Editore"s Note
Tilting at Windmills

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March 25, 2008
By: Kevin Drum

LEVERAGE....Contrary to their reputations, bankers have a well-known tendency toward imprudence. After a few years of good times, they usually overreact and start making too many chancy loans. When the market corrects, they overreact in the other direction and turn the loan spigot down to a trickle. This is completely normal.

The same thing is happening now, except worse: credit markets haven't just cooled off, they've almost completely frozen. Partly this is because most modern financial institutions have a big chunk of their assets invested in complex instruments that were originally valued by impenetrable computer-driven models, and when those models failed no one knew how to revalue the affected securities. Trading in them stopped, and when that happened access to credit dried up as well. After all, no one wants to extend credit to institutions holding a bunch of illiquid assets of questionable value.

But that's not all there is to it. Tyler Cowen:

This gridlock is especially harmful because leverage is so high, and financial institutions are so interconnected through swaps and loans. Institutions that rely so heavily on debt are precarious and need up-to-date information about valuations. When they don't have it, markets freeze up. This is what has taken policymakers by surprise and turned a real estate crash into a much bigger financial problem.

In an ordinary commercial bank, leverage is regulated by the capital requirements of the Fed. However, outside the commercial banking system — i.e., most of the global financial industry these days — leverage is barely regulated at all. Capital requirements don't apply, and astronomical bets are made on minuscule and subtle arbitrage opportunities. Because the bets are so big, failure is big too. Today Tyler expands on his suggestion that insisting on consistent capital requirements everywhere is one of the key reforms that we need to consider going forward:

  1. As long as the Fed and Treasury are providing a safety net, insisting on capital requirements is entirely reasonable and it lowers moral hazard. If you're going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips.

  2. When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy's leverage ends up in the unregulated shadow banking sector.

  3. If you are anti-regulation on this issue, make the capital requirement relatively low but still impose it symmetrically across financial sectors.

  4. Ideally capital requirements should be adjusted for risk. That probably implies higher capital requirements for shadow banking activity, not lower requirements.

  5. Regulatory issues aside, market participants are less sure of themselves in the shadow banking sector. Derivatives are non-transparent, for a start. That's another reason not to push too much financial activity into the shadow banking sector.

  6. A final solution to excess risk-taking and leverage has to come from shareholders; regulation can only do so much and of course capital requirements are only a small part of regulation. But in the meantime I think the case for more symmetric capital requirements is a strong one, recognizing all the usual comments about horses and barn doors, etc.

This is a no-brainer, I think, sort of a litmus test for hackdom (i.e., if you aren't willing to accept even an obvious reform like this, you're just a hack). After the LTCM debacle of 1998, the great and good, including Robert Rubin and Alan Greenspan, solemnly produced a report explaining that "excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole," and suggesting that we should "encourage," "promote," and "consider" guidelines that might prod financial institutions into reducing their drunken sailor approach to leverage. As we now know, the financial institutions of the world gravely considered those recommendations and then went about their business.

Now, among other things, I'd say that Congress also needs to take a close look at the role that rating agencies have played in our current meltdown. They pretty clearly were not operating as honest brokers. But if the Fed is going to act as lender of last resort to everyone, not just Bob's Savings & Loan down the street, then at a minimum everyone needs to be required to restrain their betting to levels that don't threaten the entire financial system if they collapse. This is a pretty moderate proposal, and probably ought to be one of our first steps. For more, read this New York Times piece.

Kevin Drum 5:58 PM Permalink | Trackbacks | Comments (34)

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Comments

You can thank the Slickster and the DLC.

Hillary Clinton denial she ever supported financial liberalization should be out in time for the late local news.

Obama claim to support unspecified "change" in the system will be on the morning press briefing tomorrow.

Carry on.

For more left-liberal non-Democratic blogging, see my blog.

Posted by: SocraticGadfly on March 25, 2008 at 6:04 PM | PERMALINK

Nobody's as levered-up as Joe Blow homeowner. Everything else is just icing on the catastrophic risk cake.

Posted by: Ed Drude on March 25, 2008 at 6:07 PM | PERMALINK

When they don't have it, markets freeze up. This is what has taken policymakers by surprise

Stupid policymakers by surprise maybe. The economics blogs have been talking about this possibility for years.

Sounds to me like we need to replace the policymakers.

