Financial Crisis: Remembering What Got Us There Is Critical

Only 6 months ago, at the peak of the financial crisis, the world witnessed well over $30 trillion of its wealth disappear inexplicably. That came as a surprise to just about every banker or regulator, as none of them believed a general contraction of such severity was possible for our planet’s free-market economies.

Ironically, the real surprise is not that it happened, but that we still don’t know how it happened. Governments and economists everywhere are still perplexed as to how the global financial system sunk so deep and so fast. As the G20 nations prepare to discuss new banking regulations in Pittsburgh next week, the most critical element is still missing: consensus on the reasons behind the crisis. Without that, how can global regulations exist, let alone be effective?

But politics is a funny business: comprehension is always secondary to pleasing. It seems that debating compensation caps on bankers’ pay is more newsworthy than exposing the more complex reasons behind the panic, still shrouded with disbelief. Besides, with many of world’s stock markets now near euphoria, as manifested by their 30 to 60% rebounds in 6 months , why spoil the party? “Selective amnesia”, or the ability to choose not to remember that we still have many unanswered questions, is more comforting for most, even if temporary.

Yet, euphoria and amnesia form a strangely perverse blend: the more they mix, the more they feed on one another, until their combination is no longer possible. The excitement of euphoria, which is usually focused on the future, cannot co-exist with the embarrassment of amnesia, which is concerned with the past: until and unless reconciled, their combination is an unsustainable proposition.

Anticipating that sooner or later some of these unanswered questions will surface again, revisiting some of the problems perceived to be behind this economic crisis, presents a fertile platform for reflection and learning. Let’s review some of them.

Pinning the problem exclusively on the U.S. subprime mortgages is naively biased, as it fails to explain the severity of this global economic contraction, reaching all the way to Russia. After all, the latter had apparently no banks exposed to subprime or to other toxic paper.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, does not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not commercial banks with deposit-based and regulated lending practices, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks have also been so devastated. It is now widely acknowledged that, beyond the venerable U.S. investment banks – most of which could not survive - the practice of overleveraging was alive and well on both sides of the Atlantic : banking conglomerates like UBS, Deutsche Bank (DB), RBS and Barclays (BCS), to name some, were keeping rivals like Bank of America (BAC), Citigroup (C) and JP Morgan (JPM) in good company.

It is increasingly clear that this economic crisis, although triggered by the US subprime mortgage problem, has its roots in world’s biggest credit surge in history. Simply put, many financial institutions everywhere have been allowed to create and lend a lot more money than reasonable, finally disrupting the delicate global balance.

Well, who is it precisely that allowed this to happen: Governments? Central bankers? Regulators? Management? If lawmakers worldwide are expected to devise and implement lasting solutions, the answers cannot be ambiguous. It is in this spirit that I would like to point out three areas from which lessons must be drawn before attempting to craft new rules or regulations.

The first one is on the role and impact of an accommodative monetary policy. For world’s central bankers, that financial assets were ballooning away could not have been a secret. According to the Federal Bank’s own records, from 1997 to 2007, the US financial sector’s debt grew much faster than GDP to exceed $16 trillions. And, that is only part of the problem. Recognizing that the U.S. accounts only for about 20% of world’s GDP, the corresponding global excess scales up from there to more scary heights. Enough to make even those central bankers defying acrophobia take notice.

So, what have learned from this: should world’s central bankers avoid using cheap credit to prevent debt bubbles from forming? Most likely, but not without understanding the merits and pitfalls of the opposite force: expensive credit. As remarkably demonstrated by Paul Volcker in the past, independent tight monetary policy is salutary in curbing speculation and control inflation, but how will that play out now in a global scene where interdependence is the new norm? Can any large country now modify its monetary policy independent of the ramifications that it might have on its major trading partners and the valuation of its currency?

The second area for examination is the creation of debt overdose. Although much has been said about the U.S. investment banks and their pushing the capital-ratio limits beyond 30 with exotic and risky derivatives, this was not an exclusive practice. Over-leveraging was also eagerly embraced by Europe’s largest banks, known as universal banks. Whether it was because of their regulators who could not rein them in, or because of their management’s insistence that they should be exempt from capital limits, no one has so far claimed responsibility, let alone accountability, for what has now proven to be serious errors of judgment.

