Friday, February 18, 2011

Ben Bernanke Is Still Looking For Cause of the Credit Crisis

Dear Chairman Bernanke,

Please allow me to explain the cause of the credit crisis.  The reason that I am volunteering to do this is I just finished reading your paper, "International Capital Flows and the Return to Safe Assets in the United States, 2003-2007", and I can see that you are still looking for the explanation.

As regular readers of this blog know, the cause of the credit crisis was the failure of the US government to fully implement the FDR Framework.  This framework was developed during the Great Depression and has served as the bedrock for the global financial system since that time.

Under the FDR Framework, there are strict guidelines for what governments should and should not do in dealing with the financial markets.
  • Government should ensure that all useful, relevant information is made available in an appropriate, timely manner to all market participants.
  • Government should not recommend specific investments.
In your paper, you identify a host of factors that contributed to the credit crisis. [emphasis added]
A broad array of domestic institutional factors--including problems with the originate-to-distribute model for mortgage loans, deteriorating lending standards, deficiencies in risk management, conflicting incentives for the GSEs, and shortcomings of supervision and regulation--were the primary sources of the U.S. housing boom and bust and the associated financial crisis.
In addition, the extended rise in U.S. house prices was likely also supported by long-term interest rates (including mortgage rates) that were surprisingly low, given the level of short-term rates and other macro fundamentals--a development that Greenspan (2005) dubbed a "conundrum." The "global saving glut" (GSG) hypothesis (Bernanke, 2005 and 2007) argues that increased capital inflows to the United States from countries in which desired saving greatly exceeded desired investment--including Asian emerging markets and commodity exporters--were an important reason that U.S. longer-term interest rates during this period were lower than expected.
All of these factors contributed to the credit crisis.  However, if one of these factors had not been present, its absence would not have prevented the credit crisis.

The absence of the factor that would have prevented the credit crisis was left off the list.  The factor left off was the failure of government to ensure that all the useful, relevant information was available in an appropriate, timely manner to all market participants.

Had all the useful, relevant information been available in an appropriate, timely manner to all market participants, the credit crisis would not have happened.

That is a bold statement, what is the evidence to back it up?

The Financial Crisis Inquiry Commission found and reported a considerable amount of evidence showing the critical role the lack of access to all useful, relevant information played in the crisis: [emphasis added]
Furthermore, when the crisis began, uncertainty (suggested by the sizable revisions in the IMF estimates) and leverage would promote contagion. Investors would realize they did not know as much as they wanted to know about the mortgage assets that banks, investment banks, and other firms held or to which they were exposed. To an extent not understood by many before the crisis, financial institutions had leveraged themselves with commercial paper, with derivatives, and in the short-term repo markets, in part by using mortgage-backed securities and CDOs as collateral. Lenders would question the value of the assets that those companies had posted as collateral at the same time that they were questioning the value of those companies’ balance sheets. [ pdf page 256] 
In a context of opacity about where risk resides, . . . a general distrust has contaminated many asset classes. What had once been liquid is now illiquid. Good collateral cannot be sold or financed at anything approaching its true value,” Moody’s wrote on September.  [pdf page 281] 
The key concern for markets and regulators was that they weren’t sure they understood the extent of toxic assets on the balance sheets of financial institutions—so they couldn’t be sure which banks were really solvent. [page 373] 
Had all the useful, relevant information been available in an appropriate, timely manner, market participants would have purchased far less "toxic" securities in the first place.  They would have seen the deteriorating underwriting standards and that the quality of the mortgages did not match the representations in the prospectus.

Had all the useful, relevant information been available in an appropriate, timely manner, market participants would also have known the extent of each bank's exposure to "toxic" assets and therefore which banks were solvent and which were not.

The issue of "toxic" assets causing solvency concerns would not have occurred because market participants would also have been able to exert discipline on the banks.  As the exposure to "toxic" assets went up, the bank's share price would have decline and the bank's cost of funds would have increased to reflect the increase in risk the bank was taking on.  A decline in share price and an increase in the cost of doing business is an unambiguous and easily understood message to bank management to cease and desist.

I look forward to meeting with you and your staff to discuss how the application of the FDR Framework going forward would restore financial markets where investors bear the risk of loss and governments are not required to bailout financial institutions.


Your Humble Blogger

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