18.9.08

THINKING ABOUT BANKING. At Talk Left, the short version. The repeal of the Glass-Steagall Act is not the culprit.
Lehman Brothers did not fail because it engaged in commercial banking. And no commercial bank will fail because it engaged in investment banking.
The American Prospect's Robert Kuttner dissents.
But if government must act to contain wider damage when large banks fail, then it is obliged to act to prevent damage from occurring in the first place. Otherwise, the result is what economists term "moral hazard"-- an invitation to take excessive risks.
That's partially correct. The actions the government takes to contain wider damage sometimes -- as is the case with deposit insurance -- come bundled with moral hazard.

The history he offers next is instructive.

Government, under Franklin Roosevelt, got serious about regulating financial markets after the first cycle of financial bubble and economic ruin in the 1920s. Then, as now, the abuses were complex in their detail but very simple in their essence. They included the sale of complex securities packaged in deceptive and misleading ways; far too much borrowing to finance speculative investments; and gross conflicts of interest on the part of insiders who stood to profit from flim-flams. When the speculative bubble burst in 1929, sellers overwhelmed buyers, many investors were wiped out, and the system of credit contracted, choking the rest of the economy.

In the 1930s, the Roosevelt administration acted to prevent a repetition of the ruinous 1920s. Commercial banks were separated from investment banks, so that bankers could not prosper by underwriting bogus securities and foisting them on retail customers. Leverage was limited in order to rein in speculation with borrowed money. Investment banks, stock exchanges, and companies that publicly traded stocks were required to disclose more information to investors. Pyramid schemes and conflicts of interest were limited. The system worked very nicely until the 1970s -- when financial innovators devised end-runs around the regulated system, and regulators stopped keeping up with them.

Look carefully at that last sentence. Glass-Steagall and the rest of the reforms required banks to declare whether they were commercial banks, which were deposit-insured, and, in addition, subject to limitations on the rates at which they could borrow or lend, or investment banks, which operated under different rules. The separation works as long as the interest rates on savings accounts are close to the yields of corporate bonds. When those yields diverge, there's an incentive for Mr Kuttner's "financial innovators" to create assets, such as the money market funds, to offer higher yields to and attract funds from small investors who in Mr Roosevelt's vision were supposed to be happy with their 3.25% passbook accounts.

The same dynamic is at work in the first of seven ways things went wrong.
Until 1969, Fannie Mae was part of the government. Mortgage lenders were tightly regulated. Homeownership rates soared throughout the postwar era, from about 44 percent on the eve of World War II to 64 percent by the mid-1960s. Nobody in the mortgage business got filthy rich, and hardly anyone lost money. Fannie's job was to buy mortgages from banks and thrift institutions, to replenish their money to make mortgages, and along the way to set standards. Fannie financed its operations by selling bonds. In the late 1970s, private Wall Street firms started emulating Fannie. They packaged mortgages, and converted them into bonds. Over time, their standards deteriorated, because they could make more money creating riskier products. In order to avoid losing market share, Fannie emulated some of the same abuses. Government did not step in to regulate the affair -- which was a time bomb waiting for the creation of the sub-prime mortgage business.
Again, the devil is in the details. "Deteriorated" standards mean people who otherwise might not have a shot at owning a house now get a shot. That's not destabilizing per se, and the restoration of the old standards we are currently seeing means some aspiring owners will have to pay rent and put some more money away first. (As an aside, those were the 5-4-3 years of banking: lend at 5, borrow at 4, on the tee at 3. I have no objection to turning off the 24/7 treadmill.)

The next thing to go wrong looks like material for several dissertations.
Bonds are given ratings by private companies that have official government recognition, such as Moody's and Standard and Poors, but no government regulation. These rating agencies have become thoroughly corrupted by conflicts of interest.
I haven't followed that part of the story carefully enough to comment.

Mr Kuttner sees a regulatory failure as part of the problem.
The core idea of bank regulation is that government inspectors periodically examine the quality of bank assets. If too large a portion of a bank's loan portfolio is behind in its interest payments, the bank is made to raise more capital as a cushion against losses. Problems are nipped in the bud. But complex securities require more sophisticated regulation than simple loans. Regulators basically waived the rule on adequate capital for the new wave of mortgage lenders who created sub-prime. Many mortgage companies were not banks.
That nobody bothered to keep track of how much of which mortgage was held in any portfolio does bother me. It does not follow, however, that a government bank examiner would catch it. And as long as the property values were appreciating, keeping track of the individual mortgages is an expense the asset-holders might have guessed wasn't worth incurring. Oops. That's exactly the fourth error.
The financial economy is crashing today because so much speculation was done with borrowed money. A typical leverage ratio of a hedge fund or private equity company is 30 to one. That means $30 of debt for $1 of actual capital. If you make one serious miscalculation, you are out of business. And in the case of sub-prime mortgage companies, the leverage ratio was infinite, because they had no capital. The game was entirely based on creating debt. As long as times were good, financial firms could keep borrowing to finance their deals. But once investors looked down, they panicked. Some parts of the system are unregulated, such as hedge funds and private-equity companies. But they all ultimately get a lot of their funding from banks. And regulators do retain the power to look closely at banks' books (see Sin No.3 above). Had they used that power to police the kind of highly risky stuff banks were underwriting, they could have shut it down.
The essay continues in a similar form. But toward the end comes this odd observation.
[Repeal of Glass-Steagall] in 1999, was one of two major cases when a cornerstone of New Deal regulation was explicitly repealed. (The other was the repeal of the Public Utility Holding Company Act, and if your utility rates are sky-high, you can thank Congress for that, too.) Glass-Steagall provided that if you wanted to speculate as an investment bank, good luck to you. But commercial banks were part of the banking system. They created credit. They were regulated, supervised, usually enjoyed FDIC insurance, and had access to advances from the Fed in emergencies. So commercial banks and investment banks were two different creatures that should stay out of each other's knitting.
That higher utility rates might have something to do with, oh, no investment in new nuclear generating stations, or higher natural gas prices, or environmental regulations that make Union Pacific rich hauling low-sulfur but thermally anemic Powder River coal east to be delivered beyond the Appalachian coal fields hasn't occurred to Mr Kuttner. (I've also seen no rush by the power companies to invest in the latter-day electric railways called light rail, which the Holding Company Act effectively forbade.) But the problem with the separation of responsibilities that Glass-Steagall requires is that money is fungible, and the higher yields to "speculate as an investment bank" ought not be for big-money investors only. A restoration of the New Deal regulatory structures will simply create the same temptations to invent around that entrepreneurial people discovered in the late 1970s.

Perhaps the policy to emerge will restore some of the New Deal constraints. On the other hand, there's the old time religion.
The bankruptcy of Wall Street firm Lehman Brothers and the forced takeover of Merrill Lynch are the latest demonstrations of the collapse of American capitalism. All the lies and propaganda about the supposed infallibility of the “free market” are being discredited. The people of the US and the world are confronting a financial catastrophe on a scale not seen since the Great Depression.
A proper socialist tract has lots of angry words, which this one does.

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