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Monday, November 17, 2008

Leverage limits should be determined by the need to moderate deflationary cycles, not by the riskiness of the leveraged assets

A friend who witnessed the sub-prime meltdown from the inside confirms one of my suspicions about the regulatory failure. How did regulators ever let these markets get so overleveraged? They must simply have taken their eye off of the need to keep leverage in a certain safe range, and instead set margin requirements based on some theoretical determination of the riskiness of these complicated subprime assets.

Yup. Instead of trying to keep leverage ratios in a rule-of-thumb safe zone, they tried to derive a theoretically "proper" leverage ratio for assets that they never even understood. Apparently they ended up allowing twice the leverage ratio of traditional banks (up to 20 to 1, versus 10 to 1 for commercial banks). Banks are actually subject to multiple requirements--reserve requirements and capital requirements and other oversight--that make them fundamentally safer than investment banks and other non-bank brokers to begin with. Thus the regulators allowed inherently less safe institutions to run half the margin requirements of safer institutions. Pure insanity.

Even if the regulators did understand the assets, they were looking at leverage ratios the wrong way. The reason to limit leverage ratios is to limit the vicious cycle of deflationary feedback in the event of a market downturn. We have learned through painful history that if markets get too leveraged they become unstable, prone to speculative bubbles and deflationary collapse (where leveraged holders are forced to sell to consolidate their positions, further driving prices down). As a rule of thumb, reserve requirements and margin requirements in the range of 20% have been found to be cautious and safe; reserve requirements of 10% are reasonable; while leverage ratios much beyond 10% are dangerous, regardless of the riskiness of the assets themselves.

The riskiness of the leveraged assets only determines the likelihood of a negative shock, but the likelihood isn't what matters. We want to be able to survive an event, whether the probability of its occurring is 1 in 10 or 1 in 100. The purpose of limited leverage is to make sure that when market downturns do occur, they don't create a propagation of bankruptcy that extends beyond the real shock to the economy. Economies are always going to suffer large and small shocks. We just want the shocks to be contained to the necessary damage, without creating a general propagation of collapse.

The subprime regulators took their eye off that ball. They thought (wrongly) that these assets had very little chance of turning belly up and deduced (wrongly) that that made it okay for investment banks to hold these assets with very little margin. But the margin requirement should be set, not by the likelihood of the assets turning belly up, but by the need to limit the propagation of collapse in the event that the assets DO turn belly up.

It makes sense to allow SOME adjustment for the safety of the assets. We impose substantially greater reserve requirements for stock speculation (25%) than for normal bank loans (10%), but there's no excuse for allowing leverage ratios to get outside of the normal rule-of-thumb bounds, especially when regulators didn't even understand the assets that they were dealing with. Faced with that fundamental uncertainty, they should have turned to traditional leverage ratios as a guide, and it's hard to understand why they didn't.

Maybe there was corruption involved. We know that the Republicans tried for years to curtail irresponsible behavior by Fannie Mae and Freddie Mac, while Democrats like Barack Obama and Barney blocked reform efforts so that their friends could keep feeding at the public trough. On the other hand, the people who allowed the tiny subprime margin requirements are either executive branch (the SEC) or independent (the Fed).

I'm guessing that in this case the regulatory failure was a classic case of the regulators being captured by the industry. They all become buddies, and it's hard for the regulators, who understand less than the industry people, to tell the industry people that they're wrong, especially when the industry is making money hand over fist. It's only when it all goes wrong that they all start remembering why they're supposed to be cautious.

Treasury Secretary Paulson himself is tremendously vulnerable to that dynamic. Not only is he pals with the honchos at Goldman Sachs (a primary beneficiary of the bailout), but he probably still has a good chunk of his $500 million there, giving him a tremendous conflict of interest. Given his evident lack of expertise (claiming earlier this year that: "our banks and investment banks, are strong"), that conflict is hard to justify.

Changing the bailout plan from TARP (Troubled Asset Relief Program) to re-capitalization

This could be a move in the right direction, if it is done right. The original bailout plan was probably a dead letter. How was the government going to do a better job of pricing and managing all of these complicated assets than the bankers whose job it is to price and manage complicated assets? At best this was going to take time, but it seems that time has already made the TARP approach passé.

According to my friend in the business, the bad debt from the ill-advised sub-prime lending has already “worked its way through the system,” via the traditional tools that the Fed has at its disposal for combating financial instability. First is the Fed's discount window (making loans to banks, with the banks’ long-term assets as collateral). The discount window addresses the fundamental instability of the banking system: that a banks liabilities are short-term while its assets are long-term, raising the prospect of “runs on the bank” in the event of a financial panic. It looks like the Fed has already made a couple trillion dollars worth of discount window loans, but that only solves half the problem.

The banks long-term assets have taken a major hit thanks to the sub-prime meltdown. If the sub-prime meltdown has already “worked its way through the system,” that means the loss of asset value has been incorporated into everybody's balance sheets and stock values, leaving us with a bunch of undercapitalized banks. In normal times, the Fed handles the periodic bank failure by facilitating a reorganization, where the distressed bank is taken over by a healthy bank, with something close to a complete loss of equity value for the owners of the distressed bank.

