Some answers to the financial crisis (considerations of Stephen Barber)
“The market seems to be spinning in an established cycle. First it is in latency, then in improvement -cultivating confidence, prosperity, excitement, negotiation, convulsion, pressure, stagnation and suffering-. At the end returns to dormant state”. Samuel Jones Loyd (Lord Overstone), 1837.
What are the origins of the financial crisis?
Non-US governments, oblivious to their own policies of cheap money, regulatory or inadequate neglect or mismanagement of local banks, blame their country’s housing market. However, the connection with U.S. is the excess of savings worldwide (especially Asia) generated by excessively low interest rates, which found accommodation in world’s largest financial market, that of United States. There the two huge government-sponsored mortgage agencies, Fannie Mae and Freddie Mac, promoted a securitization frenzy that spread all over the world. But blaming mortgage brokers is like considering someone responsible for the First World War.
Is it possible that securitization allocate capital more effectively and therefore reduce risk in the system?
Scientists and academics imagine even more complicated securities, with the desire to place in the market packages of low quality assets, divided into several tranches and different credit ratings, able to accept a certain level of risk. But it turned out to be a chimera. Why? It is like the flood prevention systems of some Governments that initially allow communities to settle in areas of flooding-on fertile land reserved for crops. Then banks of the river are reinforced and water levels rise beyond the natural level. But when high precipitations arrive the enormous volumes of water run downstream, where destruction and flooding are even greater. It’s the same as falling prey. Securitisation, by propagating risk, allowed greater risk in the system, creating an interconnection when the bubble finally exploded. In addition, it did not consider investor’s ignorance, nor the problem of agent or broker, whose interests differ from those of the client.
How the crisis developed?
It first emerged in February 2007 when two funds of Bear Stearns closed, considered worthless mortgages. At first the greatest fear was solvency, as markets speculated on size and extent of the assets impaired. Thus, commercial and investment banks, in an attempt to rebuild bases, had to expand capital by 50 billion dollars, mainly from sovereign funds. The first sign that the worst was to come was the collapse of Northern Rock in England, which had relied excessively on wholesale money markets to finance mortgage liabilities and collapsed after depositors flight. The most desperate phase of the crisis -liquidity–came with Lehman’s bankruptcy Brothers. The banks literally stopped trusting themselves and the interbank market got completely dry, making it very difficult to finance activities and the need to resort to the Central bank.
Is capitalism guilty?
Some say the crisis represented the apotheosis of Reagan-Thatcher revolution, which began around 1980 in reaction to post-war social democratic consensus. Thus, it is said, a dogmatic faith came about unfettered free markets and hard market capitalism, as a global standard to be ended in a predictable financial meltdown. For most of three decades Alan Greenspan maintained control of US Federal reserve. He believed the stock market, credit, real estate and other bubbles are impossible to identify and the Central bank authorities should concentrate on cleaning up the disorder later (The Age Of Turbulence, Alan Greenspan, 2007). Undoubtedly this philosophy contributed to acceptance of a continuous increase of risk on global financial markets, because the Federal Reserve would always save weak investors. This policy contributed to moral hazard and the size of the bubble. It also financed an era of unprecedented economic growth, innovation, and globalization, which brought several hundred million people across the world out of poverty, mostly due to financial deregulation and liberalization, accompanied by benign monetary policies from central banks around the world.
Are the bubbles inevitable?
In a nutshell, as William Mcchesney Martin, former Federal reserve chairman, said, the Federal Reserve takes off when the party is at peak, rising interest rates when the irrational exuberance–Greenspan’s commentary in 1996- threatens to stay. Market bubbles have occurred throughout history, as inevitable consequence of human psychology. When markets go up, fear of losing evaporates and conviction of certain profits takes over. This creates new raises that promote belief in greater profits. The bubble emerges and explodes, following a stablished cycle (Lord Overstone). So it is no wonder that the big bubbles emerge once market participants who have experienced rises and falls for most have retired or died. This suggests a typical long cycle of 45 to 60 years (Kondratieff) or about 25 years since postwar period (World’s financial history, Niall Ferguson and Allan Lane, 2008).
Is the answer more regulation?
Excessive or misinterpreted regulation is as dangerous as non-regulation, as carries unintended, not all benign, distortions and consequences. Supposedly Basel makes it difficult for banks to reduce necessary margin of resources or leverage out of balance (through ad-hoc vehicles and risk hedging with credit insurance contracts). An example of intentioned but reactive and anti-productive regulation is the rush to abolish shorting. Even with the ban equities continued to decline, simply from direct sales, but the measure reduced liquidity and potential rise, as uncovered sales generate stock purchases. In addition, it deprives hedge funds from its raison d’être. What good regulation should do is implement a coherent set of rules within which markets can function effectively. At the same time, banks need to be recapitalized, as has happened, with taxpayers ‘ money and soon. The only restriction is politics-unpopular measures and greedy but flimsy bankers. Indeed, in virtually all past-century banking crises (US in 1930s, Sweden in 80´s and Japan in 90´s), the government has intervened by combining injections of new capital (and diluting ownership of pre-existing shareholders) with measures to isolate and liquidate uncollectable debts. Meanwhile the central bank provides unlimited liquidity. Bagehot He said: “Close the bank immediately and say it will not lend more than usual or lend freely and boldly so the public appreciates its intention to continue . But lending a lot and not giving confidence that it will continue is the worst of all policies (Walter Bagehot, 1 873).
José Mª Serrano-Pubul, CFA.
