Thursday, March 27, 2008

Not At Fault

Yes, we're in a financial crisis, but Megan McArdle explodes six "market myths":
  1. The Iraq War did not cause this problem

  2. The Bush tax cuts also did not cause this

  3. Being on the gold standard would also not have prevented this mess

  4. Among the many other things that did not cause the current crisis was the repeal of Glass-Steagall

  5. The collapse of Bretton Woods--also not a cause of the current crisis!

  6. The long twilight of American economic might is not yet upon us
The actual cause? According to the Economist:
the rise of the American financial-services industry's share of total corporate profits, from 10% in the early 1980s to 40% at its peak last year. Its share of stockmarket value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services account for only 15% of corporate America's gross value added and a mere 5% of private-sector jobs.

source: The Economist
(via Instapundit)


MaxedOutMama said...

Yes, except that the repeal of Glass-Steagall has a huge amount to do with the problem. She's completely wrong about that. Securitization is not the problem. Securitization has been around for a very long while and actually makes sense. By aggregating large pools of loans, you spread risk and make it predictable. This allows you to charge less for risk and produce a much more "even" product. Charging less for risk while still covering the risk allows you to create less defaults and generate wealth.

You've basically got financials in businesses like insurance, aggregating risk. This began early in the 1990s when the Clinton administration granted waivers. The reason why is that the financials aggregated risk is that there are huge financial incentives to do so. So you have a putative "bank" like CW which is actually in all sorts of mortgage-related businesses. Everybody wanted to set up their own insurance arm, etc. And for a while the money rolled in, but now it's a friggin' nightmare.

And JPM had to be PAID to take Bear Stearns. The reason why Bear Stearns couldn't be allowed to default was that it extremely active in stuff like credit default swaps. Bear was huge in derivatives. So if it went, everybody got a knife in the stomach.

But the economic imbalance you note about the financial services profits is correcting. It is the result of malinvestment. The malinvestment was created by disproportionate profits generated by the financials, and the disproportionate profits were generated by undercharging for risk. Naturally, they were temporary profits.

OBloodyHell said...

So, MOM -- when the music stopped, who got stuck without a chair to sit on?

Anonymous said...

I agree with MOM.

The Economist might not be digging deeply enough. Maybe MOM should look deeper into the core issues, too. Why was there malinvestment created by disproportionate profits generated by the financials, and why was there undercharging for risk? Whose fault is it? Perhaps there were (and still are) seismic problems with the divergence of traditional economic theories and policies and the new, Internet-connected world: Analog Dial-up meet Digital Broadband. Foreshocked is forewarned.


MaxedOutMama said...

OBH - the financials, but also the investors. And since the people who are into fixed-income are often retirees or those saving for retirement, it is indeed Bloody Hell.

For someone who is not deeply immersed in banking, the easiest way to understand the effect of repealing Glass-Steagall is that it eliminated checks and balances. In essence, it is as if the powers of Congress, the Presidency, and the Judiciary were all concentrated in one institution.

Investment banks are the entities that create financial products. Commercial banks are the entities that do the lending. Insurance companies are the entities that lay off risks for a fee.

The 90s changes in a law allowed insurance, investment and commercial functions all to be owned by the same company, but did not institute any new system of checking for risk.

This made it possible for an institution to make money off making bad loans, insuring the rate risk, securitizing them, selling them to investors, and servicing them.

Under the old system these were different entities, and each of them had the ability to shift the responsibility for bad decisions back to another counterparty. This made it essential for the commercial bank not to hand bad loans to the investment bank, etc, because the investment bank would send them back. Since the parties were all getting revenue from only one part of the process, they all had contractual agreements with each other about responsibilities, and any party had a strong incentive to control the fundamental health of their own profit-generating business.

But when one company owns everything from the servicing op to the commissions on the sale of the security, it changes the risk picture. The company knows it will get revenue on origination, servicing, insurance, and sales. The initial profits are very high even on very bad loans! Therefore the risk is deferred and future whereas the profits are immediate. This produced a huge incentive to underplay risk, devalued the stocks of more conservative companies, and created soaring wealth for more reckless companies.

Carl said...


I don't get it--securitizations predated 1999. So did the meltdown of Long Term Capital. What, exactly, did the repeal of G-S do to cause the current crisis?