Posted by: Walker on March 25, 2008 at 6:10 PM | PERMALINK

This is semi-related. What is with McCain talking about doing away with mark-to-market accounting rules? Is that as insane as it sounds -- the problem is too much accurate information that scares people?

Posted by: dp on March 25, 2008 at 6:12 PM | PERMALINK

prod financial institutions into reducing their drunken sailor approach

Why is everyone always picking on the Navy? Doesn't anyone else ever spend recklessly? How about a "drunken Senator" approach?

Posted by: Quaker in a Basement on March 25, 2008 at 6:17 PM | PERMALINK

President Bush has shown us that teetotallers can outspend the drunk handily.

But I am shocked to find myself agreeing with Tyler Cowen completely, and for all the reasons that he states (that regulation/requirements should be uniform, in particular).

Posted by: dr2chase on March 25, 2008 at 6:29 PM | PERMALINK

"Congress also needs to take a close look at the role that rating agencies have played in our current meltdown"

Agree with that.

But I don't think consistent capital requirements can be instituted. (Even if they are made specific to the type of product, which seems impossible given the thousands of types of products). Margin requirements are just collateral for loans - reflecting a complicated assessment of borrower history, expertise, some kinda VaR calculation (amount that might be lost in a given period), the borrowers total portfolio/total business risk, etc.

Banks will always make loans to entities which wanna then re-invest it. If margin requirements were increased, banks will probably just structure the loan contracts differently to get around them - mitigating the risk in another way.

Maybe I'm wrong, but I don't think it can be done technically, and the industry would simply innovate around it.

Posted by: luci on March 25, 2008 at 6:50 PM | PERMALINK

The other alternative is that the Fed could NOT act as a "lender of last resort" to everyone.

Posted by: Sean on March 25, 2008 at 6:52 PM | PERMALINK

I understand the logic of bailing out LTCM and the financial industry for the good of the whole economy, but what bothers me is the individuals who ran their companies into the ground were also bailed out. I saw the palace one of the LTCM principals built for himself on the PBS special and wondered how come this fucking asshole was able to keep his fortune after requiring a public bailout of billions of dollars in order to save the financial markets he would have ruined with his imprudent leveraging of capital.

The individuals who run financial institutions so far into the ground that they threaten economic solvency and require public bailouts ought to have their fortunes forfeited and prevented from working anywhere but as dishwashers. That should stifle some of the institutional imprudence of these financial fuck wizards.

Side note: I saw Robert Rubin say Hank Paulson was doing a great job as Sec. of Treasury on the Bloomberg channel last Saturday.

Posted by: Brojo on March 25, 2008 at 6:58 PM | PERMALINK

Brojo: prevented from working anywhere but as dishwashers

Hey! When I was washing dishes I wouldn't have wanted to rub elbows with scum like that. Maybe Norman Rogers needs a poolboy or something.

Posted by: thersites on March 25, 2008 at 7:04 PM | PERMALINK

Brojo >"...prevented from working anywhere but as dishwashers...."

Send them to The Empty Quarter.

Per my comment in the previous thread, they can work with all those other Randians creating their fantasy world there.

"The comfort of the rich depends upon an abundant supply of the poor." - Voltaire

Posted by: daCascadian on March 25, 2008 at 7:15 PM | PERMALINK

I became a dishwasher after dropping out of college. I guess I wouldn't want to work with those lying financial fucks or use any dishes they washed.

The individuals who run financial institutions so far into the ground they threaten economies need to become untouchables.

Posted by: Brojo on March 25, 2008 at 7:18 PM | PERMALINK

I think we are talking about a competitive monetary system where more groups can issue money then standard banks.

How is Kevin going to implement this reform, which involves a liberation of the central reserve system, not further regulation?

Once Kevin solves this current crisis with a competitive monetary system, then Kevin is stuck when he wants to bank to inflate the wealth of his special interest groups. Kevin, after his reforms, will no longer have the government manipulation of money as one of the tools in the progressive toolkit.

Posted by: Matt on March 25, 2008 at 7:20 PM | PERMALINK

From the NYT article:
"What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values."

Information. Wasn't that supposed to become more and more *perfect* as time went on according to the invisible hand crowd? Perfect information was supposed to mean perfect competition with zero profits. Some utopia that turned out to be. Information is just about as obscure and opaque as it ever was. Technology is increasing comparative advantage not decreasing it.

