PrefBlog

Menzie Chinn writes in Econbrowser a very gloomy piece about the state of the US banking industry and urges a bail-out … of some kind:

As I’ve said before, “Just say ‘no'” is not a viable policy. The key point is to realize that, just like some of the East Asian economies in 1997, we are well past the point about worrying about the impact of current policies on “moral hazard” (see this analysis [pdf]). We needed prudential regulation in the period leading up to the housing boom (sadly, policy makers failed in that respect).
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And make no mistake — the financial system is to some degree already frozen, and there is little prospect for a complete unfreezing of the system without substantial government intervention.
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In this sense, the current crisis is very much like the S&L crisis. And as it looks more and more likely that the government will have to spend billions of dollars bailing out investors, banks, and households, it seems to me that accountability is required.
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And we should look very carefully at the proposals that are being pushed by the financial industry, even as we acknowledge that laissez faire is not tenable, and we seek to establish procedures and institutional reforms that will prevent a replay. In particular, thinking about a well-funded, integrated, regulatory system that is insulated from political pressures would be a good place to start.

Now, I’m the last to deny that the banking industry is having problems, but this is simply too much.

At this point, it is not accurate to say that the current crisis is reminiscent of the S&L crisis, for the very good reason that there have been no failures or insolvencies of note. Illiquidity and losses have led to the takeover of Countrywide by Bank of America, and to Citigroup getting expensive new capital, but this is not the same thing as insolvency. The American banking system has been regulated sufficiently (by the Fed, through such measures as Tier 1 Capital ratios) that the system has been bent, but not broken.

Even the nationalization of Northern Rock in the UK (very briefly mentioned on February 19 – as the ultimate consequence of illiquidity and a subsequent run on deposits – has not been due to insolvency: it has been due to illiquidity, which is not the same thing.

In Germany, there has been a government bail-out of IKB Bank, which has been criticized (see February 13 and February 14).

As far as the overall health of the banking system is concerned, let’s look at the Fed’s Term Auction Facility. The last one was reported on February 12; there was one today. The very low premium on this money relative to Fed Funds – and the continuing drop in the TED Spread – leads me to conclude that insolvency, potential or undiscovered, is not a problem in the banking system. It’s illiquidity, pure and simple.

Given that insolvency is not a problem, the illiquidity will sort itself out over time, as loans, good and bad, run off the books. There are continuing anecdotal reports of credit being scarce, but that too will become less problematic as operators improve their balance sheets – either by the sale of new equity or simply reducing share buy-backs and retaining a greater proportion of earnings – to take advantage of the tighter conditions.

All this being said, there are clearly improvements that can be made to the regulatory process, improvements that will be familiar to assiduous readers of PrefBlog.

Firstly, the boundary between the core banking system and the shadow banking system must be more sharply defined. Willem Buiter has suggested regulating hedge funds like banks if they act like banks; presumably this would apply as well to SIVs. I say no; this will choke off innovation and, perhaps more to the point, a respectable and well-understood channel for speculative animal spirits. There will always be speculators, and God bless ’em. Let us ensure that they speculate in ways that are both useful and at least one step removed from the real economy … that is, in the financial markets.

But while letting the speculators speculate, we should ensure the core financial system is not put at risk; this may be accomplished simply by increasing the capital charges on banks’ exposures to shadow-banking. The capital charge for liquidity guarantees to SIVs does not appear to have been enough – double it! And, as I have argued, it appears that in practice, banks retain credit exposure to instruments held by their money market funds – they should be taking a capital charge for this exposure.

I suggest as well – given the Northern Rock experience – that the definition of Risk Weighted Assets for regulatory purposes, in addition to the charges for operational risk and market risk, include a charge for financing risk … too much dependence on any one source of financing would result in the need for more capital.

Other potential improvements to capital adequacy rules will doubtless be apparent to those who are more specialized students of the banking system than I.

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

And, quite frankly, I find it hard to cry about the current decline in housing prices. James Hamilton of Econbrowser reports, for instance, that house prices in San Diego have doubled in the last seven years. What goes up very often goes down. Get used to it.

As my parting shot, I will take further issue with Mr. Chinn’s assertion that the current situation bears resemblance to the S&L crisis. As discussed above, there is the important difference that we are not seeing much in the way of insolvencies at the present time; but the roots of the situation are more to the point. I suggest that the causes of the current situation bear a lot of resemblance to the bond bear market of 1994, in which a lot of people – notably, Orange County – got hurt because they had engaged in term-extension trades to take advantage of 1993’s extremely steep yield curve. I suggest that term-extension trades – in SIVs, in Auction Rate Municipals, in Northern Rock’s financing strategy, in the pricing of RMBS at spreads to LIBOR – are deeply implicated in the current crisis.

Update: Taking the last point a little further, I will highlight my confusion as to why the brokerages are taking such enormous write-downs on sub-prime product. This has never made a lot of sense to me … but, if we accepts that a lot of this stuff is issued at a spread to LIBOR, how about the following transmission mechanism:

• Client buys long-term spread product
• Client levers the hell out his position (given that it’s investment-grade rated spread product, the temptation to do this may have been overwhelming)
• Price goes down
• Margin call gets made
• Client walks, and/or
• Position sold out at a loss

I suggest that one things the authorities could look at is whether (or, perhaps I should say, how much of) the losses are due to this mechanism. If significant, perhaps an extra capital charge could be levied with respect to loans collateralized by securities which have a term greatly in excess of their spread index.

This could, possibly, be made more general: if you’re building a nuclear power station, get fixed-rate financing for the long term!

Update, 2008-2-27: James Hamilton at Econbrowser highlights the new housing price numbers and (rather sniffily, I thought!) points out the danger:

The reason to be concerned about this is that the farther house prices fall, the greater the number of homeowners who move into the category of negative net equity, that is, owe more on their mortgage than the home is worth. And the farther into the red a household becomes, the greater the incentive and propensity for the homeowner to default on the loan. More defaults mean more losses and greater risk of insolvency for large financial institutions.

And if you think the economy can continue to hum along without those institutions continuing to extend credit, well, we may get some interesting additional data relevant for your hypothesis in a rather short while.

In other words, regardless of how good a ride it’s been for the decade as a whole, a downward trend is going to lead to more jingle-mail.

Well, that certainly is a factor. What I don’t know at this point is:

• What the current loan-to-value distribution of mortgages is
• how the reaction of new negative equity holders will compare with the older ones (presumably, the outright scam artists and cavalier speculators have already mailed in their keys
• how much of the damage will be borne by the banking sector, as opposed to the investment sector (e.g., pension fund investments)
• how much of this damage has been discounted already

Stay tuned!

Update, 2008-02-27: I note a Cleveland Fed Research Report:

The Federal Reserve Board’s January 2008 survey of senior loan officers (covering the months of October 2007 through December 2007) found considerable tightening of credit standards for commercial and industrial loans since the last survey. About one-third of all domestic banks and two-thirds of all foreign banks surveyed reported having tightened standards for these types of loans for small as well as large and medium-sized firms. The remaining fraction of banks reported little change. The reasons cited for tightening included a less favorable economic outlook, a reduced tolerance for risk, and worsening of industry-specific problems. A large fraction of domestic and foreign banks increased the cost of credit lines and the premiums charged on loans to riskier borrowers. About two-fifths of the domestic banks and nearly eight-tenths of the foreign banks surveyed raised lending spreads (loan rates over the cost of funds).