Posted: December 15, 2009
udge Richard A. Posner's A Failure of Capitalism gives away its thesis in the title. There are many culprits in this timely book, but capitalism itself, specifically laissez-faire capitalism, shoulders most of the blame for the current financial crisis. Posner claims we are in the midst of a depression caused by a market failure born of the deregulation of the financial sector. Though his history of the crisis is occasionally illuminating, his arguments for increased regulation of the financial sector are unpersuasive.
A federal appellate judge and prolific author, Posner is modest enough to call his book a work in progress and reminds us that we are still learning lessons from the Great Depression. Yet he believes it's not too early for some rather dramatic conclusions: banks are the lifeblood of a capitalist economy, and their deregulation allowed the market failure that caused this depression; therefore they must be more heavily regulated so they cannot wreak such havoc again. Given Posner's reputation as a champion of deregulation, interventionists have seized upon his surprising endorsement of re-regulation-with the loudest hosannas coming from the failed regulators themselves.
Treasury Secretary Timothy Geithner, for instance, has recently called for the creation of a "systemic risk regulator," an entity whose purpose would be to police those financial intermediaries deemed so large or integral that their failure would threaten the entire financial system. Good idea, perhaps, but the job description sounds very much like that of the Federal Reserve Bank of New York, whose mandate is to "foster the safety, soundness and vitality of our economic and financial systems." The head of the New York Fed while much of the recent trouble was brewing? Timothy Geithner.
Had Posner not started with the conclusion that deregulation is to blame, he might have asked whether the crisis was caused by deregulation, or by misguided regulations and inept regulators. It's the kind of analysis he might be good at.
Credit Default Swaps (CDS) take a beating in his book because they are unregulated instruments that played a role in the crisis. Warren Buffet famously called Credit Default Swaps "financial weapons of mass destruction," and George Soros recently said they should be outlawed. Posner uses the Lehman bankruptcy as an example of the dangers posed by CDS:
Suppose bank A had insured Lehman against a loss of $X, and bank B was insured by Lehman against a loss of $X. Then A should have given B $X, rather than both getting entangled in Lehman's bankruptcy. But the bankruptcy was so sudden that the A's and the B's didn't have time to find each other, and so were left uncertain about their position in light of the bankruptcy.
Here Posner is quite specific, and gets it exactly wrong. Using Lehman's collapse to prove that the Credit Default Swaps are instruments of financial havoc ignores what actually happened. Lehman's failure was a perfect storm. Lehman was not only the fourth largest U.S. securities firm, it punched above its weight in fixed income, and specifically in credit derivatives. It was both a huge dealer in CDS and one of the most common reference names to be traded in individual swaps and CDS indexes. Worse, the settlement of Lehman Credit Default Swaps was about as bad as could be imagined. The settlement price determined by dealer auction was a measly 8.625 cents on the dollar, that is, a loss of more than 91 cents on the dollar. This means that of the $400 billion in Lehman CDS outstanding, Protection Sellers (those long Lehman, i.e., betting that the value of Credit Default Swaps would go up) had to pay $365 billion to the Protection Buyers (those short Lehman). Before the settlement of those swaps last October, concerns surrounding the payments were widespread. The New York Times's Floyd Norris worried that "we do not know how many such swaps are even outstanding, let alone who is on the hook to pay." But settlement was a non-event. Given the widespread trading in Lehman CDS, and the near zero recovery rate, it is remarkable that the CDS market was able to function as designed. More impressively, there does not appear to have been a significant knock-on effect, whereby counterparties to Lehman faced outsized losses; most firms that traded with Lehman seem to have had sufficient collateral.
While it is fashionable to decry the unregulated nature of CDS, the market did its job fairly well because the collateral system among banks and hedge funds insured that most of the money that Protection Sellers would need to pay Protection Buyers was already in place. Posner joins many commentators who seem wholly unaware of these collateral arrangements. His chaotic scramble of a bunch of As and Bs running about trying to identify each other simply never happened.
