* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download BG Perspective 2
Survey
Document related concepts
Systemic risk wikipedia , lookup
Land banking wikipedia , lookup
Federal takeover of Fannie Mae and Freddie Mac wikipedia , lookup
Syndicated loan wikipedia , lookup
Household debt wikipedia , lookup
Global financial system wikipedia , lookup
Interest rate ceiling wikipedia , lookup
United States housing bubble wikipedia , lookup
Shadow banking system wikipedia , lookup
Interbank lending market wikipedia , lookup
Public finance wikipedia , lookup
Transcript
Updated Comments on 2008 Financial/Economic Crisis (December 2008) Since the onset of the full-scale financial crisis in mid September and my comments concerning it, new information and developments have sparked additional questions and clarification of existing questions. How precarious was/is the situation in financial markets? Most people seem now to appreciate that the situation in September/October was serious, yet, just how serious is still not widely understood. On the “wholesale” side of short term credit markets, the equivalent of a “bank run” emerged. Institutions and wealthy investors moved huge sums away from their typical accounts and into Treasury Bills. This put substantial sections of the “retail” financial system (checking, debit, and credit accounts for households and businesses) in extreme danger of being frozen. Rumors from within the Fed indicate that these retail effects came within a few hours of materializing. The behavior of interest rates backs up the rumors. The rate on 3-month Treasury bills dipped near zero while rates on other sources of short term funds climbed to 5% and above -- indicating that these sources had all but disappeared. Why has so much money been put into or put up as guarantees for the banking/financial system? Doesn’t this justify saving any and every large business? Banking and financial firms stand in a unique position at the very center of the crossroads of the “payments system.” Most payments from borrowers to depositors, from employers to employees, from consumers to businesses flow through them. If these payments systems falter on a large scale with only cash purchases and payments and limitations on checking, debit, and credit accounts, the failures and freezes on “Wall Street” would cripple “Main Street” very, very quickly. In this way, banking/finance services resemble basic services such as electricity and water – if they don’t flow, nothing works. If housing markets are at the root of the problem, why not put more money/effort toward limiting foreclosures rates? Because of its immediacy and widespread implications, the payments crisis has been the central focus. However, efforts toward modifying loan agreements are going forward. . Although not making headlines, all of the major banks have implemented policies to renegotiate the terms of large percentages of their troubled mortgages. JP Morgan Chase, for instance, is working on renegotiating over 70% of 65,000 mortgage in difficulty. The FDIC has also been modifying terms on troubled mortgages for institutions that have failed. Some policy makers (such as the FDIC Chairperson) and economists (such as Harvard’s Martin Feldstein and more recently Fed Chairman Ben Bernnake) have encouraged the adoption of broader loan modification plans. For example, the FDIC has forwarded a plan by which the agency would make $1000 per renegotiated loan available to institutions and would agree to guarantee 50% of any losses incurred if modified loans defaulted. Feldstein and others have suggested similar “opt-in” plans. The FDIC estimates a $25 billion expense to their plan. To date, however, policy makers (both the White House and Congress) have not endorsed these plans. The reason appears to be political – each side wanting the other to take responsibility. In addition, the modification of loan terms through renegotiation has been slow because many of the troubled mortgages are bundled together into pooled instruments discussed below. This bundling drastically complicates renegotiation. The rights of renegotiation do not necessarily reside with a single entity. In addition, healthy and unhealthy mortgages are combined together and must be disentangled, a slow process. Is the situation in financial markets improving any? The wholesale side of short term credit between banks and companies has improved but remains very abnormal. Typically the differences between T-Bill rates and other short term funds are tiny -- small fractions of 1%. Currently, the differences run on the order of 2%. Even overnight loans in these markets stand nearly 1% above Treasury rates. The 3-month Treasury Bill rate hovers barely above 0.0%, indicating that many institutions and wealthy investors still harbor deep suspicions about defaults on even these short term loans and prefer to park their cash in the safest haven (Treasury Bills). As widely reported, the stock market continues to swing wildly – down 30-40% since early September. Besides the losses to investors, the downward swings have pushed the stock values of many seemingly viable companies near bankruptcy levels as investors run away from any perceptions of risky situations. Meat processing stocks are a particular example. If companies with relatively sound long run outlooks get pushed into bankruptcy by short term panic selling, that bodes ill for the economy. How did we get here? Can high housing prices and their collapse do this much damage? The