Systematic Risks: Implications for Regulation and the Bailout

Includes: DIA, SPY
by: Lok Sang Ho

There is an ongoing skepticism about the “bailout” programs which the US federal government as well as other governments have put forth to address the financial crisis.

If a commercial entity collapses, why not just let it collapse? After all, many of the firms that are facing difficulty today owe their difficulties to mistakes made in the past. Why protect people from the consequences of their own actions?

There is also an ongoing concern about the huge debt load the bailout package implies. Was it not the excessive indebtedness that caused the current problems in the first place? Creating more debt, according to this logic, will only lead to more problems down the road.

I will argue that the “bailout” programs are needed, and that in fact most of these are not really in the spirit of a bailout. They are, rather, more in the spirit of a “circuit breaker” to prevent a systematic collapse of the global economy. I will also argue that the mounting debt load of the governments is not a real threat to the economy. Although it would have been nice not to have to take such actions, the “bailout” packages announced by governments around the world represent the lesser of evils which the global economy has to swallow on account of the terrible mistakes key decision makers have made in the past.

First of all, most of the bailout programs that we have seen are not bailouts in spirit. Bailout in its proper sense should mean protecting decision makers from the consequences of their mistaken decisions. But the recent “bailouts” were not like that at all.

Take the case of Bear Stearns. The Federal Reserve Bank of New York provided an emergency loan to avert the company’s imminent collapse. The company was sold to JPMorgan Chase (NYSE:JPM) for $10 per share, a price far below the the historical high of about $150 per share, even though much higher than the $2 per share originally proposed. Were investors in Bear Stearns bailed out? Notwithstanding the bailout, they lost almost everything. Was the CEO of Bear Stearns bailed out? Former CEO James Cayne was reported to have lost about one billion dollars of personal fortune in the crisis.

Take AIG, for example. At its high point in 2000, a share of AIG was worth around $100. After the “bailout,” the shareholders of AIG were hardly bailed out at all. AIG shares have been trading well below $2 a share recently. More or less the same story applies to the big three automakers, whose shares continued to sag, even after the “bailout” that offered life-support to the companies.

The main beneficiaries of the “bailouts” are, rather, people who have not taken any active role in the decision-making of the companies. As Bear was tightly interconnected with many Wall Street firms in the role of both a borrower and that of a lender, its collapse would have brought many of its major creditors in Wall Street along to doom. If Bear failed to pay them, they themselves would not be able to pay their own creditors. That could trigger another dangerous wave of defaults. It is these innocent people that benefited from the bailout, and it would be innocent people who would hurt the most if the “bailouts” did not go through.

It is this kind of cascade or systematic effect that the bailouts were intended to avert. Years ago, back in 1998, the Fed would not allow Long Term Capital Management to collapse. Long Term Capital Management was merely a hedge fund, though a big one. It is therefore quite a big surprise to me that the Fed would allow Lehman Brothers, a leading investment bank in Wall Street, to go bankrupt. After the collapse of Lehman Brothers set off the Financial Market Tsunami in September 2008, the world was totally different. The business outlook grew dimmer. Fear fed upon fear, and the credit market seized up. Trillions of dollars evaporated as stock markets around the world plunged. Consumer confidence faltered. Businesses failed. Unemployment zoomed.

It is easy for people to advise the government to let businesses that could not survive the market test fail. It is certainly correct to let businesses fail if they are poorly managed, rendered obsolete because its technology was outdated, or if they could not face the challenge of competitors. But it is quite a different matter if the business climate worsens so much that hundreds of thousands of businesses go under.

Among those that would have to go under in a poor business climate are well managed firms that are producing needed products. Many would be failing just because there was a lack of “effective demand” as the ranks of the unemployed rise; many would be failing because they could not collect money owed by others; while others would be failing because banks refuse to lend; still others would be failing because consumers cut back their spending for an extended period in an attempt to rebuild their savings which were lost during the crisis. Such business failures represent a big loss to society and should not be confused with “creative destruction.”

It is also true that excessive borrowing was a key source of the current problems. However, “excessive borrowing” in this particular context refers to borrowing that was motivated by greed with a disregard to the ability to repay the money borrowed. There are two kinds of such excessive borrowing: one is household debt, which is incurred when people purchase a house that they cannot afford, hoping that price increases would bail them out, or when people spend more than they can afford on various consumption goods and services, typically on credit. The other is corporate debt, which is borrowing excessively so the business could earn more. Both Long Term Capital Management and Lehman Brothers, for example, leveraged heavily and had been very profitable when market conditions were favorable. Such business strategy made the companies extremely vulnerable when business conditions reversed.