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Posner makes the same mistake that then-Treasury Secretary Henry Paulson made last summer when he decided to bail out AIG. While most of the banks that traded with Lehman had collateral against their exposure, most who traded with AIG did not. AIG was the 800-pound gorilla and was able to bully counterparties, often getting away without posting collateral—unless it were ever downgraded, whereupon it would face massive margin calls.
Facing imminent downgrade, and realizing it would not be able to post sufficient collateral to satisfy its contractual obligations, AIG found an equity partner in the U.S. taxpayer. We know a large part of the taxpayer's investment went to satisfy the "margin calls" of banks and brokers to whom AIG had sold protection. We also know that Goldman Sachs, Paulson's old firm, got the biggest slice of the pie.
Paulson apparently believed that if AIG failed, the stress to the system would be too great and systemic collapse would follow. Posner shares this view of the system's fragility—thus his call for more regulations. AIG's unusual arrangement became a metaphor for the whole system. But AIG's collateral arrangements were the exception, not the rule.
There is a widespread view that the derivatives market is the Wild West, and that it is nobody's job to know who owes what to whom. Many seem to believe there are vast exposures lurking undetected by regulators. This view is nonsense. The Office of the Comptroller of the Currency (OCC) publishes a Quarterly Report on Bank Trading and Derivatives Activities that lists this information for the nation's largest banks, the top five of which represent 96% of the total amount. Want to know the volume of credit derivative contracts entered into by the Regions bank of Alabama? It's in Table 12.
Posner does a better job of introducing what many have called the "shadow banking system," that complex interplay of banks, hedge funds, structured investment vehicles, mono-line insurers, and derivative products companies. He points out, correctly I think, that there is not all that much difference among these various actors in providing credit intermediation. A hedge fund that is selling protection via a CDS is providing credit much the same way that a bank is in making a loan.
I think Posner is correct that in their essential credit creating capacity it makes little sense for banks, insurance companies, and hedge funds to be operating under vastly different regulatory regimes. Banks are regulated by the Fed, the OCC, the Office of Thrift Supervision, the FDIC, and state regulators. Each state has its own insurance regulator. And hedge funds, as we hear again and again, are barely regulated at all. It seems clear that the regulatory structure is inefficient and likely to be gamed. It is and it was. But surprisingly for an astute observer like Posner, he seems to miss the main point: the high correlation between the level of regulatory scrutiny and the contribution to the credit crises.
Back in 2006 there was a general recognition that credit was too easy to obtain, whether for housing, commercial real estate, consumer finance, or corporations, and trouble of some sort would surely strike. At the time the dominant view was that the future would be a replay of the Long-Term Capital Management (LTCM)crisis. In 1998 the Federal Reserve Bank of New York had organized a bailout by LTCM's largest creditors to avoid collapse in the financial markets. The anticipated chain of events was a large hedge fund failing and taking down its lenders in a chain reaction. Instead, the banks failed, threatening the hedge funds. The rush to re-regulate ignores the reality that the least-regulated entities in the system—hedge funds—fared far better than the highly regulated entities like banks and insurance companies.
One would have expected this negative correlation between regulation and success in weathering the storm would have leaped out at Posner. It is the type of interesting insight he normally pounces on. He does notice that hedge funds fared a good deal better than banks, but rather than explore this interesting point, he uses the Bernie Madoff affair as further proof of the need to regulate hedge funds.
The lessons from Madoff seem very different from the ones Posner wants to draw. First, in a nation with over 8,000 hedge funds managing more than $1.3 trillion, cases of undetected fraud like this one appear to be extremely rare. Second, it is now well known that the SEC had clear warnings of problems with Madoff's funds—whistles were blown—but failed to act on them. In fact, the relatively good performance of hedge funds in general could force the conclusion that the informal networks regulating hedge funds—the scrutiny of funds of funds, outside consultants employed by pension fund investors, credit departments of bank lenders, and rigorous internal risk management—did a far better job sniffing out risk than the regulators keeping watch over banks.
