First published: Financial Times, 25/02/2008
A transcript of the FT’s video interview with George Magnus, UBS senior economic adviser, conducted by Gillian Tett, global markets editor. They discussed: likely total losses from the credit crisis as high as a trillion dollars; the inability of monetary and fiscal policy alone to solve the problems; the likelihood of major regulatory and legislative changes; and a possible US housing bailout by October.
FT: Gillian Tett, global markets editor, Financial Times
GM: George Magnus
FT: Hello, and welcome to View from the Markets with the Financial Times from London. My name is Gillian Tett, and I am the global markets editor of the FT. With me today is George Magnus, the senior economic adviser to UBS. Well, George, you raised some eyebrows in the markets about a year ago when you started warning that the world might be on the edge of a Minsky moment and a lot of people out there said that that is absolute rubbish, but a year later some of those warnings are starting to look rather accurate. What exactly is a Minsky moment and why does it make the current credit crisis so difficult to deal with?
GM: Well, Minsky, Hyman Minsky, was an American economist who died, probably in 1996. He was very interested in the causes of financial instability so, by looking back through large swathess of history, he identified leverage, effectively phases of borrowing, which were the cause of instability. Not that he was opposed to it as a concept; in fact he thought it made capitalism very efficient. But there came a point in what is, for Minsky, the third stage of leverage, where people start to get a little bit racy in terms of the risks they take. And if the asset price underlying the leverage that’s going on at this stage of leverage begins to fall, Minsky’s problem about this was that investors will want their money back, creditors would cut the lines, and the leverage schemes would collapse. And, at that point, he said that central banks and governments must intervene in order to protect good borrowers and good lenders from going bankrupt, effectively. So I called that a Minsky moment this time last year because I felt that the whole subprime problem was in danger of spreading out of control and that central bank intervention and governments would have to intervene.
FT: Now, a lot of people said, at the time, that’s rubbish, because the dominant idea was that the subprime problems would be contained, but here we are a year later. How much further do you think we have to go in terms of this implosion?
GM: Well, interestingly, Jim Grant, who runs a magazine called Grant’s Interest Rate Observer was asked this last year, and he said that the subprime crisis has been contained; it’s been contained on planet earth. And I think, obviously, that was somewhat tongue-in-cheek, but I think it kind of hit the spot, really, because clearly it has spread now to almost every form of credit instrument, and because of the reactions of financial institutions to losses, either experienced in the past, or anticipated, obviously the credit channels are beginning to fur up and freeze.
FT: So just how bad do you think things would get? I mean, people were saying a year ago that this was going to be contained. Do you think the problems will be contained, or are we just in phase one of an implosion of the credit world?
GM: It’s kind of hard to say, to be honest. I think, certainly, as things look today, I don’t think it’s getting better yet, so the corollary is that things are still beginning to deteriorate. Although, having said that, it’s difficult to distinguish between news that’s coming out just because we have more information which we didn’t have before, and how much of it actually represents a deterioration of conditions, actually, in credit markets, and, of course, in the economy. But I think that most sort of avenues of credit and most credit instruments, clearly, are very much in the frame now; they have been adversely affected, spreads have shot up pretty aggressively everywhere. It’s possible that we haven’t seen all the bad news yet because there are still unresolved questions about what happens, for example, to the so-called monoline – the bond insurers – what happens in the market for credit default swaps. And, obviously, it’s clear that banks still, and lenders generally, haven’t fully recognised the full value of the writedowns which probably will take place during the course of this year.
FT: Do you have a back-of-an-envelope calculation as to how big the total hit could be in the credit world?
GM: Well, looking at the losses in subprime and collateralised debt obligations and related instruments, including the spillover into leveraged loans, for example, certainly colleagues and I think that it’s something of the order of about $500 or $600 billion, which would make it on a scale of the banking crisis of Japan between 1990 and 1994. But I’m afraid we’re still counting, because on top of all of these problems that we’ve had, of course, the US economy is in or close to being in a recession and the European economy is clearly slowing down very significantly. And, of course, we have all the vanilla credit-cycle problems of credit cards, consumer loans, corporate debt, corporate loans, and these things will, obviously, have to be built on to the estimate, so I don’t know. If you want to take a sort of a round number, something close to $1,000 billion at the end of the day is not an impossible number.
FT: So a trillion dollar meltdown.
GM: Of that order.
FT: So if, indeed, we are facing a potential or possible trillion dollar meltdown, what should the central banks be doing about it?
GM: Well, I think the central banks are, or at least the Federal Reserve, I think, has taken out a very, very extreme form of insurance against this sort of meltdown. And, clearly, the speed and the rapidity with which interest rates have come down is indicative of that, and most people agree that that’s not the end of the story that the Federal Reserve will carry on cutting interest rates maybe at least another 100 basis points. The Bank of England has already made a couple of gestures in this direction. Not yet the ECB [European Central Bank] which is a little bit like the Bundesbank in disguise, but when the ECB actually does begin to cut interest rates I think they’ll do so quite aggressively. But this is not really the answer to the problem, in my opinion. I think it’s necessary, and I think it helps, and it certainly is of great benefit to hard-pressed homeowners. And it helps to offset the tightening of credit conditions and monetary conditions which is taking place through the spread markets and through the prices in credit markets. But, actually, it’s only a part of the solution, the solution…
FT: So what else should they be doing, I mean, because everybody keeps looking at the monetary policy question, and we all keep focusing on interest rate cuts?