housing market comprised part of the iceberg but not the whole of it. The housing market both contributed to and reflected an economy-wide trend from 2001 onward of unusually high borrowing/lending. In 1990, the ratio of household sector debt to income stood at 60%. By 2000, this figure had risen to 70%. In six more short years, this ratio jumped all the way to 100%. Such growth in the “leveraging” of income increases purchasing power. It also generates larger capital gains when the purchased item is a long-lived asset like housing and resold. The trouble is, that such debt-leveraged purchases also fuel greater losses and increases financial stress when prices decline. A combination of influences spurred the rapid expansion of debt and leveraging: a) households that made choices to take on much more debt relative to their incomes; b) very lenient lending terms by banks and financial markets, and c) a variety of government programs intent on expanding home ownership and provide more lenient credit terms. Along side this growing reliance on debt-financed purchases, financial markets developed instruments that they intended to provide “insurance” against defaults in housing markets or other debts. These included the bundling of mortgages and other debs together into “Collateralized Mortgage (or Debt) Obligations” that traded like bonds as well as more exotic forms of debt “insurance” such as “Credit Default Swaps.” Most of the insolvent financial firms and banks such as AIG held large amounts of these “insurance” instruments. The problem with such “insurance” against default is, like all insurance, they work only when small parts of the insured market experience problems. If a sizable percentage of Allstate holders, for instance, file big claims on their insured property in a year, the insurance becomes worthless. That describes what happened in financial markets. With large decreases in housing prices and defaults growing at a pace much higher than anticipated by the financiers, the insurance provided only the mirage of a backstop. What was thought to insure against losses only added to the losses. Will things get as bad as the Great Depression? During the Depression of the 1930s, incomes fell, on average, by 30 percent and unemployment reached 25 percent. Like the 1920s, debt-laden purchases abound. On the down side, the reliance on non-cash payments systems is much higher now than then, making the links between financial sector problems and the rest of the economy more immediate. On the up side, we do have several things going for us now that make a repeat of economic disaster less likely (though not impossible). First, the Federal Reserve (supported by the U.S. Treasury) has been very proactive in trying to keep short term credit markets working and keeping banks operating. So far, when banks have become insolvent, the Fed/FDIC facilitated sales to keep deposits and payments moving. In contrast, at the outset of the 1930s, the Fed essentially did nothing to help the banking system. (See Milton Friedman’s TV series: Free To Choose: Anatomy of a Crisis for details). As a result, thousands of banks failed, many depositors lost their holdings, and credit markets dried up for nearly a decade. The Fed is not allpowerful or all-knowing. Mistakes have and will be made, but, overall, their contributions have helped mitigate, or, at least, push back a catastrophe. Again, the electrical service analogy applies. In the 1930s, when the wires started falling, nothing was done. In the current situation, they continue to be put back up, even if on some shaky soil. Second, many social safety nets such as unemployment payments, social security, Medicaid, and others exist now that did not in the 1930s. This helps those experiencing the most trouble able to continue making key purchasing for their households. Third, Percentages do not tell the whole story. Current household wealth and living standards exceed those of the 1930s by many times. Unlike 1930, very few now live close to subsistence. A 30% reduction in income during the 1930s put many families in a hand-to-mouth existence. Even if average consumption levels fall back to 1990s levels, those levels are still very high. Today, tough economic times for a household of modest income levels will mean cutting back on Christmas purchases, on eating out, on clothing purchases, on travel, or similar items. Yet, with wealth levels, social safety nets, and private charities, food, clothing, housing, and medical care should not only be available but, in most cases, exceed consumption levels from the 1970s much less the 1930s. Isn’t the Fed to Blame? The charge of the Fed being the vehicle for the run-up in household debt gets a lot of traction. While convenient and simple, it just does not hold up to scrutiny. As I noted in the September post, inflation from 2001 to 2005 ranged between 1.6% and 3.4% annually and 13% for the whole period. Blaming a 13% rise in the average price level over 4 years for a 100% increase in some housing markets or an increase in household debt to income from 70% to 100% is a bit like blaming an electrical blackout on the guy who turned on his garbage disposal – yes, there is some connection but it’s a drop in the bucket. One very large misunderstanding pertains to the Fed’s role as “lender of last resort” to the banking sector. To some, even among economists, this means that the Fed should only provide assistance directly to banks. For example, the assistance to “Commercial