Posner is so sure that deregulation caused the crisis, he hardly bothers to offer any evidence that it did. It didn't. There are really no linkages between specific deregulatory actions and the current crisis. Unfortunately, his admonition to go slowly in crafting new regulations is likely to be ignored, and the failed regulators are busy drafting new rules to cover past incompetence. To the extent Posner provides ammunition for the re-regulators, he does us all a disservice.
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What few commentators have questioned with any rigor is, why did banks become so heavily exposed to these housing risks in the first place? A more complete analysis would look more closely at the types of risks taken by the banks that fell into trouble. Overwhelmingly they lost their shirts on low-yielding, highly rated securities that exposed them to "tail risks," supposedly small chances of horrific outcomes. Because such supposedly safe securities had low yields, the banks needed to commit massive amounts of funding to buy them. They were thus exposed to a small, but it turns out, not that small, chance of total failure. Why did they own this stuff? Why did the regulators let them own this stuff?
Banks owned these disastrous securities because, in large measure, the risks were rated AAA. Therefore, in the economy of both the bankers and their regulators, they did not have to hold much capital against the securities. AAA securities that yielded 30 or 40 basis points of net interest margin were attractive to banks only because the regulatory regime allowed enormous leverage on such highly rated securities. It was called "regulatory capital arbitrage," and it was a disastrous game, but it was a direct response to a regulatory environment where risk assessment was outsourced to the rating agencies.
Owning huge amounts of high rated, low yielding assets—in retrospect a doomsday trade—was a direct response to a regulatory regime that mandated capital requirements based on ratings. It was not a failure of regulation to detect or prevent excess leverage. Leverage grew in response to foolish regulations.
The government's paw prints are all over this crisis. The effective duopoly enjoyed by Moody's and S&P is and was a government construct. U.S. Security and Exchange Commission (SEC)rules endorsing Moody's and S&P as "Nationally Recognized Statistical Rating Organizations" were only recently amended to broaden the field. Imagine a world where ten or twelve rating agencies competed freely. Much has been made of the fact that issuers pay for their own ratings. This is not ideal; but the real problem stems from the SEC's anointment of only a few.
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John B. Taylor's slim collection of essays was rushed to market, but we should be thankful that it was. Both Posner and Taylor charge Alan Greenspan (chairman of the Federal Reserve, 1987-2006) with primary responsibility for the housing bubble. Taylor, a professor of economics at Stanford University and senior fellow at the Hoover Institution, provides compelling evidence to support the charge. Greenspan himself has of course denied any responsibility for this, pointing out that there was a global savings glut that contributed to massive inflows into many asset classes, including housing.
Taylor will have none of this. In a simple and cogent analysis, he shows that there is no evidence to support the global savings glut theory, and then demonstrates that the housing bubble was highly correlated, both here and abroad, with deviations from less discretionary approaches to monetary policy such as the Taylor Rule.
The Taylor Rule (named after him) is a simple monetary policy rule that prescribes how a central bank should adjust its interest rate policy in response to inflation and macroeconomic activity. If the Fed had followed such an algorithm, it would have started raising rates at the start of 2002, over two years before Greenspan actually began to hike them. Taylor demonstrates concretely what others have suggested with less evidence. The decision to leave rates below 2% between 2002 and 2005 was a direct contributor to the contemporaneous overinvestment in residential housing. He argues that this excessively cheap money was a chief cause of the housing bubble. His graph showing that across Europe deviations from the Taylor Rule are highly correlated with excessive investment in housing stock is particularly convincing.
