. But one possible reason JP Morgan escaped some of the housing damage is because JP Morgan’s MBS team just wasn’t very good at originating loans and issuing securities. Dimon’s one superb skill is PR, so he turned this weakness into a message of prudence. In 2007-2008, as the crisis unfolded and banks began cutting back on spending, the rumors were that Dimon stepped up and funded very significant amounts of lobbying and PR in DC. Thus, “fortress balance sheet”. And now, there are laudatory stories in the Wall Street Journal about how Dimon “couldn’t breath” after he learned of possible losses, and how he admitted the problem is taking decisive action. Of course, the more likely story is that JP Morgan isn’t well-managed and has risks and interdependencies we don’t understand.
With this in mind, let’s look at whether the Eurozone crisis could turn into a financial panic in the US.
Lehman was the light-switch to full-fledged panic mode during the financial crisis. Investors, over the past thirty years, had moved their deposited money from the regulated banking system covered by deposit insurance to the shadow banking system, where returns were higher but there was no government insurance. One key area where this took place was in money market funds, which held roughly $4 trillion. While technically money market funds are not insured, in reality investors saw them as safe liquid deposits. While they weren’t backed by government guarantees, they were backed by unassailable triple A rated assets, such as, well, Lehman Brothers bonds. So when Lehman blew up, there was the beginnings of a bank run-style panic in the money market funds. Most normal people have their savings in the regulated banking system, so they weren’t in trouble, but wealthy people, foundations, and corporations were in panic-mode. The Federal Reserve eventually stepped in and backstopped the money markets.
Lehman’s bankruptcy had a tremendous psychological impact on the political officials who forced the investment bank to file for bankruptcy, such as Tim Geithner and Ben Bernanke, as well as the entire economics and financial establishment. Subsequently, their attitude became so risk-averse in restricting banks or financial elites, lest they trigger another Lehman-style situation. It was very much a “9/11 changed everything” attitude, except with a financial shock in place of 9/11.
But the real question with Lehman was political, not technocratic. Would the government force the wealthy to pay for their use of the shadow banking system by allowing a run in the money markets, or nationalizing the money markets and forcing haircuts on money market accounts? Would the voters prevent bailouts with deep rage once they realized what was going on? When the government allowed Lehman to fail, the answers seemed like they verged on yes. But as soon as the markets realized, over the course of the next year, that the government would do everything possible to ensure that the shadow banking system would function, with an effective backstop, and that the voters were powerless to act, the panic subsided. The question of the Eurozone’s impact on the US financial system is similar. If the Eurozone breaks up, or even if Greece defaults, it is not obvious who is exposed, or by how much. It’s not clear if the credit protection sold on European bonds would have to be paid out, because there is now no standard for sovereign defaults. There’s also counterparty risk. The number of bets internally at any of our banks is also an unknown. And then there are the unknown unknowns. That Wall Street is shocked by Dimon’s incompetence is in itself an indication that the environment is well-designed for panic.
As Krugman notes, the question on the Eurozone is whether governments, international institutions and central banks will throw enough money at the various national banking system to prevent defaults. Since there are swap lines between the Federal Reserve and the European Central Bank, the ECB can get as many dollars as it wants, in return for colored pieces of paper known as the Euro. American politicians could begin to get edgy on Federal Reserve exposure to the Eurozone. And ultimately, the ECB must be backed by Germany, so the question of what happens will come back to the German political establishment and the politics of austerity. Will Germany pick up the tab for Italian, Spanish, and Greek debt, which is really just a bailout for its own (and French) banks? Will the Greeks vote for anti-bailout parties in the upcoming election?
What I find most disturbing about the question of Eurozone is how little we still know about our own banking system, and how sanguine we are about the extent of American exposure to another financial panic. The assumption that our banks are now well-capitalized, that they have been effectively stress-tested, is, while not completely pervasive, still accepted by a shockingly large number of market actors. It should be pretty clear that our banks are large, rogue, and fragile, and that we just don’t know what they are exposed to, or how their exposures could impact the real economy. Dodd-Frank was a missed opportunity to restructure our banking system to make it more resilient and less able to transmit financial shocks. We may soon get another one. I don’t know if the European establishment is going to prevent the dissolution of the Eurozone or keep Greece in the Euro, but I’m not confident that we can avoid a panic if it does.