This essay was written in September of 2008, in reply to the horrid week of the Lehman Brothers' Collapse, and the rise of the 'Paulson Plan'. Though some of this is outdated (In particular the 'Paulson Plan', which was swiftly changed from buying toxic assets to having an equity stake in firms), it is still a nice read, in that it looks in general at how the financial crisis developed and the nature and philosophy of bank bailouts. Unfortunately finance is not my cup of tea, but hopefully you will still enjoy this piece. This essay was the beginning of my burgeoning interest in the crisis, and it is nice to reflect on how much progress I've made since then.
What appeals to me in this financial crisis is the need for a coherent path of leadership in reforming the financial system. The financial system seems to have lead itself to its own catastrophic destruction, and we now face an almost structural problem of illiquid assets held by over-leveraged institutions right across the world, perpetuated of-course by the ungainly events of August 2007, when mortgage originators began to tumble in the US. The problem originates from the general trend of lending standards being lowered to unsustainable levels. By unsustainable it means that the rapid growth in lending, and in credit, has far overtaken the growth in lending for productive activates and the accumulation of productive capital. Such low doc housing loans could potentially be very profitable in backing highly sophisticated instruments like structured investment conduits and collaterised debt obligations (CDOs and SIVs). These instruments are backed by mortgages, and once this cash flow of funding liquidity is disrupted, then the assets of many institutions are in question. Once the cash flow of these assets dissipates, it is only natural that financial intermediaries engaging in this irresponsible lending should deteriorate.
These balance sheets are interconnected with many other institutions, including commercial banks, investment banks, insurance companies and the like. This is because one company’s debt obligations no longer have the cash flow to provide funding for the debt. What happens to these intermediaries is an inability to meet debt payments with a large cut of the sourcing of their funds. Naturally they turn to selling their assets, both their illiquid and liquid assets. If information is transmitted of the intermediary’s collapse, potential partners, by the nature of adverse selection, will insure themselves from the risk of buying up bad debt, and will not buy the assets of the intermediary, even if they are good. This is because they cannot take the risk of differentiating between the good assets and the bad assets, and can naturally conclude that any company in trouble will attempt to sell their bad assets at an inflated price.
What happens is an almost circular path of a company with an initially negative balance sheet becoming even more negative over time, with a declaration of insolvency the likely result. Note that the interconnection of financial institutions underplays another, more subtle role, that of financial innovations that have enabled companies to be in partnership, say a Hedge fund, or even directly lending to such intermediaries. The defaulting on debt by the intermediary can lead to a reduction in the source of funding for interconnected financial institutions. In some cases the interconnection is so poignant that the collapse of the intermediary brings about a phenomenal reduction in their source of funding.
What is sparked by the collapse of one such intermediary? What could potentially happen is a human element coming into play; a crisis of confidence could develop. The crisis of confidence will entail a large reduction in the lending capacity, as all financial institutions wish to hoard funds and assets rather than the healthy steady financial flow we witness in good financial times. A lack of trust due to asymmetric information is a market failure, as there are many credit-worthy assets that could be traded, but due to the inability to differentiate between a firm’s good and bad assets, no trades are made to begin with! The crisis of confidence highlights the systemic risk in a system that has reduced interest rates and leveraged institutions to fundamentally unsound levels.
The inclusion of Government in times of recession and depression is philosophically questionable. One can argue against government intervention solely on the principle of private enterprise, that regardless of the situation, the private sector management of a situation will lead to the optimal outcome. Yet with such a deep and prolonged financial crisis, the strains on the private sector are too deep-rooted to be solved by the private sector alone. The private market failure is occurring because in bad times the usual healthy flow of capital does not occur between firms. It is a tragic case of self-fulfilling expectations of a crisis perpetuating this contracting of economic activity, a circularity that cannot be cured by the private sector without a very painful recession-or depression, for that matter. The government has the ability to justify corrective action where the private actions do not cumulate in social returns. In this case the private actions are catastrophic for society, and the Government, as a provider of social infrastructure, must prevent such diversion of activities from taking place.
