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March 11, 2008

Financial Innovation

Friedrich von Blowhard writes:

[Editorial Note: I wrote this last night, before news of coordinated activity by the Federal Reserve, the European Central Bank, the Bank of Canada and the Swiss National Bank had come out. As far as I can tell from a quick overview, none of that changes the overall conclusions of this post.]

Dear Blowhards,

As those of you who are following the financial news are no doubt aware, the ongoing saga of the credit crisis has taken another turn for the worse. Now that the banks have taken nearly $200 billion worldwide in write-downs, another domino is apparently falling: hedge funds. Many of these institutions use money borrowed from banks to help fund their investments, a practice known as lending (or borrowing) on margin. Unfortunately, the value of some hedge fund investment portfolios -- which are apparently in mortgage-related bonds -- has fallen, and the banks are demanding that a number of hedge funds reduce their margin loans now. If this is impossible, as the amount of money needed is very large, the banks will seize the hedge funds' bonds (as they have the legal right to do) and sell them off to raise cash.

This, however, is a bit trickier than it looks. Right now, there aren’t many people willing to buy these mortgage-backed bonds – at least not without demanding a serious discount. In a market with very few buyers, sales such as these drive the price of the seized bonds down.

Gillian Tett of the Financial Times in a story "Vicious Spiral Haunts Debt Markets" points out that this is a catch-22 situation. The quickest way to end the current crisis in financial markets is for the prices of assets, like for example those bonds owned by hedge funds and banks, to be driven down to the point where they actually look cheap to investors. At the moment, the investors are currently sitting around with their hands in their pockets, hording their dough. Why? Because the investors figure that even though much of these bonds are being offered at a discount, it will likely be offered at a still-larger discount next week or next month. Back in the S&L crisis of the late 1980s, the government helped resolve a similar problem by staging auctions of the assets of failed thrifts; as soon as investors saw people buying those assets at fire sale prices they figured the bottom had been reached and felt confident that anything they bought today was likely to retain its value in the future. Investors started reaching for their wallets and life in the financial markets went back to normal.

However, Ms. Tett points out a key difference between then and now; in the late 1980s banks didn't have to reflect the market value of their own assets in evaluating their financial condition. Today they do; this is known as 'mark to market accounting.' And banks hold a lot of bonds very similar to the ones that they are forcing the hedge funds to sell. A fall in the price of the bonds will undercut the banks' own financial position, and, if taken far enough, may cause some banks to fail.

It is generally considered that it would be a Very Bad Thing if a large bank such as, say, Citi or UBS, would fail. Coincidently, in another Financial Times story from the same day, a representative of UBS was quoted as saying that this horrible conundrum could only be dealt with by the U.S. taxpayer, who should fork out to keep homeowners from defaulting on their mortgages, which would in turn restore the value of these bonds and thus let banks go on about their business untroubled by vicious debt spirals. Or, as the story by Michael Mackenzie puts it:

William O’Donnell, strategist at UBS, said: "It seems it is time for the Congress to put a floor under markets that are not directly responding to the actions of the Fed.

"The US taxpayer’s wallet, and not just rate cuts, is what’s needed to restore order during the most chaotic times in the credit markets seen since the Great Depression."

Is this really necessary? Must we fight to the last dollar in our wallets to preserve the Financial System As We Know It? Well, the case for preventing major bank failures is put pretty clearly by Yves Smith on her blog, Naked Capitalism:

It isn't just that [having major banks fail] is politically unacceptable. Some of these firms are too big to fail in a practical sense; the damage to the confidence in the financial system would offset the salutary effects of reaching the market clearing price level. In addition, they are an essential part of the modern financial infrastructure. Lose, say, a Citi and a UBS, and you have impaired global intermediation capacity, much like losing part of a road system or electrical grid. You can probably still get from A to B, but with more cost and less speed…

Her analogy to the electric grid reminded me of something I had read by Martin Wolf of the Financial Times back in November in a column entitled Why Banking is an Accident Waiting to Happen.” In it, Mr. Wolf pointed out that banking is generally an anomolously profitable industry, and that this unusual profitability is made possible chiefly by very generous government treatment. Favorable government policies such as deposit insurance, discount windows, Term Auction Facilities, etc., permit banks to engage in enormous volumes of profitable transactions with relatively tiny amounts of capital. This is one of those brilliant arrangements that works like gangbusters until, like now, it doesn’t. This leads Mr. Wolf to a radical conclusion:

What seems increasingly clear is that the combination of generous government guarantees with rampant profit-making in inadequately capitalised institutions is an accident waiting to happen -- again and again and again. Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. [Emphasis added]

While I know only a little about finance, I happen to know quite a bit about regulated utilities, especially electric ones. When utilities go bankrupt, they don’t shut down for even a minute. Over a period of years the senior management is let go, the equity shareholders are wiped out, the debt is crammed down to a level where it doesn’t stop the utility from recapitalizing itself, but the lights stay on. And there’s no taxpayer bailout.

I don’t know about you, but it strikes me that the regulated utility model Ms. Smith and Mr. Wolf conjure up could have some advantages if applied to the financial world. It might be a lot better than having the banks first lend so recklessly that they create or at least enable a housing bubble, and then put the economy into a recession when the housing prices prove unsustainable for an economy in which most people’s incomes aren’t growing at all in real terms.