Posted by: Doc at the Radar Station on March 25, 2008 at 7:34 PM | PERMALINK

Brojo: I understand the logic of bailing out LTCM and the financial industry for the good of the whole economy ...

Today I'm left of Brojo! (and a bigger believer in capitalism, which is not surprising in and of itself, but a curious companion to my first point).

Bailing out LTCM was not necessary for the good of the whole economy - they should have let it crash and burn. Alternatively, LTCM could have accepted the private offer to buy them out. Tough shit if it wasn't as nice as they would have liked - that's capitalism.

The economy was in good shape back then, there was no general crisis, and an occasional crash and burn of a high flier is a good way to remind people that there are actual risks to playing financial games. If the lesson had taken (admittedly a stretch) it might have lessened the current problem.

Posted by: alex on March 25, 2008 at 7:49 PM | PERMALINK

Not that I am favor of carrying McCains water, the mark-to-market thing makes some amount of sense. Mark to market essentially means that if I hold an asset -say someones mortgage, I have to price it at the current (financial) market value. Now we see that sometimes the market value gets out of line with reality. Like when overleveraged gamblers are receiving margin calls. This is essentially been happening to a lot of this mortgage stuff. Even if 100% of home owners defaulted, housing sales would probably make up half the value anyway -yet the current market is so traumatized that no one will buy this stuff at that price. So it seems that mark to market is increasing instability. We need a better metric than instantaneous market prices -perhaps some sort of compromise between market stability, and the best theoretical pricing. Whatever is chosen should be tested against systemic risk to black swan events, so as to avoid a repeat. So in this particular case St John's advisors might not be completely crazy.

Posted by: bigTom on March 25, 2008 at 7:55 PM | PERMALINK

Famous saying among con men:"If you can't fool a banker, you should find another line of work".

Posted by: MattF on March 25, 2008 at 8:19 PM | PERMALINK

Tyler Cowen's piece on Mises and the Calculation Debate was one of the most lucid and helpful analyses of the current catastrophe I have read. No one has any idea how much anything is worth.

Posted by: on March 25, 2008 at 8:22 PM | PERMALINK

This is what McCain actually said:
First, it is time to convene a meeting of the nation's accounting professionals to discuss the current mark to market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding and there is widespread concern that this approach is exacerbating the credit crunch.

Banks don't want to do repos or other overnight/short-term lending unless there is some idea of the collateral value. The easiest way to determine whether to make a loan in the absence of complete information, especially given Bear Stearns) is to take the Nancy Reagan approach.

Posted by: TJM on March 25, 2008 at 8:48 PM | PERMALINK

An uncorruptable currency is what is needed to sort all this crap out and ensure it can`t occur again.

Start here & here.

There will, of course, be a test.

"If you don't deal with reality, reality will deal with you" - C.J. Campbell

Posted by: daCascadian on March 25, 2008 at 9:03 PM | PERMALINK

Bailing out LTCM

Understanding the rationalization of why something was done is not advocacy, but I didn't really notice LTCM's significance at the time and accepted Rubin's explanation. Had LTCM been allowed to fail, perhaps the dot bomb and the present credit crisis would have been avoided with the increased regulation LTCM's failure should have stimulated.

I have complained before about the lack of regulation the LTCM failure should have stimulated from the current batch of Democratic candidates, whether there was a bailout or not. Edwards especially. Bill and Hillary and Rubin should be grilled for why exactly they let the LTCM guys off so lightly and why there has not been more regulation policy from the Democratic Party. The poor Democrats receive the most blame for a lack of a response to needed regulation because there is no expectation a Republican would do the right thing.

Posted by: Brojo on March 25, 2008 at 9:16 PM | PERMALINK

I hear the social security and medicare are going broke. Is there a discount window for these?

Posted by: pa kettle on March 25, 2008 at 10:01 PM | PERMALINK

A large reason why more regulation didn't come out of the LTCM bail-out was:LTCM was reorganized and continued to operate. By the next year it paid off its loans and was effectively liquidated by early 2000.

Then there's the Cato view: The Fed's intervention was misguided and unnecessary because LTCM would not have failed anyway, and the Fed's concerns about the effects of LTCM's failure on financial markets were exaggerated. In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained.