So, how can we introduce more regulations without understanding what should be a “permissible” leverage for financial conglomerates? If governments must stand behind entities “too big to fail”, then they have a duty to determine how much risk is reasonable to assume on behalf of their taxpayers money. The irony is that, contrary to recent arguments by some banking executives, this is not interfering with capitalism, but safeguarding its survival and prosperity.

The third area is on the governance model of publicly-held megabanks.Come to think of it, in these troubled megabanks, who or what was in charge of supervising the disproportionate allocations to real-estate, high-risk lending for oversized takeovers, off-balance sheet opaque bookkeeping and, finally, allowing a compensation system that begets uncontrollable risk taking? The answer is clear : their corporate governance system. Whether it is called a Board of Directors in the US, or a Supervisory Board in Europe, this is the place where the validity of the strategy, the accuracy of accounting, the quality of the performance and the adequacy of executive pay are supposed to be objectively and regularly assessed.

Yet, it seems that in the financial sector oversight has been divorced from accountability. Allowing high leverage to associate so closely with executive compensation — leading to dangerously destabilizing excesses on both fronts— points to malfunctioning corporate supervision.

Furthermore, one of the least understood lessons from the Lehman (LEHMQ.PK) bankruptcy is the role of corporate governance vis-à-vis : a) shareholders - the purveyors of equity capital on whom banks depend to exist, more so than in any other business – and, b) the taxpayers -- providers of invaluable guarantees through government backing- , when things go wrong. Overlooking the pain inflicted on both shareholders and taxpayers while debating compensation limits on the so called “talent” that wrecked the system is neither reasonable nor constructive.

Learning from all three of the above areas will be critical in designing a more dependable and robust financial system. Failure to do so, as we have regrettably experienced last year, erodes confidence in banks, even among depositors, threatening capitalism at the core.

Moris Simson

Comments

[Mad Hedge F...:]

und ) I spent the evening with David Wessel, the Wall Street Journal economics editor, who has just published In Fed We Trust: Ben Bernanke’s War on the Great Panic. I doubted David could tell me anything more about the former Princeton professor I didn’t already know. I couldn’t have been more wrong. Bernanke was the smartest kid in rural Dillon, South Carolina, who, through a series of improbable accidents, ended up at Harvard. He built his career on studying the Great Depression, then the closest thing to paleontology economics had to offer, a field focused so distantly in the past that it was irrelevant. Bernanke took over the Fed when Greenspan was considered a rock star, inhaling his libertarian, free market, Ayn Rand inspired philosophy. Within a year the landscape was suddenly overrun with T-Rex’s and Brontesauri. He tried to stop the panic 150 different ways, 125 of which were terrible ideas, the remaining 25 saving us from the Great Depression II. This is why unemployment is now only 9.8%, instead of 25%. The Fed governor is naturally a very shy and withdrawing person, and would have been quite happy limiting is political career to the local school board. But to rebuild confidence, he took his campaign to the masses, attending town hall meetings and meeting the public like a campaigning first term congressman. The price of his success has been large, with the Fed balance sheet exploding from $800 million to $2 trillion, solely on his signature. The true cost of the financial crisis won’t be known for a decade. The biggest risk now that that having pulled back from the brink, we will grow complacent, and let needed reforms of the system slide. How Bernanke unwinds this bubble with define his legacy. Too soon, and we go back into a depression. Too late, and hyperinflation hits. Let’s see how smart Bernanke really is.

Sep 23 02:17 PM

[phil from E...:]

This article is excellent. Your point on European banks is important. Another fact to consider is that the AIG credit default swaps supported the European banks leveraged position. Another point I would suggest is how truly benign was the US trade deficit?

The Fed was of the opinion that the US was satisfactorily repatriating these dollars. But in actuality the returning dollars were stimulating the irrational housing market.

In Europe, the banks were lending heavily to Eastern European economies.

The Fed and the G20 thought they had a workable system and were successfully transitioning China, India and Eastern Europe into the capitalist system. They were wrong.

Sep 23 06:02 PM

[nukldrager:]

Bernanke was not the cause of the financial crisis. What was, is still a good question, and topic for discussion. Matt Blackman reported here over a year ago that the possibility of a black hole had been created when $535 trillion in CDS and CDO inventions along with sub prime lending started unravelling around Bear Sterns Monday.
Greenspan wrote in his book "Age of Turbulence" (we may just be in the eye of the hurricane at present) about the elegance of derivative swaps in risk management, but also the danger that arose along with their creation because the technology used to create them, and the instruments themselves were not fully understood by the creators (where are those guy's? will any of them be in Pittsburgh next week?). Maybe elegance and danger have morphed into "miss-pricing of risk" in Mr G's furthering of the discussion. Any thoughts...