Now, it certainly could be argued, and with considerable justice, that a regulated utility model would be a lot more stodgy than today’s go-go world of high finance. Heck, stodgy is probably too mild a term. Regulated utilities are about the most conservative businesses on the face of the earth; they have to be, as they have regulators second guessing their every move with 20-20 hindsight. They’re not innovative -- even when it makes sense to be -- and they move with the all the speed of a racing tortoise.

But would slowing down the pace (and reducing the profits) of the financial sector really be such a bad thing? According to a posting, "Assets, GDP and Debt" by financial blogger Hellasious at Sudden Debt, in 1990 the U.S.’s total debt was around 2.4 times its annual GDP. Today our total debt is around 3.4 times our annual GDP. In other words, we’re packing 40% more debt relative to our income these days.

So what, exactly, have we done with all the extra debt we took on, a sum of money the size of a full year of our GDP? Did we spend it on upgrading our productive infrastructure? Did we use it to discover a cure for cancer?

Well, over the exact same span of time, the combined value of U.S. real estate and U.S. stocks have risen from around 2.4 times annual GDP to 3.75 times annual GDP, a number which I confidently expect is now shrinking to something around 3.4 times our annual GDP. In short, that extra debt was 'invested' in pumping up the value of our financial assets.

We all seem to think that rising asset prices are a good thing. The stock market at record highs is wonderful, right? So is living in a home that gets more valuable every year. It all seems to promise money for nothing. Sit in your increasingly expensive house, watch the price of your stocks rise, and grow rich. But at the end of the day, the same underlying cash flows or, to put it another way, the same underlying real economy has to support high asset prices. This is especially true when they are made possible (as they have been in America over the past couple of decades) by ever increasing bong-hits of debt. Are high asset prices really a good thing when incomes are growing much more slowly? Wouldn't we really be better off if, over time, the hours of labor (or months of salary) required to say buy a house (or, heck, an education) were dropping, not rising? Or at the very least, holding steady?

You know, a stick-in-the-mud financial system might be just the thing this country needs!



posted by Friedrich at March 11, 2008


I will happily buy you lunch if the financial institutions don't manage to manipulate our political masters into having the government assume all of this debt before the year is out.

Posted by: Don McArthur on March 11, 2008 12:00 PM

Another downside of ever-increasing real estate values is that they make it more and more difficult for new buyers to enter the market. Many of the ridiculous financial arrangements which are now going bad in droves wouldn't have existed in anything like their actual numbers had prices not been so exhorbitant.

Posted by: Peter on March 11, 2008 3:27 PM

Yikes! Finance as a regulated utility? That's a little scary. Stocks, bonds, and derivatives are all just promises about the future -- pay a certain amount of cash now for an uncertain amount later. Seems to me that nationalizing everything up to and including "I'll cover it today if you buy me lunch next week" is a little harsh.

If Citi blew up, what we'd miss was a lot of accumulated cruft, in the form of bad investments and the bad policies that caused them. We wouldn't lose the, um, Citi-zens who made it happen -- the good ones would get hired away ("Amaranth" is a great thing to have on a resume, even though Amaranth itself imploded disastrously) and the bad ones would find a new line of business. There would be disruption, but only to the extent that promises from Citi were treated as certain to be fulfilled -- in other words, people would be harmed roughly in proportion to how wrong they were.

I'd rather see a less regulated system. We should get the good and bad we deserve, rather than the averagest system we can impose.

Posted by: Byrne on March 11, 2008 3:44 PM

See this...

Posted by: Charlton Griffin on March 11, 2008 10:04 PM

Given the history of fiat currencies and the surreal skyward curve of money printing and indebtedness, does a prediction of runaway inflation deserve to be regarded as delusional these days? I'm inclined to think that, ten or fifteen years hence, people will look back and marvel that so few saw hyperinflation coming. Commodities have been the star performers since the turn of the century, but to read MSM articles, you'd think buying gold/silver bullion and their miners is tantamount to playing the soybean futures. Crank up the disco.

Posted by: Yakking Guy on March 12, 2008 7:58 AM

Allowing these financial institutions to fail is simply the correct mechanism of free-market capitalism. For any human institution to claim that it is "too big to fail" only makes it clear that particular institution is inherently parasitical and it must be made to fail in order for self-correction mechanism of capitalism to work properly. When flawed and parasitical institutions fail, the dynamic creative nature of capitalism ensures that new, more functional institutions will emerge to take their place. This has always happened in the past and will always happen in the future. No human institution is "too big to fail" anymore than it is possible to be too rich, too thin, or too beautiful. There is no such thing.

The rise in housing values over the past 8 years has been clearly an unsustainable bubble, just like the equities bubble that occurred before it. The people running these financial institutions clearly believed that these increases were real and reflected underlying economic value. This makes it clear that these people are either 1) stupid, 2) deluded but not stupid or, 3) simply greedy and lying through the teeth and didn't give a rat's arse about if the bubble was sustainable or not.

Clearly the economic system contains much rot. The rot must be purged from the system. Liquidation of these institutions, just like the S&Ls of the early 90's is the appropriate corrective mechanism of a functioning free-market system.

The parasites whining madly for a bailout want upside capitalism, but downside socialism. This is NEVER, EVER acceptable under ANY cercumstance whatsoever.

Posted by: kurt9 on March 12, 2008 3:34 PM

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