The Lesson of the Financial Crisis

Would tighter control have prevented East Germany from collapse? An analogous lesson to avoid future financial crises is currently offered all over the world by both professionals in financial stability and all-round intellectuals, in particular.

Of course, there were skeptics who did not believe in the Fed funds rate cut of 18 March 2008 as a healer of the credit crunch: why an additional dose of the same drug, low nominal and real rates of interest which was behind the excessive growth of credit and money. There are possibly fewer skeptics who see the on-going crisis as a consequence of the regulatory system of banks.

Any effective measure of regulation creates its own counterforce that tries to nullify the initial impact of regulation because inventive individuals are always clever in finding out ways to circumvent the constraints set on them. Solvency regulation of banks is based on the risk-weighted assets in the balance sheet of a bank that must be matched by the minimum of the so-called tier I capital, i.e., equity in practice.

Because equity is an expensive source of funding the simplest way to avoid issuing new equity is to reduce the size of the risk-weighted balance sheet in respect of a growing loan book. Therefore the US financial institutions transferred the risky loans off balance sheet by the originate-to-distribute practice. Though in Federal Reserve Chairman Ben Bernanke’s words the model "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," he believed in fixing the model April 10, 2008. My Green cheese factories post explained why the credit risks were not transferred off balance sheets in the end and why recapitalization of the financial institutions quickly would help the central banks to fight the inflation problem.

An additional means to reduce the size of the risk-weighted assets is to buy insurance for the loan book which contributed to the exceptionally low world interest rates. AIG, an established and profitable insurance company but a novice in evaluating credit risks, was the biggest underwriter of such deals, i.e., the final counterparty that was supposed to bear the risks of mortgage defaults.

Perhaps the final feature of the US system which so abruptly ended the music playing is that their mortgages are non-recourse loans. Such a legal contract gives the borrower the incentive for walking away from the mortgage whenever she expects the value of her house to remain below the value of the mortgage. After the repossession of the collateral, the mortgage will no longer be the borrower’s problem, but the bank gets an additional problem from the realization of the house.

Imagine yourself as investing the extra cash of your bank in short-maturity mortgage backed securities to awaken next morning to the fact that your over-night investment returns a capital loss. You would immediately lose confidence in the issuer of the securities and in all those middlemen who originally helped in its issue. That is why short-term money market rates of interest, libors and euribors, shot up well above the steering rates of the central banks.

Tight solvency regulation of banks combined with low steering rates of central banks is at the root of the current crisis.

One policy comment focuses on tighter regulation, another on better regulation and a third comment on border-crossing regulation in preventing the world from future crises. East Germany was controlled by border-crossing military forces. They did not prevent it from collapse, though choked down uprisings.

The US bill for a “bad” bank

George Soros also favored the recapitalization of the US banking system in yesterday’s FT rather than relying on the purchases of bad “assets” from the US financial institutions. In Paulson’s plan the bad assets are not real assets but “toxic” packages of claims to real assets. That is why the acceptance of Paulson’s plan will not end the game, but allows it to continue.

In the best tradition of Stalinist central planning, the bureaucrats will continue to decide which institution has no perspective (Lehman Bros) and which will have (AIG). Paulson’s plan does not attract co-financing from existing or potential new investors in the troubled institutions unless the bureaucrats are known to treat the institution in question very generously indeed.

That is why Paulson’s plan will be expensive for the taxpayers, driving the US dollar to a state of permanent undervaluation.

Modify Paulson’s plan!

Do not offer to buy bad assets from financial institutions but offer them capital infusion, Mr. Treasury Secretary! Cannot you invent any fiscal incentives for the first-time homebuyers that would re-vitalize housing market?

Events of the current financial crisis unfold very quickly - during those days and weeks spent abroad or in the outback, in particular. That is why I have had no comparative advantage over financial press to comment the process.

Paulson’s rescue plan rejected by the House would have given the bureaucrats broad powers to buy mortgage backed securities from distressed financial institutions at deeply discounted prices. That is, the bureaucrats would determine in casu how big a hidden subsidy each deal would involve for the seller institution.

Why cannot the banks and other financial institutions themselves trade such assets at market prices? They lack strong enough financial muscles.

The idea of recapitalizing financial institutions in the April 21st post stated that only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.

Since nationalizing Freddie Mac and Fannie Mae less than a month ago, the US Treasury has been subject to wide criticism for rewarding short-term players, short sellers, by nullifying the existing long-term value investors’ equity stakes. On this chosen road no private sector investor will participate in the recapitalization of any US financial institution.

US Treasury must do it itself by offering convertible notes which would count as tier I capital for the institutions. All banks subject to federal regulation should be eligible for accepting such an offer of capital infusion in proportion to their size, measured by their risk-weighted assets and off-balance –sheet commitments as stipulated by the BIS standards. The total of the capital offering of the size of 200 billion dollars, about 1.5 percent of the GDP, is roughly needed.

And, the terms should such that the offering would be attractive enough even for the most solvent and most liquid banks: a seven-year note, the first two years at the current interest rate on the 2-year US treasuries (about 2 percent), the third year interest rate at Libor, and thereafter each year at rising penalty rates above the Libor.

Such terms would buy time for settling the crisis. The offer of capital would provide the strongest institutions enough power not only to acquire assets at market prices from the weaker ones and to raise additional tier I and tier II capital in financial markets, but also would offer them an incentive to pay back the notes to the US Treasury before the convertibility carver threatens their independence.

Instead, the taxpayers’ money should be directed towards attracting buyers to the housing market. Buyers flee the market if they expect home prices to further fall. The most obvious target group, mentioned most often, is the first-time buyers, whether they intend to buy new or existing homes. There must be ways of temporarily granting a more generous mortgage relief or deducting one-off expenses from taxable income.

The above scheme would represent a market solution to the current crisis of financial markets in contrast to Paulson’s plan of giving power to the bureaucrats, i.e. to the central planners.

(Incidentally, I happened to participate in settling the Finnish banking crisis as deputy member of the board of the Government Guarantee Fund)