The government intervention has recently been taken in the form of take-overs, with the Fannie and Freddie may takeovers being seen as successful in significantly lowering mortgage rates and returning consumer confidence. The take-overs have been successful, but they are implemented only in exceptional cases. The catastrophic failure of these institutions poses a downside risk far greater than the losses incurred by government in meeting the funding shortfall of these institutions. The problem of Government intervention becomes more complex wherein there exists institutions that are not insolvent, that have great potential to re-capitalise, but at the moment are unable to do so. This re-capitalisation is integral to returning to normal levels of asset trading, and for firms to bolster their balance sheets and boost their credit ratings once again.
To kick-start these institutions is a problem being addressed by the US treasury, with the secretary of Treasury Henry Paulson declaring his ‘Paulson Plan’. This plan has a ‘calming effect’ in at-least reassuring Wall street that liquidity will be provided in the short to medium term. But conceptually it may not attack the real problem at hand. The problem is threefold, we have had problems with an unacceptably low levels of interest rates and leverage, we have had problems with excessive de-regulation of the financial system which has enabled systemic risk to rise to unsustainable levels, and the human element; the ‘crisis of confidence’ discussed earlier. The proposed solution, which in its general form is a $700 Billion bailout plan consisting of reverse-auctioning (to buy assets at the lowest bid price) the mortgage securities market. This intervention is in stark contrast to the intervention of the Great depression, where Government tended to intervene in buying the good stock of firms, but in this case the Government wants to buy the toxic waste bonds of the credit markets.
This solution is being seen by many as being a very short-term solution, a ‘throwing money at the problem’ rather than digging into the underlying problems at hand. One problem with the bail-out is the price at which securities will be auctioned. Will it be so low that the selling of securities at such a low price will in fact be even more disadvantageous to the competing firms? Will the price be too high such that there is an inequitable resource transfer from the innocent taxpayers to the guilty managers of ruptured portfolios and their shareholders?
The Government is intervening, as outlined before, to uphold its provider of social welfare for the people. But nowhere is it given an encouraged role to ‘reward’ the mistakes of exposed corporate managers and the respective shareholders of these firms. One such problem that may increase the price beyond the fundamental value is the case of moral hazard. Firms that rely on Government intervention to subsidise their losses tend to make more risky investments than they otherwise should in a situation wherein they receive no such assurance. This means that firms could well make a profit by selling at an inflated value to the Government and come out even stronger in relative terms after the bailout. If the Government were to require a warranty, to seek a return of profits contingent on the success of the firm after bailout, would this warranty minimise the moral hazard problem? According to the Modigliani and Miller theorem, this is not likely. All the warranty will do is to be capitalised into a higher price for these assets, where firms typically estimate the likelihood of success, and base their prices on the net present value of assets (where it must be discounted for the future earnings of Government shares of the company). This lower net present value means to retain a certain benchmark NPV, they require a higher price. Thus we are still stuck with a situation of how the price convergence is going to occur. At present market critics feel that the price is likely to be below their fundamental value, and there is more of a concern that the price may be too low to enable illiquid institutions from becoming operational again.
What is even more questionable is the relative impacts it will have on illiquid institutions relative to liquid institutions. This plan may have little impact on the solvent institutions, but may be largely wasted on institutions that may have little chance of recovery even after ridding themselves of the toxic waste. In such circumstances it would be ‘money better spent’ to spend on the fittest survivors of the market. Also is the natural question of whether there would be a return to pre-crisis standards of exchanging assets; whether re-capitalisation can actually occur in this method. One can only say that such levels will be returned to after a severe revamping of the financial system. The credit growth must be at a rate coinciding with rate of growth of productive capital. If the rate of growth of speculative capital exceeds the growth of productive capital, such an inequality of growth precipitates asset price bubbles. In this case the capital ratio must be rationed by banks to converge to steady levels of capital growth.
Financial crises are a backdrop from which economists, like myself, can analyse with vigour the workings and functioning of a largely unknown world. It is a painful experience, but a great one for learning, and having been endowed with an economist’s curiosity, I can’t help but indulge myself in such depressed times!
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