Extend and Pretend Policies Perpetuate Financial Instability

The FDR Framework is a model that cannot be ignored because of its predictive abilities.

As discussed previously (see here and here), the FDR Framework predicts that financial regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability.

An example of how financial regulators perpetuate financial instability is the policy of extend and pretend.  The goal of these policies is to plan on a future event bailing the financial institution out of its current problem.

The classic for regulators practicing extend and pretend was the late 1980s Savings and Loan crisis.  As a result of the high interest rates in the early 1980s, the S&Ls were insolvent.  Rather than acknowledge this, regulators came up with a one-time equity adjustment.  This allowed the S&Ls to gamble on redemption in commercial real estate and long term bonds.  Ultimately, their gambles did not pay off and the regulators had to close most of the S&Ls.

The FDR Framework predicts that extend and pretend policies will most likely fail because financial regulators miss that analysts understand their role in our financial markets under the FDR Framework is to trust, but verify.  They trust the government when it says that everything is ok.  Then they start digging around to find the facts that verify the accuracy of this statement.

The only question with extend and pretend policies is how long will it take before the market analysts ferret out enough information to show the statement is wrong.

If the gamble on redemption works before the market analysts can ferret out enough information, then the extend and pretend policy works.

If the gamble on redemption has not worked when the market analysts ferret out enough information, then the market is subject to financial instability.  Unfortunately, this financial instability is not limited by the actual facts, but is driven by worse case assumptions as the actual facts to anchor the market are not available due to the regulators' information monopoly.

So what happened with the extend and pretend policies involving Spain and its savings banks?

According to an article in Bloomberg,

Thirty of Spain’s smaller banks had their senior debt and deposit ratings downgraded, as Moody’s Investors Service reviews whether governments are willing to support all their lenders in a crisis. 

...“It seems increasingly plausible that hard choices will need to be made at some point over the rating horizon, balancing the sovereign’s incentive to support the banks with the need to protect its own balance sheet,” Moody’s said in the statement. “It is, in Moody’s view, increasingly likely that the sovereign will not be prepared to write all banks a blank check.” 

Governments are seeking to guarantee taxpayers don’t have to step in to support lenders in distress by ensuring creditors bear losses, prompting Moody’s to reconsider the state support it factors into its ratings. 

...“This is the first step in a wider review of the systemic support available to smaller institutions, institutions we think it unlikely would be considered to be systemic,” Moody’s Chief Credit Officer for Europe, the Middle East and Africa Alastair Wilson said in a telephone interview today. “We’re going to carry out a series of country-by-country reviews of banking systems.” 

He declined to say which countries would be examined next. 

Banks of a size to make them central to the smooth running of the financial system are still likely to receive support, Wilson said. 

...“That certain lenders have problems is well-known and can’t be denied,” said Pablo Garcia, head of equities at Oddo Sociedad de Valores in Madrid. “But in our opinion, at least 70 percent of the Spanish financial system is highly solvent.” 

Spain’s credit rating was cut to Aa2 on March 10 by Moody’s, which said the cost of shoring up the banking industry will eclipse government estimates. The ratings company said then that Spanish lenders may need as much as 50 billion euros ($70.3 billion) to meet new capital requirements, a figure that compares with the Bank of Spain’s estimate that 12 lenders will need 15.2 billion euros.

As the analysts at Moody's ferret out more information, they are concluding that the Spanish government's estimate of how much capital the savings banks need is wrong.  Without the current asset level data to constrain their analysis, the analysts are now applying assumptions that call into doubt the solvency of the sovereign.

As predicted by the FDR Framework, adopting the extend and pretend policies with regards to its savings banks did not enhance Spain's financial stability.  The extend and pretend policies appear to have set the stage for a sovereign credit crisis.