Posted by: TJM on March 25, 2008 at 10:02 PM | PERMALINK

Mark to market essentially means that if I hold an asset -say someones mortgage, I have to price it at the current (financial) market value. Now we see that sometimes the market value gets out of line with reality. Like when overleveraged gamblers are receiving margin calls. This is essentially been happening to a lot of this mortgage stuff. Even if 100% of home owners defaulted, housing sales would probably make up half the value anyway -yet the current market is so traumatized that no one will buy this stuff at that price.

You are incorrect. These loans are leveraged, by 10:1 minimum. Carlye was leveraged 32:1, which means that their loans only have to lose 4.3 % of their total value before they are completely wiped out.

http://en.wikipedia.org/wiki/Leverage_(finance)

You've missed the entire point of Drum's post.

Posted by: anom on March 25, 2008 at 11:16 PM | PERMALINK

Maybe all our economic woes are caused by McDonald's ceasing its advertising aimed at children.

Posted by: Swan on March 25, 2008 at 11:22 PM | PERMALINK

Cascadian, What the Fuck do either of the Odum brothers have to do with "incorruptible currency"? You been smoking some Ron Paul doobie?

Posted by: SocraticGadfly on March 25, 2008 at 11:31 PM | PERMALINK

Kevin, I agree with everything you say. But let us remember that this is just the latest in a series of cases where the economics profession failed to spot, and even facilitated, dangerous trends that lead to disaster. This clearly indicates that there are some systmatic and deep-rooted problems in the economics profession, and for that reason some major reforms are needed.

Posted by: Les Brunswick on March 26, 2008 at 12:18 AM | PERMALINK

anom:
The mark to market applies to the underlying loan. Of course if something drops to 50% of par and you are leveraged 2:1, you are at zero. Leveraged at 10:1 and you are at -4 (i.e. someone on the other side of the moral hazard equation gets shafted bigtime). Of course uncovered leverage needs to be seriously restricted in the future as that is a primary driver of instability. Accounting rule changes need to be carefully modelled as well, in order to avoid nasty side effects, such as we are seeing today.

Posted by: bigTom on March 26, 2008 at 12:34 AM | PERMALINK

"Contrary to their reputations, bankers have a well-known tendency...."

Does anyone else see something wrong with that snippet? From a semantic standpoint. Hint: reputation and well-known tendency mean the same thing.

Posted by: petty on March 26, 2008 at 12:43 AM | PERMALINK

Well, our banker neighbor three blocks away (going by normal block lengths--or 20-zillion blocks away if you go by all of the little curling lanes and drives and dead ends) just massacred his large family yesterday. That was very imprudent of him, and it definitely reflected poorly on the banking profession.

Maybe even non-insane, non-killer bankers are just a bunch of narcissists. Everything and everyone is just an extension of me, me, me. Screw the consquences, I'm the measure of all things.

Hmmm, sounds like Bush....

Posted by: Squidgerino on March 26, 2008 at 12:45 AM | PERMALINK

There is another tool available... not to replace capital requirements, but perhaps a nice compliment.

Actually tax gains in the not-banks system. Ideally, tax them at a higher rate than gains made in the more highly regulated and lower risk real bank system. We could even get the windfall benefit of increasing the savings rate if we lowered the taxation rates for things like good old fashioned savings accounts (while increasing them for more risky ventures).

Posted by: travc on March 26, 2008 at 5:36 AM | PERMALINK

Anybody would think it had been 100 years, rather than less than 10, since the repug/DINO congress repealed the Glass-Steagall Act.

You know, the Depression-era statute that regulated banking and for more than 60 years prevented precisely the completely inexcusable and totally predictable idiocy we're now suffering from.

Henry Gonzales of blessed memory tried to warn us. He told us - and Congress - over and over again that eliminating banking regulation would have the same consequence that eliminating saving and loan regulation did.

Only 100 times worse.

Hank, we should have listened.

Posted by: Yellow Dog on March 26, 2008 at 6:44 AM | PERMALINK

Kevin,

It's not completely true that "Capital requirements don't apply" outside of the commercial banking system. The SEC sets Net Capital Requirements for broker-dealers. It seems as if both BD's and banks have been able to avoid these requirements by use of various off-balance sheet entities such as SIV's, VIE's TOB's, etc.

Posted by: Mike Jenkins on March 26, 2008 at 5:59 PM | PERMALINK

H5hdDN comment2 ,

Posted by: Ktogwseu on June 26, 2009 at 8:51 AM | PERMALINK




 

 

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