The meltdown remains a whodunit

In his Wall Street Journal column, Holman Jenkins observes that the cause of the global financial panic is not well understood.

Actually, regular readers know the cause of the global financial panic is well understood.  The cause was opacity in the financial system.

Opacity made it impossible to value structured finance securities.  Opacity made it impossible to value banks let alone determine which banks were solvent and which were not.

Opacity provided the feeding ground for fear to sweep the financial system.

Opacity meant that the absence of facts and therefore reason could not check the emotion of fear from sweeping the financial system.

Interestingly, even though he does not discuss opacity, Mr. Jenkins manages to raise the issue of transparency when  he concludes with the question

how can we avoid financial instability in the future given that regulators lack clairvoyance and foolproof regulatory strategies aren't possible—needs an answer. One solution is giving back to bank creditors the job of policing bank risk-taking.

As regular readers know, the only way that bank creditors can police bank risk-taking is if they have access on an on-going basis to each bank's current asset, liability and off-balance sheet exposure details.  This is the data bank creditors needs so they can assess the risk of the bank.

What idiots [referring to the members of the FOMC in 2006]. And yet they were right. Jobs, consumption and stock prices were holding up smartly despite the well-recognized turn in housing markets. Then came the financial panic. Did the housing bubble cause the panic—or was the panic somehow separate, making everything worse, including the housing crunch?

Good question.

Gratifying, then, is the attention showered on a recent book by Jeffrey Friedman and Wladimir Kraus, "Engineering the Financial Crisis." Their work is refreshing for many reasons: It does not assume the housing bubble is the whole story. It allows that honest ignorance (especially about the interaction of complex regulations) might explain the behavior of bankers and regulators. It asks especially interesting questions about the triple-A mortgage derivatives at the heart of the financial meltdown.

Whether these securities ever deserved their triple-A ratings is, of course, a debatable proposition. But what's certainly true is that these "structured products" were structured to protect investors' cash flow even in the face of a considerable rise in mortgage defaults. From many accounts, including the Fed's, which ended up owning a bunch of them, the securities have largely performed as advertised.

Yet when the panic hit, it was the presence of these assets on bank balance sheets that fomented a global loss of trust in banks. Why?

As discussed above, panic hit because the opacity of structured finance securities and 'black box' banks prevented anyone from valuing either the securities or the banks.

In the absence of facts, market participants assumed the worse!

And why did so many banks load up on these assets in the first place? Blaming "greedy, reckless" bankers, the authors say, is a stretch because banks' housing assets were in fact heavily tilted toward the safest. Citibank was entitled, for capital purposes, to treat higher-yielding triple-A and double-A private mortgage securities the same as Fannie- and Freddie-issued securities. Yet Citi held a lot more Fannie and Freddie than it did the private securities.

The future is unknowable. Capitalists will make mistakes. But why the same mistake? Here the authors blame the homogenizing effect of the Basel banking regulations spawned in 1988, ironically to address the same fears of "moral hazard" and Too Big to Fail on every lip today.

Basel tried to make banks safer by prescribing capital levels, and by steering them toward "safe" assets. Experience had shown that mortgage-backed securities were among the safest, safer than business and consumer loans and even whole mortgages. So the Basel rules strongly favored mortgage-backed securities. Alas, this became an incentive to over-produce these assets until they became very dangerous indeed to the entire financial system (a formula also implicated in Europe's sovereign debt crisis).

Much remains to be sorted out. Why did markets become frantically alarmed about banks holding these illiquid triple-A securities? Even in Citi's case, they were just 2% of assets. Was it because creditors and counterparties feared banks would be forced to recognize accounting losses on these assets, putting banks in danger of being seized by regulators?

Whether a financial institution recognizes or does not recognize an accounting loss has no influence on its solvency and whether regulators should seize it.

Solvency is defined as the market value of the bank's assets minus the book value of its liabilities.  Clearly, the market adjusted by writing down Citi's exposure.

What the market feared was what else was hidden on or off Citi's and every other banks' opaque balance sheet.