Possible Outcomes from the 2008 Financial Situation: Part I

We have discussed the financial crisis in previous blogs. Inevitably, several changes will be considered by government policymakers and the private sector as the result of the events of 2007-2008. Political considerations will drive these reforms regardless of issues relating to free markets and capitalism.

1. New Regulation. There will be new financial regulation, including rules to reduce leverage and to control markets that have been unregulated. The use of 30 to 35: 1 debt-to-equity financial leverage used by certain securities firms to enhance returns will be limited to the same rules as apply to banks, about 10:1. Unregulated instruments like the credit default swap market will be subject to controls, somewhat like the rules that exist for the futures markets. Banks may be limited in their securitization activities and could be forced to retain ownership of portions of loans as an inducement to better lending practices.

2. Existing Regulation. The operational regulator for banks is the Comptroller of the Currency, an agency that has been in existence since the American Civil War. (The Federal Reserve is a strategic regulator for the entire financial system as well as the central bank of the U.S.) The supervision expected of banking practices includes the appraisal of asset quality, including the terms and documentation of loans; the competence of management; and sensitivity to interest rate, operating and other risks.

New levels of examination will be required, including analysis to predict situations that may lead to non-performing loans, verification of the value of collateral, proof of earnings and assets, review of performance on loan repayment, and other steps to improve the balance sheets of banks. This should prevent future distressed bank sales like Wachovia Bank in 2008, but will inevitably deny credit to marginal borrowers who may be struggling to buy their first homes or keep a business afloat.

3. Government Political Actions. Government helped create the current financial problems largely for political reasons. Some examples:

· To satisfy homeowners: deductions for homeowners on mortgage interest and property taxes on residential real estate
· To appeal to those at lower incomes: encouragement to Fannie Mae and Freddie Mac for loans to borrowers with questionable credit histories
· To induce borrowing activity: unrealistically low interest rates as set by the Federal Reserve
· To placate business managers: the business deduction for interest on debt

Political decisions will again be made to satisfy angry constituents and place blame. It is difficult to know who will bear the brunt of this anger, but a reasonable forecast is that the financial industry will be the target. The restoration of the pre-deregulation regime is unlikely – the period before the Gramm-Leach-Bliley Act of 1999 (GLB) – but some changes are inevitable; see the following section on the organization of regulation. However, we must remember “the law of unintended consequences” which basically states that passing new regulations inevitably causes other (and possibly worse) problems.

Additional possible changes will be discussed in our next blog.

Advertisements

I’M FROM THE GOVERNMENT AND I’M HERE TO HELP …

The year 2008 has been tumultuous, with economic changes that would have required decades in normal times. It required years of lobbying for the two major financial deregulation laws to be enacted; it took less than a month in early Fall to nationalize Fannie Mae and Freddie Mac; rescue and seize control of AIG, the world’s largest insurer; extend FDIC coverage to money-market funds and to increase bank deposit guarantees; temporarily ban short selling in nearly one thousand stocks in the financial industry; commit to the continuing liquidity of the commercial paper market; and provide $700 billion to assume control of non-performing bank loans, primarily mortgages.

The major investment banks have disappeared, with Bear Stearns and Merrill Lynch now owned by commercial banks, and Goldman Sachs and Morgan Stanley becoming commercial banks. Of course, smaller investment banks exist for regional transactions, but the securities industry has been transformed in ways considered unthinkable even a year ago. How could this happen and what will be the new look of the financial system, both with regard to the financial companies providing the services and the corporations that depend on credit and equity to conduct their business operations?

Financial markets are probably inherently unstable, as banks and other institutions seek new methods to enhance the fairly small return from lending or fee-based activities. It is a struggle for a bank to earn one per cent on its asset base even in prosperous times, and the innovations developed by the quants were largely intended to enhance these fairly puny returns while limiting the amount of equity capital required to support normal activities.

Can government develop a better system to improve stability while avoiding the chaos that has recently been experienced? The history of federal law on finance has been uneven, with Congress often ready and willing to find a scapegoat rather than getting to the real sources of a problem. A positive result was President Roosevelt’s creation of the SEC (through the Securities Act of 1934), and for many years, it did a very credible job in supervising the investment banking industry.

A negative result was the Glass-Steagall Act of 1933 that separated commercial and investment banking for two-thirds of a century, on the theory that these institutions somehow caused the 1929 stock market crash. However, we now understand that there were other far more important causes, including the use of margin to buy stocks (as much as 90% of a stock’s cost could be margined or borrowed in those years), and the decline in farm prices throughout the Midwest and West Coast in the 1920s, due largely to mechanization, the use of fertilizer and overproduction, that eventually destroyed banks and small businesses in those areas.

In my next blog I’ll review likely government actions as changes are debated on the regulation of the financial markets.