Paper” markets where money market funds have lots of short term cash at risk has come under criticism. The trouble is that this fails to grasp the “wholesale” side of credit markets and their inter-connections with the retail side. The idea that retail banking services and payments can withstand a freeze on the wholesale side is a stretch. The Fed has made some errors. The decision to let Lehman Brothers fail while rescuing AIG has been widely criticized for precipitating the September financial crisis. Yet, their reluctance arose, in part, out of political criticism from both the left and right in the rescue of Bear Stearns in March (rescue of creditors, not stockholders) and the ensuing “bailing out Wall Street” mantra. The Fed, despite what some may think, is not entirely independent of the political system or climate. Some economists, such as Princeton’s Alan Blinder, have chided the Fed for not communicating the scale and scope of the crisis better; but in this, the Fed stood between two very undesirable alternatives: use relatively broad language trying to reassure depositors and credit holders but failing to really get the attention of the public or express more clearly the true gravity of the situation and create panic. They chose the former as the lesser of two evils. Doesn’t this show that the financial market are regulated too little and that deregulation over the past two decades is a failure? The “deregulation” in banking in the 1980s and 1990s accomplished two primary outcomes: 1) permitting the geographic expansion of banks; this change has helped alleviate pressures on banks in the current crisis by reducing the number of banks with loans outstanding in only the most troubled areas; 2) permitting banks to expand the array of financial services offered; this has no direct link to the current crisis since things like mortgage lending and consumer credit were already part of bank products. Banking and finance in the U.S. are, in fact, highly regulated, witnessed by the thousands of pages of federal regulations in the Code of Federal Regulations related to banking/finance. If just passing laws and rules were the simple answer, we should be in great shape. Markets, in general, are very good at valuing everything from butter to stocks. The current crisis makes more than obvious the fact that, sometimes, market valuations do not make sense. Sometimes, markets fund too much debt. Sometimes, they develop new products, like default insurance, without fully grasping the possible implications. However, it should be noted that it has been nearly 80 years since this kind of broadbased market miscalculation and confusion has ensued. Ideally, politics would provide protections for and from markets that enhance their benefits and limit their shortcomings. Politics, like markets, do not offer utopian solutions. In the current situation, political actions contributed to rather than protecting from things such as high debt to income ratios and too lenient lending policies. Furthermore, political actions often create rules with superficial appeal that do very little good and may do harm. As case in point, one regulatory agenda over the past two decades has been “disclosure” in financial transactions. Yet, anyone who has ever signed papers at a mortgage closing knows that “disclosure” has been regulated to the point of sapping meaning and relevance from it. Fostering a mountain of disclosure ultimately discloses next to nothing. Politicians also often over-react to crisis, searching for voters drawn to simple but misguided “solutions.” In response to the 1930s financial and economic crisis, many stifling policies were adopted or policies that did little more than favor one part of the financial industry over another part or keep wages unrealistically high and worsen unemployment. Rather than trying to come up with all sorts of regulatory solutions limiting financial services or trying to get politicians and their helpers into the business of financial market design such as micromanaging the role of standardized exchanges or clearinghouses, I would propose that just a couple of more modest changes would have kept the current situation from developing into what it has: 1) More stringent capital controls on financial institutions. Broker-dealer firms like Bear Stearns and Lehman faced regulations limiting the ratio of assets holdings versus owner investments (equity). These limits, though in existence, were not nearly tight enough, permitting ratios in excess of 30. To some extent, this advice is moot for the time being, as these broker-dealer firms have become bank holding companies, subject to more stringent capital requirements. 2) More stringent standards and auditing of bank/finance customer creditworthiness and use of funds. Among some non-bank loan originators and among some banks, there was not due diligence to ascertain the true status of customer income/net worth. Of course, this requires politicians refraining from agendas pushing leniency in lending standards. Finally, increased regulatory stringency in these areas needs to be pursued in modestly, not wildly. The idea is not to turn banks into simply money warehouses where deposited money just sits for a fee. In the 1930s, the regulatory response in financial markets substantially lengthened the Depression by limiting access to funding to only a small number of businesses or individuals. We want to provide safeguards without making homeownership or business ventures a cash only business.