The following post is by InfiniteGuest, a regular reader and frequent commenter.
It's earnings season, it's bonus time, and now that the Angelides Commission has begun holding hearings and legislation is under way to form a permanent resolution authority for troubled financial institutions, the related topics of what caused the financial crisis and how to handle the next one have garnered fresh attention, to put it mildly. Juxtaposed against the sluggish real economy, the robust health of our financial sector makes it an easier target than ever for enemies of every stripe. Yesterday, under acute political pressure, President Obama used the bully pulpit to blame the financial crisis on the greed of financiers unfettered by ill-advised deregulation, advocating among other things the reinstatement of Glass-Steagall. The Angelides Commission will need a strong constitution to keep from being unduly influenced in their investigation by the President's statements. He has identified the causes, he's found a solution, and he is, after all, the most powerful man on earth. One could be forgiven for believing that the final narrative of the Angelides Commission has already been written even though the inquiry has barely begun.
I have a more fundamental topic in mind. Before asking about causes and solutions, shouldn't we first define the crisis? As it now stands, The financial crisis, the subprime fiasco, the recession and the current unemployment picture have all been jumbled together -- by the media, by elected leaders, economists and other experts -- to the point that in the public imagination they are all one thing; and although I do not dispute that they are related in the context of our larger society, I put it you that unless we look at them all as different and distinct phenomena, we can't investigate their causes, we can't find effective solutions, and we can't help blaming the financial industry for all of it.
High unemployment is ongoing and may continue to rise. Recent reports of growth notwithstanding, the recession is probably also ongoing. The subprime fiasco is ongoing in the sense that foreclosures continue, but not in the sense of any new subprime loans. The great financial crisis is over. None of the major financial institutions is in imminent peril of bankruptcy. No one is worried about a run on the banks. US Treasuries are near record highs. The TED spread is back to pre-crisis levels. Financial markets are open for business trading record volumes once again. Volatility is relatively close to the long-term mean. Mutual funds have recovered most of their value, and, as profitability returns, so do the stock prices of most publicly-traded financial institutions. Even the Fed earned a record profit. Regardless of the causes of the financial crisis, it is over. It began with the forced sale of Bear Stearns, and if it wasn't over before Citi repaid TARP, then it certainly is now. The financial crisis was just that. A financial crisis. It was a period of time during which, because of fears that major financial institutions' liabilities exceeded their assets, the financial system itself was endangered.
Understanding, as we all do, that we live in a world where markets are the preferred mechanism for price discovery and where banks and investment banks play a key role in the allocation of capital, one appreciates that a financial crisis on this scale necessarily impacts the real economy. That the financial industry accounts for a great share of global income, profits and of course consumption only multiplies the impact of a financial crisis. But the primary victims of the financial crisis, those most immediately and directly hurt, were the owners, the managers and the employees of major financial institutions.
It should be obvious that the forced sale of Bear Stearns did not cause the subprime fiasco, and that Bear was not the sort of "Too Big To Fail" banking Frankenstein that, by repealing the Gramm-Leach-Bliley Act, the President aims to dismantle. Some people seem to have forgotten that Bear was a victim of subprime lending. It may be less obvious that Bear Stearns was a victim of GLBA.
Recall that in the summer of 2007, Bear bailed out their own investors, at great cost, after Merrill Lynch seized BSAM's collateral over concerns about the failing subprime market.. Don't blame Merrill. Especially under the framework that has prevailed since the collapse of LTCM in 1998, seizing Bear's collateral, though aggressive, was a responsible, even conservative course of action. But since the collateral took the form of illiquid CDOs, simply seizing it was insufficient to reduce Merrill's exposure. They had to sell it.
There was a time when the practice of valuing illiquid financial instruments by reference to more liquid benchmarks was controversial, and it was once acceptable to ignore a price when either of the counterparties had a more compelling interest than the transaction at hand, but the fantastic success of derivatives risk management long ago made any such reservations seem quaint. The "price discovery" from Merrill's failed sale of BSAM's collateral provided a reference for the pricing of other related securities, forcing writedowns everywhere and giving Bear Stearns its first ever quarterly loss, and sowing the seeds of the catastrophe that would sprout the following spring. The point of this brief history lesson is simply to remind us, in case we have forgotten, that prominent among the proximal causes of the financial crisis were Merrill's prudent risk management and Bear's extraordinary commitment to shield their investors from the full cost of the deteriorating subprime market. All the while, the economy was sinking into recession.
In order to maximize utilization of capital, the industry tends toward financing its own interest obligations with no intention of ever repaying principal. So long as the economy grows, and inflation remains relatively low, that approach is generally sustainable.. There are technical reasons why this should be so, but intuition is sufficient. Finance is primarily the business providing capital to the economy with the expectation of future revenue. Growth in the economy thus financed provides the necessary revenue. Inflation, on the other hand, reduces the relative value of fixed-interest obligations and creates demand for higher short-term interest rates. The recession that began at the end of 2007, like the inverted yield curve that preceded it, deteriorated the capital position of the entire industry.
Let's all remember at this point a familiar and related structural issue, specifically with respect to depository institutions, that they are in the position of matching liquid deposits against illiquid and often non-recourse assets. Relative to the institution, the depositor essentially holds a zero-cost-structured American-style option, paying a premium to the bank in the form of a reduced interest rate. Reserve requirements and deposit insurance are meant to protect the economy from the obvious peril of placing the financial system in that position. But as we have seen, deposit insurance was mispriced and reserve requirements inadequate relative to the asset side of the equation. The problem here is not one of insufficient regulation but rather one of over-regulation, that is, the financial system is obliged to value its assets by reference to market mechanisms, but not its liabilities. Deposit insurance is moral hazard.
GLBA gave banks the freedom to move in on the broker-dealer business, and absent a run on the banks, it gave them a funding advantage over existing broker-dealers like Bear Stearns. Their funding edge allowed banks to depress the prices swaps and derivatives, relatively speaking, but so long as the repo market was healthy and everyone made money, not enough of an edge to create the incentive for broker-dealers to compete with banks for deposits. And in less sanguine times, the broker-dealers had no means to acquire the protection of a depository base, which was suddenly far more vulnerable in any event. On the other hand, good times made it cheaper for banks to develop their brokerage business in large part organically, but as we have seen in several cases, including the case of Bear Stearns, uncertainty made for bargain-priced acquisitions.
The Angelides Commission has pledged to follow the evidence wherever it leads,to investigate any fundamental problems, and to make recommendations for the future. Their final report will be the official narrative of the financial crisis, the one that goes into the history books for the next generation. I, for one, hope they take their mission seriously, independent of the prevailing political winds. If they discover that, in hindsight, financial institutions were by-and-large too conservative, that the smaller and less diverse ones were more vulnerable, that regulation was too heavy, that mathematical modeling didn't go far enough and that the financial crisis was brought on by weaknesses in the real economy, rather than the other way around, I hope the Angelides Commission reports just that. I hope their word is their bond.