Taylor, like Posner, goes easy on Greenspan, faulting him for essentially analytical errors: keeping rates too low for too long, overestimating the risk of deflation. Neither author mentions the political debate from that time. Was Greenspan giving too much consideration to the dynamics of the election cycle? Recall that in 2003, with the George W. Bush and John Kerry campaigns in gear, many were predicting, correctly it turned out, that Greenspan would be reluctant to jack rates until after the election. He would try not to do to Bush 43 what some had accused him of doing to Bush 41, namely, undermining his reelection with a tight monetary policy. As Greenspan the Maestro begins more and more to look like Greenspan the Fumbler, rules look more attractive, and the Taylor Rule seems better than most.
Taylor points out that, in the crisis of '08, the government initially misdiagnosed the problem as one of insufficient liquidity (not enough money in the system) rather than counterparty risk (financial institutions being fearful of dealing with one another because they did not know who might be the next Lehman). The government's rush to provide liquidity through various funding facilities missed this important distinction, and wasted precious time.
Worse, the federal government exacerbated the crisis by "supporting certain financial institutions and their creditors but not others in an ad hoc way, without a clear and understandable framework." Bear Stearns failed, Fannie and Freddie got rescued, Lehman was allowed to fail, Washington Mutual failed, AIG got rescued. None of it made sense at the time; none of it makes sense in retrospect.
Taylor looks for guiding principles in these bailouts and, finding none, criticizes the government for not having a predictable framework for intervention. He calls for the development of a framework for exceptional access to government support. Certainly it has been painful watching Paulson and Geithner simply winging it.
Taylor suggests that we look for guidance to the International Monetary Fund (IMF) which, after a tumultuous string of emerging market crises in the mid- to late 1990s, adopted in 2003 an "exceptional access framework," allowing for the restructuring of debts in preference to continual IMF bailouts. The example seems appropriate. The linchpin of the IMF framework is that bondholders in emerging markets debt now face the prospect of severe restructurings if the countries' policies head off track. The IMF will not always be there, and creditors face the real threat of having their holdings diminished. Consequently, creditors police the economic policies of nations to whom they lend. The tragedy of our bailout is that the bondholders of the most reckless banks now apparently hold obligations that are virtually government-guaranteed. So while Citibank's stock is still down more than 90% from its high, Citibank's bonds are trading close to full face value.
By advocating a new framework, Taylor implicitly supports incumbent regulators who claim they lacked the tools and the authority to deal with these faltering financial behemoths. But do we need a new framework? Current regulations require that such institutions be put into receivership. That was the framework; in the panic of last fall it was abandoned.
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A popular current view is that the Lehman experiment with market discipline was a disaster. Taylor correctly argues that, after Lehman's collapse, the threat to the system was uncertainty. Who would be next? At that point there was a need for regulators to identify which financial institutions were healthy, and which were not. Regulators missed this opportunity, markets unraveled, and beginning with AIG those deemed too big to fail got bailed out.
In retrospect, it appears that the regulators failed to separate the strong from the weak because they simply did not know which was which. The fact that Geithner was initiating stress tests on the nation's 19 largest banks in the first quarter of 2009 surely points to massive regulatory incompetence. What in the world had he been busying himself with beforehand? Apparently, before April 2009 regulators did not know which financial institutions could weather a 25% downturn in home prices and an unemployment rate above 10%. These same folks now want more authority.
It was, and is, the primary responsibility of regulators to know which banks have insufficient capital to weather expected and unexpected economic upheavals. As the unexpected becomes likely, regulators have a duty to protect the system by shuttering the weakest players and, if necessary, fortifying the strongest so that systemic collapse is not a realistic threat. We don't need new regulations or a new framework to accomplish that.
The Obama Administration's latest proposals for financial reform seem to envision a superhuman regulator who will catch excesses before they occur. This is naïve. Regulators need not be heroes if creditors have an interest in being vigilant; and creditors will have such an interest if recklessness faces the penalty of real loss. Unfortunately, we have just assured all creditors that their interests will be protected, no matter how reckless they are.