Thursday, March 1, 2012

Financial crisis amnesia

Once again, US Treasury Secretary Tim Geithner has taken to the op-ed pages of the Wall Street Journal.  This time he wants to remind everyone why in the aftermath of the financial crisis we needed to reform the financial system.

Regular readers know that financial reform as represented by the Dodd-Frank Act was pushed through before the Financial Crisis Inquiry Commission had submitted its work explaining what were the causes of the financial crisis.

Whether you agree with the Commission's conclusions or not, the simple fact is that Dodd-Frank does not address them.

For example, the Commission concluded that opacity in the financial system played a significant role in the financial crisis.  The Commission went further and defined by example that it was valuation opacity and not price opacity they were talking about.

The example the Commission gave was the opacity of banks that made it impossible to tell which banks were solvent (the market value of their assets exceeded the book value of their liabilities) and which were insolvent.

Dodd-Frank does nothing to address the absence of valuation transparency for banks or, much more remarkably, the opaque, toxic structured finance securities. [valuation transparency refers to the disclosure to market participants of all the useful, relevant information in an appropriate, timely manner so they can independently assess risk before making a buy, hold, or sell decision at the prices shown to them by Wall Street.]
Four years ago, on an evening in March 2008, I received a call from the CEO of Bear Stearns informing me that they planned to file for bankruptcy in the morning. 
Bear Stearns was the smallest of the major Wall Street institutions, but it was deeply entwined in financial markets and had the perfect mix of vulnerabilities. It took on too much risk. It relied on billions of dollars of risky short-term financing. And it held thousands of derivative contracts with thousands of companies. 
And no one in the market had access to its current asset, liability and off-balance sheet exposure details so that they could properly assess its risk and adjust both the amount and price of their exposure based on this risk assessment.

Instead, market participants had to rely on the financial regulators to assess this data and to convey just how much risk they found.

Based on how much risk Bear Stearns had at the time of its failure, it is doubtful that the amount of risk was successfully conveyed to market participants.
These weaknesses made Bear Stearns the most important initial casualty in what would become the worst financial crisis since the Great Depression.
Not exactly a high hurdle given that we had not had a major financial crisis since the Great Depression!
But as we saw in the summer and fall of 2008, these weaknesses were not unique to that firm. 
In the spring of 2008, more Americans were starting to face higher mortgage payments as teaser interest rates reset and they could no longer refinance out of them because the value of their homes stopped rising—the leading edge of a wave of foreclosures and a terrible fall in house prices. By the time Bear Stearns failed, the recession was then already several months old, but it would of course get much worse in coming months. 
These problems were partly the result of amnesia. There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up outside of the safeguards all economies require.
Actually, all of this risk build up was the result of the regulators having amnesia and failing to require banks and structured finance securities to disclose all their useful, relevant information in an appropriate, timely manner.  Without this information, market participants were not able to properly assess risk of either the banks or the structured finance securities nor were they able to exert market discipline.

This crisis represented a huge failure of the regulatory system.  It was the regulators who failed to remember the lessons of the Great Depression.  The leading lesson of the Great Depression being the need for transparency (see creation of SEC as Exhibit I).
When the CEO of Bear Stearns called that night, it was not because I was his firm's supervisor or regulator, but because I was then the head of the Federal Reserve Bank of New York, which serves as the fire department for the financial system. 
The financial safeguards in the law at that moment were tragically antiquated and weak. 
Neither the Fed, nor any other federal agency, had the necessary comprehensive authority over investment firms like Bear Stearns, insurance companies like AIG, or the government-sponsored mortgage giants Fannie Mae and Freddie Mac. 
Regulators did not have the authority they needed to oversee and impose prudent limits on overall risk and leverage on large nonbank financial institutions. And they had no authority to put these firms, or bank holding companies, through a managed bankruptcy that wound them down in an orderly way or to otherwise adequately contain the damage caused by their failure.... 
What regulators did have was the authority to make sure that there was no opacity in the financial system.  They had all the authority they need to require all of these financial institutions to disclose all their useful, relevant information in an appropriate, timely manner.

Had regulators done this leading up to the financial crisis, the market would have exerted discipline and reigned in the risk taking behavior of these financial institutions.

However, by letting opacity run wild in the financial system, the regulators effectively neutered market discipline.  Precisely at the time that they had made the internal decision to rely on market discipline as being more effective than regulation.
A large shadow banking system had developed without meaningful regulation, using trillions of dollars in short-term debt to fund inherently risky financial activity.
The derivatives markets grew to more than $600 trillion, with little transparency ...
The reason it is referred to as a 'shadow' banking system is because it is opaque and provides no valuation transparency.
The failure to modernize the financial oversight system sooner is the most important reason why this crisis was more severe than any since the Great Depression, and why it was so hard to put out the fires of the crisis. 
The failure to reform sooner is why the crisis caused gross domestic product to fall at an annual rate of 9% in the last quarter of 2008; why millions of Americans lost their jobs, homes, businesses and savings; why the housing market is still so far from recovery; and why our national debt has grown so significantly....
Outside of Washington, nobody believes it was the failure to modernize oversight of the financial system that was responsible for the fact that the fires of the crisis have still not been put out.

Market participants have the common sense to know that valuing opaque structured finance securities is the same as blindly guessing the value of the contents of a brown paper bag.  As a result, market participants know it was the failure of the regulators to require ultra transparency and not antiquated oversight that is responsible.

Market participants also know that it was the choice by the Obama administration to pursue the Japanese model for handling a bank solvency led financial crisis.  As a result, the administration championed preserving meaningless bank book capital and banker bonuses over protecting Main Street from damage from the excesses in the financial system.

Had the administration not listened to the regulators who were responsible for the crisis in the first place and instead adopted the Swedish model for handling a bank solvency led financial crisis, Wall Street and the banks would have rescued Main Street and we would have significantly less national debt and a better economy.
Remember the crisis when you hear complaints about financial reform—complaints about limits on risk-taking or requirements for transparency and disclosure....
Given that Wall Street's Opacity Protection Team helped to write Dodd-Frank, there aren't many complaints about transparency and disclosure as it only relates to price and not valuation.
Are the costs of reform too high? Certainly not relative to the costs of another financial crisis.... 
Hence the reason that the mother of all financial databases should be built so that all market participants have access to the current asset, liability and off-balance sheet exposure details for every bank and structured finance security.
Are these reforms complex? No more complex than the problems they are designed to solve....
Ultra transparency is the simplest reform and could be written in less than three pages.  There is no ambiguity about updating disclosure daily for all observable events that occurred with the bank's or structured finance security's exposures.
These reforms are not perfect, and they will not prevent all future financial crises. But if these reforms had been in place a decade ago, then the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy....
It is absolutely true that the reforms included in Dodd-Frank are not perfect and that they rely on regulators to be perfect.  Since one of the major lesson of the financial crisis is that regulators are not perfect, it seems that relying on them to be perfect is simply gambling with financial stability.

Instead, regulators could focus all of their attention on making sure that they eliminate opacity where ever it may be in the financial system.

This does not require that the regulators are perfect in their analysis.  This simply requires that regulators ask themselves is their information that market participants might find useful.
We cannot afford to forget the lessons of the crisis and the damage it caused to millions of Americans. Amnesia is what causes financial crises. 
Which is why we need the mother of all financial databases.  So that the next time the regulators forget and let Wall Street try to introduce opacity through financial innovation, there will be an entity in the financial system who sees it as its responsibility to insure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

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