The current crisis is too deep to be managed by reorganization alone. The healthy banks are not healthy enough to absorb the failing institutions and still have the resources to do the lending that they need to do if the economy is to function. Unfortunately, says my insider friend, simply infusing the reorganization efforts with bailout money is already proving not to work. The treasury has pushed huge amounts of money on some of our biggest banks in hopes that they will lend it, but instead they've actually tightened credit.

It isn't that they are afraid they're not going to be paid back. The problem is that they have better things to do with the money then lend it. With banks collapsing all over, any institution that has money can pick up valuable assets at fire-sale prices, so instead of doing their jobs (making the loans that allow the economy to function) they go on shopping sprees to improve their balance sheets. It makes perfect economic sense for them. It just doesn't solve the banking crisis.

This was the impetus for Ed Koch’s letter to Treasury Secretary Paulson and Federal Reserve Chairman Bernanke, asking them to require banks to make loans to “creditworthy” customers. But can the government really bully banks into doing what is not in their interest? Such an approach is doomed to fail.

If we have gotten ourselves to such an impasse, a better alternative--one that might actually work--is for the government to buy the failing banks itself. Then it can run them how it wants, infusing them with loanable funds and having them perform the traditional banking role of making loans, so that the economy can continue to function. Once these banks are back on their feet, the government can sell them, and it ought to be able to make a profit in the bargain. There is a reason why the healthy banks want to buy up the distressed banks. They are getting a good deal, which means the government can too. Today's failing banks are loaded with valuable assets that should pay off over time. Get them through the present crisis (and run them so that they help all of us through the crisis by doing their money-lending job), and the asset value should prove out in the long-term, so long as the government's bank managers don't use recapitalization funds to go making more bad loans to un-creditworthy borrowers.

The government already took an equity position in the AIG bailout and essentially took over management. Whether this kind of takeover is part of the current bailout plan I don't know. It seems that Paulson and Bernanke are figuring things out as they go along. But if they are going to try temporary nationalization, I will think they might be on the right track.

The banking crisis HAS to be solved

President Bush:
Those of you who have followed my career know that I'm a free market person -- until you're told that if you don't take decisive measures then it's conceivable that our country could go into a depression greater than the Great Depression’s. So my administration has taken significant measures to deal with a credit crisis.
What he said. Just remember that this mess was not caused by market institutions, but by government pressure to ignore market driven limits on lending. Congressional Democrats forced the sub-prime markets open. Sarkozy has it ass backwards when he says that the current crisis disproves the idea that “everything could be solved by deregulation, free competition and the market.” The banking system does need to be regulated, but as usual, the problem has been too much government, not too little.

Still, now that we are in this mess, we had better do whatever it takes to fix it, including such drastic steps as temporary nationalization, if that will work. The change in the bailout plan might lead some people to think that the urgency of the original plan was trumped up (especially given Paulson's private interests in bailing out his cronies), but it wasn't. The word I got from inside the business was that Armageddon was days away. The bailout money was needed. It just got shifted from TARP to recapitalization because the ground shifted. The troubled assets got incorporated into everyone's balance sheets and the emergency became the lack of capital.

Hopefully these guys can get ahead of the game and figure out how to head off the next crisis instead of just responding to it, but if they can't, it's still better to respond than not.

Nationalization in the age of Obama

What makes a strategy of temporary nationalization particularly risky today is that we just elected a president whose mentor advocated violent overthrow of American capitalism, while Obama himself shows every sign of being a ruthless aggrandizer of whatever power he can get his hands on. He is already deeply implicated in systematic vote fraud and systematic campaign finance fraud. We just elected Hugo Chavez as our president. Such a man is likely to turn temporary government ownership into permanent nationalization of the banking system.

Maybe we could put a mandatory sale date on any equity stake the government takes in any bank reorganization. Not that that would be much protection. The fact is, Obama's gonna do what Obama's gonna do. We elected this radical leftist president. It's a little too late to think about containing leftist tendencies. The barn door is already open. All we can do at this point is try to pursue the best policy.

I am far from certain that the best policy is temporary nationalization, but even in the best of times, the mismatch between short-term liabilities and long-term assets makes the banking industry inherently unstable and in need of government intermediation. It is a quasi-government industry to begin with, so a bigger government role is to be expected in a period of crisis.

In general, a lighter touch is preferred, where it can get the job done, but it seems fruitless to try to manipulate banks to do what they don't want to do. If in today's extreme circumstances it doesn't make sense for banks to act like banks, then having the government take temporary control of failed banks is an obvious solution.

A little temporary nationalization could also put a much-needed damper on the rising tide of cries for bailout money. When getting a bailout means losing ownership, expect the movers and shakers to withdraw their hands as if from a cobra.

The problem with a bailout is that it rewards irresponsible behavior. A buyout does not. That might satisfy conservatives like Michelle Malkin who are concerned about equity: “I pay my debts you pay yours!” If you don't pay your own debts, you no longer own the store.

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