On Sep 23 02:17 PM Mad Hedge Fund Trader wrote:
.... how smart Bernanke really
> is.

Sep 23 09:18 PM

[THofler:]

"The first one..."
This paragraph & the next is very balanced, but still puts too much weight on loose monetary policy. The common wisdom here is that if you have too much fuel then some random spark will always ignite it. I tend to think that we should focus more on the spark.

By analogy, the U.S. has thousands of grain elevators that usually operate with exposive atmosphere inside. They don't explode (99.99% of the time) because the operators never allow a spark source. The subprime phenomenon WAS a trigger/spark and it should have been prevented; or should be prevented in the future.

"The second area..."
The paragraph that begins with the phrase is excellent. The Basel II regulatory framework for Euro banks was horrendously flawed. It was in fact the Basel II people demanding compliance for U.S. banks operating abroad that lead to the April 2004 meeting of the SEC board. This meeting lead to the elimination of any leverage caps on U.S. I-banks, as required by Basel II committees.

The highly modern and sophisticated Basel II principle is that leverage is to be precisely matched to the mathematically calculated risks inherent in the trades and portfolio. Apparently, it never occurred to anyone that risk can't be predicted with a high degree of accuracy regardless of the mathematical firepower.

"The third area..."
This paragraph & the next is mostly populist red-herring stuff. I agree with Andy Kessler in today's WSJ. It wasn't that bankers woke up one morning and decided to take on a huge amount risk. These people mostly didn't realize the size risks they were taking.

The idea that by restucturing the compensation we will prevent the bankers from going drunk on risk is silly. They already had tons of reasons not to do that, & they were quite sure that they weren't doing so. They were just wrong. Many of them had large stock holdings that became worthless or nearly so. All of them had a lot of toxic assets on their books, so the problem wasn't the offloading of all of the risk.

The big point is that you can't improve the predictablility of risk to a very high degree by using a bunch of stupid mathematical models. And because of that fact, we need to regulate hard caps on leverage. Period.

Sep 24 01:58 AM

[Mansoor H. ...:]

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Sep 24 07:53 AM

[Warm_Paw:]

It was George Bush JR who created ballistic credit.
After his Father's one term in office, the family showed America what happens to a country when they punish him for saying "Read My Lips"
and then having to eat his words for the sake of the country.
After Clinton gave us a surplus, George JR gave everyone a home.
The larder was empty, to finance ballistic credit, the American businessman made extra profit exploiting third world labor, but everyone got a house, or a new car, or renovations with that Home Equity Loan (second mortgage).
I could understand why George JR wasn't concerned with why the bill would have to some day get paid.
That was the lesson.
Greenspan was actually promoting ARM's while Suzy Orman was giving the sound advice of Fixed Rate mortgages.
When does a Fed chief take on the role of mortgage broker while being the trigger guy on interest rates?!?!?!
George Bush SR believed Greenspan cost him a second term.
I believe it too.
I doubt it was intentional.
My opinion is that Greenspan was doing as he was told.
Maybe there was the argument this would prick a real estate bubble. Greenspan may have bought into that knowing not to buy into it would be his undoing. He sure baled when the poop hit the fan. Bernanke's doing pretty good as the fall guy. This crisis is getting handled better than I thought it would. There's still two more years to it. 2010 is past sub prime and into option ARMS - 2011 is a surge of option ARMS coming due as large as the sub prime surge.
Markets are happy because the heat begins next spring.
I see a major correction November, not on the toxic assets, but on the dollar falling apart. Fed will have to raise rates to keep the mass exodus from happening.It's a no win situation, as US dollar rises, Wall Street exits commodities. As dollar falls, inflation suppresses growth.
As for who is responsible to keep the crooks from generating false profits on Wall Street?
The SEC. Why does the SEC have no teeth or claws. Because politicians write their legislation.
As long as the govt looked to be prospering - leave the crooks alone.
What is lobbying? Bribing politicians....
In the 1500's you could pay pennance to a priest before you committed a crime. That's lobbying!

Sep 24 03:52 PM