It is not right to compare such kinds of excessive indebtedness to the increase in public debt caused by the “bailout” or “fiscal stimulation” effort. First of all, people need to be reminded that without an effective effort to avert a systematic collapse of the economy, government budget deficits would still grow bigger and could even be more long lasting. Massive business failures would mean a gigantic loss of revenue and gigantic poverty relief payments. Meanwhile much of the nation’s production machinery is ground to a halt, suggesting economic waste and a “deadweight loss” to society, because the economy was not producing even though it could.

It is disturbing to see so many people in the market place and even among policy makers who have failed to understand systematic risks. Even today, people continue to blame the sub-prime mortgage debacle on securitization, when in actual fact it was excessive leveraging and indiscriminate lending that caused the problem in the first place. If lenders had maintained their normal requirements before they approve a loan, the problem would not have arisen, even with securitization.

Even without securitization, if loans were made indiscriminately on the gamble that housing prices would keep on rising, when the housing market reversed loan defaults would mount just the same. Securitization gives buyers of mortgage backed securities the benefit of not having to worry who would default, as long as the overall default rate stays within an acceptable range. We may say that the default risks of homebuyers under such conditions are uncorrelated. When housing prices decline and large numbers of borrowers had little equity in their homes in the first place and had insufficient income to service their loans, on the other hand, massive defaults will arise. The default risks of homebuyers under these circumstances are correlated and therefore systematic.

As housing represents for most households their single biggest purchase item over their lifetimes and often also the most important “store of value,” when home prices decline the negative wealth effect will have a big impact on the economy, as homeowners cut back their consumption. As housing prices decline and loan defaults mount, lending institutions suffer big losses and have to cut back their lending activities. Since housing is also an important collateral to get loans, with housing prices falling, there will be a credit crunch, and the vicious circle between the housing market, the financial market, and the wider economy is closed. The vicious circle generates fear, and fear provides the energy for the vicious circle to gain further fury. The economy slumps into a deep recession.

To break the grip of such slump, it is imperative to break the vicious circle. One way to do this is to put an immediate floor to housing prices, as I had earlier proposed. My proposal was for the Federal government to offer a buy-back program to all existing homeowners of units below the national median price. That would stop the vicious circle immediately. The lending institutions’ balance sheets would then deteriorate no more. Financial institutions that hold CDOs related to housing or MBS would find the “toxicity” of their assets stabilize and may even gradually go away.

The Federal Reserve is now buying MBS and other “toxic assets” from financial institutions. That is also another way of breaking the vicious circle. After these assets have been lifted from the balance sheets of financial companies, even though home prices continue to fall this will not hurt the financial companies any more. So their health is protected and they need not curtail their lending activities. This is one way of dealing with the systematic effects that is propagating from the housing market to the rest of the economy and back. This approach is not as good as the direct repurchase offer directed at existing homeowners because its effects on confidence will not be as immediate. But it is a promising approach.

It is a promising approach in light of an independent stimulation effort that is massive in scale. The Obama government is now considering another 825 billion dollars of stimulation package on top of the $700 billion dollars in the TARP. An unprecedented and massive stimulation package is what is needed to restore confidence. All these efforts will certainly enlarge the national debt. But this debt is not the same kind of debt that caused the crisis. The earlier excessive debt was excessive because it was predicated on leverage to make a quick profit. The current debt created is warranted because it is needed to break the already formed vicious circle.

There are skeptics who claim that these efforts would not help, and that they would only lead to inflation down the road. But these efforts have already been demonstrated to be effective. The financial market has stabilized; the TED spread (the spread between LIBOR and the 3 month treasury bill rate, which is an indicator of risk aversion) has narrowed indicating a return of confidence; the credit market has already shown new signs of life; mortgage rates have finally fallen significantly.

I am confident that the markets will in the course of this year normalize, even though a significant recovery will still take some time. I am also confident that despite the debt-load there will be no “hyperinflation” as is feared. Moreover, an important side-benefit of this turmoil is that policy makers and the public are beginning to understand the nature of systematic risks, a subject on which I devoted two chapters in my book Principles of Public Policy Practice, published in 2001 by Kluwer Academic Publishers.