Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices--houses, stocks, bonds--as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don't cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates. The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don't know if the other bank whom they are dealing with will still to be standing tomorrow. The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades--excessively leveraged and absurdly risky to boot--banks are now dramatically undercapitalized. As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.
Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices--houses, stocks, bonds--as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don't cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates.
The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don't know if the other bank whom they are dealing with will still to be standing tomorrow.
The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades--excessively leveraged and absurdly risky to boot--banks are now dramatically undercapitalized.
As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.
Three questions seem especially on the minds of European financial industry participants and their regulators at the moment. First: Is this the end of aggressive "Americanized Finance?" Probably not. The strongest American firms are still here, and two in particular, Morgan Stanley and Goldman Sachs - with more than half of their revenues from outside the US - are among the industry's most international firms, doing business locally all over the world. For them, the capital markets of the world are fully integrated and increasing available to corporations and governments as they have never been before. They are now bank holding companies, and ought to be able to resume leadership roles in global finance once the storm has passed. Second: Does the current turbulence vindicate Europe's belief in the supremacy of the universal banking model over all other forms? Again, probably not. Universal banks have been no better than the so-called stand-alone investment banks in their ability to avoid the leveraged exposures to toxic assets or maneuver adroitly to avoid trouble, nor have they found a better way to provide adequate investment returns for their stockholders. If the data are to be believed, some 42% of impaired US mortgage-related debt now rests on the balance sheets of European banks and investors. The universal banking debate is likely to continue for some time, but the pressure today seems to be on a number of leading universal banks to dispose of their hard-to-manage investment banking units - and there is plenty of evidence that financial conglomerates fare no better than industrial conglomerates in how investors value their shares. Third, how could so much systemic damage occur to an Industry that has been diligently regulated for 20 decades? What happened to the Basel minimum risk-adjusted bank capital adequacy regime? The storm was one that destroyed liquidity rather than one that caused damage from credit defaults, and the Basel approach does not regulate liquidity. It turns out that even the most adroit credit risk modeling, in full compliance with banking regulations, completely missed the source of a risk domain that now threatens the integrity of the banking system.
Three questions seem especially on the minds of European financial industry participants and their regulators at the moment.
First: Is this the end of aggressive "Americanized Finance?" Probably not. The strongest American firms are still here, and two in particular, Morgan Stanley and Goldman Sachs - with more than half of their revenues from outside the US - are among the industry's most international firms, doing business locally all over the world. For them, the capital markets of the world are fully integrated and increasing available to corporations and governments as they have never been before. They are now bank holding companies, and ought to be able to resume leadership roles in global finance once the storm has passed.
Second: Does the current turbulence vindicate Europe's belief in the supremacy of the universal banking model over all other forms? Again, probably not. Universal banks have been no better than the so-called stand-alone investment banks in their ability to avoid the leveraged exposures to toxic assets or maneuver adroitly to avoid trouble, nor have they found a better way to provide adequate investment returns for their stockholders. If the data are to be believed, some 42% of impaired US mortgage-related debt now rests on the balance sheets of European banks and investors. The universal banking debate is likely to continue for some time, but the pressure today seems to be on a number of leading universal banks to dispose of their hard-to-manage investment banking units - and there is plenty of evidence that financial conglomerates fare no better than industrial conglomerates in how investors value their shares.
Third, how could so much systemic damage occur to an Industry that has been diligently regulated for 20 decades? What happened to the Basel minimum risk-adjusted bank capital adequacy regime? The storm was one that destroyed liquidity rather than one that caused damage from credit defaults, and the Basel approach does not regulate liquidity. It turns out that even the most adroit credit risk modeling, in full compliance with banking regulations, completely missed the source of a risk domain that now threatens the integrity of the banking system.
They are spot on that Basel regulations didn't prevent this happening, though.
And it so happens that the rating rules used by the big agencies seem to have been suspiciously pro-cyclical, ie using past data to evaluate future likelihood of default, in defiance of the most bsic rule of investing (the past is not an indicator of future performance). In the long run, we're all dead. John Maynard Keynes
Investment banking is the problem, and European banks can be blamed in so far as they were pushed by everybody to be as "sexy" as American investment banks, and yielded to that friendly pressure. In the long run, we're all dead. John Maynard Keynes
Congress has just enacted the $700 billion Paulson Plan. But this plan does not recognize that what is actually happening is involuntary equity investing. The British capital injection plan is honest about making this explicit. A model of the explicit capital injection approach from U.S. history is the Reconstruction Finance Corporation (RFC) of the 1930s. This was one of the most powerful of the agencies created to cope with the greatest U.S. financial crisis ever. The underlying logic is this: When financial losses have been so great as to run through bank capital, so that no one knows who is broke and who isn't, when waiting and hoping have not succeeded, when uncertainty and risk premia are extreme--what the firms involved need is not more debt, but more equity capital. This is the typical pattern of governments faced with a financial crisis. First, there is delay in recognizing losses while issuing assurances (e.g. "the subprime problems are contained"). Then there is the central bank as liquidity provider or lender of last resort, lending freely but providing by definition short-term debt, not equity. But when the capital is gone, something different is needed--an emergency provider of new equity capital. Created by the Hoover administration and expanded by the New Deal, the RFC's investments in American companies, mostly financial institutions, totaled $50 billion. Adjusted for the change in the Consumer Price Index since 1933, this is about $800 billion--but adjusted for the growth in nominal gross domestic product, it would be about $12 trillion. The most important element of RFC operations to address the nationwide financial collapse was its ability to invest in equity capital in the form of preferred stock, the same as the current British plan.
Congress has just enacted the $700 billion Paulson Plan. But this plan does not recognize that what is actually happening is involuntary equity investing. The British capital injection plan is honest about making this explicit.
A model of the explicit capital injection approach from U.S. history is the Reconstruction Finance Corporation (RFC) of the 1930s. This was one of the most powerful of the agencies created to cope with the greatest U.S. financial crisis ever. The underlying logic is this: When financial losses have been so great as to run through bank capital, so that no one knows who is broke and who isn't, when waiting and hoping have not succeeded, when uncertainty and risk premia are extreme--what the firms involved need is not more debt, but more equity capital.
This is the typical pattern of governments faced with a financial crisis. First, there is delay in recognizing losses while issuing assurances (e.g. "the subprime problems are contained"). Then there is the central bank as liquidity provider or lender of last resort, lending freely but providing by definition short-term debt, not equity. But when the capital is gone, something different is needed--an emergency provider of new equity capital.
Created by the Hoover administration and expanded by the New Deal, the RFC's investments in American companies, mostly financial institutions, totaled $50 billion. Adjusted for the change in the Consumer Price Index since 1933, this is about $800 billion--but adjusted for the growth in nominal gross domestic product, it would be about $12 trillion.
The most important element of RFC operations to address the nationwide financial collapse was its ability to invest in equity capital in the form of preferred stock, the same as the current British plan.
