15.9.08

ISN'T THE POINT TO DIVERSIFY RISK AWAY? Here's how a credit crunch begins.

Home loans became more affordable a few years ago when the Federal Reserve kept interest rates low. Politicians of all stripes encouraged home ownership. But lightly regulated financial outfits began slicing and dicing the resulting mortgages into securities and selling them to investors.

Eventually, it all began collapsing, prices dropped, people started losing their homes and Wall Street went into a spin.

Here's how politicians respond.

As different as their policies are, they were united in their message to voters: It's not your fault.

Courting working class voters who gave him grief in the Democratic primary, Obama sounded an I-feel-your-pain note.

Obama lamented Republican policies over eight years that he said "encouraged outsized bonuses to CEOs while ignoring middle-class Americans" and said: "Instead of prosperity trickling down, the pain has trickled up - from the struggles of hardworking Americans on Main Street to the largest firms of Wall Street."

McCain's words were sympathetic as well.

"America is in a crisis today," he said - then added: "The economic crisis is not the fault of the American people. Our workers are the most innovative, the hardest working, the best skilled, the most productive, the most competitive in the world. ... But they are being threatened today ... because of greed and corruption that some engaged in on Wall Street and we have got to fix it."

Some in the markets, he said, "have treated Wall Street like a casino."

The casino metaphor fails to convince. There's a difference between valuing risk, which is what insurance contracts, futures markets, and bond rating services do, and inventing risk for its play value, which is what casinos do.

The populist preachments are also incomplete. Sure, the Wall Street hustlers created the big bonuses for themselves by persuading people to take out interest-only loans or to use the equity in their houses as a source of cash, but people had to decide to take out those loans.

The upheaval at Lehman Brothers Holdings Inc., Merrill Lynch & Co., and American International Group Inc. - and the stunning reordering of the financial market that has following - gave the candidates an opening to press their economic ideas anew.

In line with historical positions of Democrats and Republicans, Obama generally supports stronger consumer protections, better regulatory oversight and more government intervention, while McCain broadly prefers a market system of less federal involvement and red tape.

Tyler Cowen at Marginal Revolution notes something else.
How are we going to stop all these consolidated financial entities from taking advantage of deposit insurance and other public sector guarantees?
I'll go further: why should anyone expect the consolidation of banking houses to provide more safety for investors? The slicing and dicing of mortgages the article refers to what I call diversifying risk away. An investment manager can look at the mix of thirty-year fixeds, interest-onlies, and variable rate subprimes in a fund and decide whether or not the expected return is worth the risk. More banks mean more investment managers making these decisions. Fewer banks mean the consolidated financial entities are holding the economy-wide mix of interest-onlies and subprimes, and therefore more likely to have to take advantage of deposit insurance ... that's before they start offering high-yield certificates of deposit to attract deposits, something that happened after Regulation Q was lifted.

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