Whom to trust?

Many months back, I wrote about the central issue around the financial crisis was one of trust. Until trust is restored, the gears of the financial system remain jammed. Most of the current activities around restoring market confidence have been about ensuring that there is adequate money supply however; this has not really been the central issue in this meltdown. If anything, the current solution will likely lead to inflation down the road. The central issue is not the supply of money but the velocity of money. It’s not moving and it’s not moving because it is difficult to ascertain who is credit worthy.

The here’s an article about the notion of quarantined assets in order to isolate toxic assets. Not sure about the mechanics of this but it’s an interesting idea. The moral hazard issue remains unresolved.

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Market Volatility and Interbank Lending

The markets have been taking a wild ride these past few weeks. Those of you who crave volatility must be having a field day however; one can’t help but be puzzled as to what’s causing the recent market swings.

We know that the roots of the current financial crisis lie in the securitization of sub-prime mortgages and a general failure in containing risk within these portfolios. We know that there are significant funds being made available to the financial institutions to make loans as well as to purchase toxic assets off the balance sheets of these institutions. So why all the uncertainty and when will recent measures actually bring stability to the markets?

Banks form the base of the economic pyramid given that businesses depend on them for loans for various projects that otherwise would not be carried out. At the end of the day, banks make money from these transactions and have typically relied on the ability to borrow from each other should they experience a shortfall of cash reserves at the end of each business day. The recent revelation regarding financial institutions with unprecedented levels of toxic assets on their books has resulted in a disintegration of trust among banks. This has caused banks to start hoarding cash instead of freely lending to each other.

Interbank lending rates such as LIBOR can be used as a rough proxy for the measure of trust between banks. Despite cuts of the benchmark lending rates by the Federal Reserve and the Bank of Canada, LIBOR has jumped to the highest levels since December of last year. In other words; banks do not trust each. After all, without clarity on how these assets will be divested, they could end up lending money to insolvent institutions. Furthermore, banks have no reason to believe that borrowing banks will no longer engage in the activities that got everyone in this mess to begin with. To the best of my knowledge, there has been no notable change in regulations, executives or boards of directors at any of the offending institutions. Perhaps there is a concern that any such move would be interpreted as an admission of wrongdoing. In any case, it is unclear when banks will free up capital and when business will have access to prior levels of debt financing. While this is the case, I am not sure that we can expect stable markets anytime soon.

2008 Financial Meltdown

As the US House declines to dole out $700B in “the largest government bailout of Private Industry in US History”, articles all over the web are fired up about how this happened and who is to blame. At the heart is the question of what the government did or did not do to bring about this crisis. It is refreshing to see the tide of the conversation shift from treating this as if it were a natural disaster. Let’s be clear, this is not a disaster in the sense that no one could have seen it coming – this is something that was well known and to some extent knowingly engineered by the financial institutions (in some cases by the very institutions that are crumbling as we speak.) I say it was knowingly engineered because the causes are rooted in the general culture of the financial institutions.

The most interesting assertion is that the problem was caused by the deregulation of the financial markets. I am not in the financial industry and do not scrupulously stay on top of financial regulations the way I do legal aspects affecting the technology industry, however, I highly doubt that this outcome is a result of regulations or lack-thereof. To understand why this is so, we have to delve a little bit into what’s the cause of the current meltdown and how the financial institutions are very adept at circumventing regulations through derivatives without breaking any laws.

Money lenders take funds deposited in savings accounts and turn around and lend these funds out to other customers who require a loan. Most people think that these institutions only make money on the spread between the rate of interest paid out and the loan interest – that’s not the case. Instead, institutions combine these loans into large bundles and then turn around and sell the whole thing to other institutions (or even individual investors). They then take the money raised from this sale and go at it again. In this way, institutions can lend out far more money than they actually have in deposits – in some cases, they lent out more than 30 times the amount of money they had in deposits. Of course, the whole thing works just fine so long as only a reasonable number (determined by statistical means) of the loans default.

For an individual loan, it is relatively simple to determine the risk of default – you look at the equity the individual owns, their credit history and come up with some assessment of risk. When you now combine loans together and bundle them together, you actually take advantage of well understood concepts of risk diversification so that the overall risk of the bundle is much lower than that of any individual loan in the bundle. This result of risk diversification however only holds true as long as the components of the bundle do not strongly correlate to one another. In other words, the more different the items making up the bundle, the stronger the effect of diversification. With credit default swaps for sub-prime loans, this principle seems to have gone out the window. If you were to take a bunch of rotten loans and put them all into a bundle, you don’t get any benefit of diversification – all you have is a rotten bundle. If you were to then turn around and sell this bundle, well, the problem is no longer yours – caveat emptor.

So is the bailout a good idea or a bad one? One of the least appealing aspects of the now defunct legislation is how it attempted to throw out the tried and true free-market economic policies of Hayek in favour of the Keynesian philosophy of government interventionism. As illustrated above, the failure of the markets was caused by people knowingly engaging in poor decisions in favour of short term interests (Yes that is a polite way of saying unbridled greed.) The companies that are therefore facing bankruptcy are simply facing the consequences of their own actions. If the free-markets truly embody the survival of the fittest philosophy then these businesses should collapse and better players would swoop in and buy up the functioning pieces. Bailing out the executives and the boards of directors who knowingly let this happen is absolutely the wrong thing to do. Of course, there can be grave consequences to the economy if the current crisis is not contained within the financial institutions. Financial institutions form the base of the pyramid that supports businesses that rely on them for financial services such as loans and diversification of risk through hedging. These services are essential to keep the economy functioning well. The institutions and executives who let things get to this stage have known that this fact alone would compel the government to bail out an all out collapse. The current crisis therefore illustrates that the moral hazard that some economists fear would come about as a consequence of this bailout in fact already exists today.

Here are some other opinion pieces for you to consider:
Bankruptcy, not bailout, is the right answer
Bailouts will lead to rough economic ride