GM: Yeah, and I think a lot of people still believe that the efficacy of monetary loosening, in conjunction, say, with the US fiscal package that was passed a week or two ago, will actually give us a short, shallow, downturn from which we can, you know, the economy will grow again in the second half of the year. I’m very sceptical about that; I think that the real addition in terms of policy initiatives that we need actually lies in the regulatory and legislative arena, and that when you’re faced with, as we’ve discussed, this kind of Minsky moment where you have problems that are based on balance sheets and on solvency, not just liquidity, you have to go beyond monetary and fiscal policy. And it’s a standard observation throughout history that, when you run into these kinds of problems where balance sheets and solvency are really involved, that government is the only way out, and I think that’s what’s going to happen.
FT: So monetary policy, basically, is not the answer, and we shouldn’t all be sitting there hanging on the ECB or hanging on the Fed and thinking they have the magic or the silver bullet that will manage to solve these problems?
GM: Yeah, definitely not. As I said, I don’t want to diminish the significance of lower interest rates; I think it is an essential part of the healing process and of the adjustment process. But on its own cheapening the cost of credit actually is not going to stop house prices from falling and it’s not going to stop collateral values from declining, so you have to address the problem differently.
FT: In spite of that, you say you think that the ECB will cut rates pretty aggressively. When do you expect that to happen?
GM: Well, of course, the ECB and the governors, obviously, can say, hand-on-heart, well, we have an inflation target – that’s our raison d’être – and as yet we don’t find the wherewithal to be able to justify interest rate cuts. That’s, of course, on the face of it, quite true. At the same time I think it’s also evident that, behind the scenes and, maybe, privately, the governors of the [European] Central Bank also know what’s going on. The economy is slowing down and some of the changes that are going on within the monetary sector in Europe and, particularly, within the banking sector, clearly are well known to them. So I think that probably around April or May would be when I think the ECB will start to move. For me it’s a little bit late but I think that’s still manageable.
FT: So within two months we’ll all be having some Frankfurt fireworks, as it were.
GM: Well, possibly.
FT: So, if monetary policy is not going to solve this by itself, what else can governments do? Are we going to basically end up with a situation where taxpayers will be footing the bill for the credit excesses?
GM: I think it’s inevitable. Of course, here in the United Kingdom, the saga about Northern Rock, of course, is now, I think, kind of reaching, or has reached, a conclusion, and, clearly, to the extent that we have some form of nationalisation or public intervention, there is a bill for taxpayers. This is pretty small beer, I think, compared with the kind of activities which I think are going to take place in the United States. And I think that a bailout for homeowners in the United States is as close to a surefire thing as I can imagine. The losses on mortgages are so high and the stories and estimates which, perhaps, more significantly, people make about repossessions and delinquencies in the housing market are so high that, especially in a presidential election year, I think it’s just inevitable that there will be very strong action from the Congress. The chairman of the Senate banking committee, Senator Christopher Dodd, is already on record as having indicated the way in which he personally would prefer the situation to be dealt with. And I think we have something of a time limit too because, of course, in October the US Congress goes into recess and the new Congress won’t reconvene, I suppose, until after the State of the Union message in late January 2009. So by the time they get round to action it might actually be quite late in the day, so I think the first bailout package, to be honest, I think is going to happen between now and the end of October.
FT: Gosh. Now, that can be jolly politically controversial. I mean, if we’re actually seeing taxpayers having to foot the bill for, effectively, Wall Street’s excess, that is going to be a pretty strong election debating point.
GM: Yes, and I think, I mean, strong, but I don’t think we should be surprised. I think Hilary Clinton and Barack Obama have already alluded to this kind of an outcome, so the Congress or, certainly,the Senate, would pick up this baton and move in this direction, should be expected. At the same time the Securities and Exchange Commission and the Federal Reserve banking agencies are having discussions and holding consultations about all sorts of things to do with mortgage lending, about hedge funds, private equity, and, I don’t know… Much of this may be just talk, talk, and will not end up anywhere, but I suspect that over the next year or two, or longer, that we will face very, very significant changes in the regulatory environment.
FT: So the market should be pricing in for a regulatory backlash potentially?
GM: Well, we should, and, in a sense, there isn’t really any other option, to be honest, because when monetary policy and fiscal policy have limitations insofar as instilling confidence in normal lending and borrowing functions, you need to basically change the rules, and I think that’s what the government sector has done.
FT: But what about people who say to me right now, well, after LTCM [Long Term Capital Managment] there wasn’t really a sweeping regulatory backlash, even after 87 there wasn’t anything that dramatic in terms of changing the way that finance is done? Do you think that that is different from the situation now?
GM: I do. And I think Long Term Capital Management, the 1987 stock market crash, 9/11, possibly other instances like the Mexico crisis in 1995, these all felt like the end of the world in financial markets, but actually they weren’t. They left no lasting economic damage, and the losses were actually containable within either an institution, or a narrow part of the financial system. I think this is different: a) because it’s big; b) because it’s widespread; and c) because it is about solvencies, not just about liquidity. And solvency requires a totally different policy approach than just a liquidity problem.
FT: Well, that is pretty clear cut and pretty chilling as well, so thank you very much indeed.
GM: Thank you.