Carl said...


Perhaps you agree with Robert Samuelson, who argued in a March 18th article:

"What distinguishes this crisis -- which brought down Bear Sterns over the weekend -- is that it involves the entire financial system, not just depository institutions, and it's more mystifying than any of its predecessors.

Previous financial crises so weakened the banks and savings and loans that they lost their primacy. As recently as 1980, they supplied almost half of all lending -- to companies, consumers and home buyers. Now their share is less than 30 percent. The gap has been filled by "securitization": the bundling of mortgages, credit card debt and other loans into bond-like instruments that are sold to all manner of investors (banks themselves, pension funds, hedge funds, insurance companies).

As a result, the nature of financial crises changed. With a traditional "bank run," the object was to reassure the public. The central bank -- the Federal Reserve in the United States -- lent cash to solvent banks so that they could repay worried depositors and preempt a panic that would spread to more and more banks and would ultimately deprive the economy of credit. But now the fear and uncertainty center on the value of highly complex, opaque securities and the myriad financial institutions that hold them.

At the center of the crisis are the now-notorious "subprime" mortgages made to weaker borrowers and subsequently "securitized." On paper, the financial system seems to have ample resources to absorb losses. Commercial banks have $1.3 trillion in capital; U.S. investment banks in 2006 had an estimated $280 billion in capital -- and other investors, including foreigners, may hold half or more of subprime loans. But no one knows who or how much. Recent estimates of subprime losses range from $285 billion to $400 billion. They might go higher. Ignorance breeds caution and fear.

The stunning fall of Bear Stearns reflects these realities. It was not a traditional commercial bank that took deposits from the public but America's fifth-largest investment bank, which funded most of its operations with borrowed money ("leverage"). On average, the ratio of borrowed money to underlying capital for investment banks and hedge funds is about 32 to 1, according to a recent study. Many of these loans -- commercial paper, "repurchase agreements," bank credits -- are backed by the securities owned by the borrowing financial institutions.

What this means is that if lenders became worried about the worth of these securities, they might ask for more collateral or pull their loans. In effect, that's what happened to Bear Stearns."

If so, perhaps you can explain the argument to me. Ok, this time it was an investment bank rather than a commercial bank. Is the difference simply that investment bank are more highly leveraged? Or that they don't tend to cover their down-side risk?

MaxedOutMama said...

Bear Stearns isn't a bank. It's a financial firm regulated by the SEC. It was less well capitalized than the other majors by the point when it failed. Bear Stearns has been rather famous for not cooperating with other investment banks when the chips were down, so no one was going to help it.

It was heavily into derivatives like CDS, plus MBS, and if it failed it would have had to sell into a declining market. Counterparties would have had direct write-offs, and the sales of its assets into the market would have caused huge additional writedowns for the rest of the system.

The FRB doesn't regulate anything about Bear Stearns except in relation to its broker status.

Banks are regulated by one or some combination of the FRB, OCC, FDIC, and states. Thrifts are regulated by the OTS. Credit unions are regulated by the NCUA.

A company that does what Bear Stearns & Co, Inc. does (i.e. package securities, brokerage ops, arrange big money deals like IPOs) is commonly known as an investment bank and is regulated by the SEC. For commodities ops it would be regulated by the CFTC. Broker dealers are able to deal directly with Treasury and have some low level of scrutiny on those operations.

All the discussion about subprime is a misdirection. The worst losses out there are going to be on Alt-A, and the greatest total of losses may come from prime eventually. As a percentage, some CMB (commercial mortgages) will deliver the worst losses, and CC and auto debt securitizations are a problem too. Also LBO (leveraged buy-out debt) and poor quality commercial debt are delivering hefty losses. Basically it is every debt category out there.

I heard last week that you can buy Fannie 15-yr PUD bonds for 90 on the dollar with a 5.75% coupon, so you can see how bad things are already. (That's a 10% discount meaning an effective 6.39% rate - junk bond.)

If you are leveraged up 10 times, a 10% loss wipes you out and BSC was more leveraged than that.

The collapse of the monoline bond insurers is what caused this. Even if they haven't been officially downgraded, no one expects most of them to be able to pay out on all claims.