In many
aspects, the current financial meltdown that brought many banks and insurers
to insolvency may be compared to the nuclear meltdown that affected the
Chernobyl power plant. And whatever Big Government pundits may tell us
endlessly - without real in-depth arguments - inappropriate state intrusions
in the economy are as much responsible for the financial crisis as poor state
management of nuclear facilities by USSR was for the Chernobyl disaster.
If the
mechanisms of the so-called “Chinese syndrome” can be described
as a process of ignition, amplification, and then propagation of atomic
reactions, likewise, the current crisis is a story of state interventions in
the economy, that ignited, amplified, and then propagated the meltdown from
its original core to the whole financial system.
Ignition
The
main factor that ignited the current crisis is how politicians forced two
state regulated enterprises, Fanny Mae and Freddie Mac , to refinance a
growing part of unsecured loans to low and very low income families. In
exchange, Fannie and Freddie were exempted from some accounting requirements
generally expected from ordinary firms, allowing them to leverage too much
credit compared to their equity, by an extensive use of off balance
“special purpose vehicles.” All these operations were made under
an implicit taxpayer provided safety net, as the statutory rules of the
department of Housing and Urban Development made possible the nationalization
of Fannie and Freddie in the case of bankruptcy.
These
government provisions, coupled with a law mandating banks to find ways to
originate loans to some high risk-profiled borrowers (the much discussed and
controversial Community Reinvestment Act), reversed the usual prudential
rules governing company CEOs: first, don’t fail, and then, make a
profit. Due to their government backing, Fannie and Freddie only had to
expand their volume of business, without too much consideration of the
underlying risks. The purchase of so many bad loans by two state-backed
giants encouraged reckless lending by banks and mortgage brokers to many
risk-unaware families.
This
behavior was greatly helped by Alan Greenspan’s decisions to lower and
maintain very low interest rates in the early 2000s without consideration of the
obvious asset bubble that was emerging in the housing
sector. When credit is too cheap, borrowers tend to be less careful in their
investments.
Amplification
But
these facts do not explain by themselves how big the housing bubble has
become. The average Joe, in the mortgage broker’s office, was not as
unsophisticated as generally described. He could lose his common sense and
succumb to easy credit only because the brokers could show him impressive
Case-Schiller index curves, which seemed to show that any housing investment
could gain more and more value every year, making the purchaser richer even
while he was sleeping. Without this apparent housing inflation, many people
wouldn’t have jumped so recklessly onto the easy credit bandwagon.
But
this housing inflation did not occur everywhere in the country. Some of the
most dynamic metro areas, in terms of population growth, haven’t
experienced any housing bubble. Recent Nobel Prize Paul Krugman, supported by
several research papers, notably from academics like Ed Glaeser
or Wendell Cox, explained it by land use regulations : when these
regulations are flexible and tend to be respectful of the property rights of
the land owner, housing bubbles cannot even get started. But when regulations
allow the existing real estate owners to prevent farmland holders to build
the houses required to satisfy all housing needs, housing prices start
skyrocketing.
Housing
mortgage debt owed by families grew from 4.8 to 10.5 trillion USD (in french) from
early 2000 to late 2007. But had every city in the USA had the same flexible
land use regulations that they had in the fifties, and that still exist in
fast growing areas like Houston or Atlanta, this exposure to risk would have
been much lower, by 3 to 4 trillion. More borrowers would have qualified for
the prime credit market and its less risky loans, since the lower price of
the purchased homes would have resulted in better credit ratings. So, despite
the bad lending practices mentioned above, the risk of a general collapse of
the credit market would have been nearly equal to zero.
Propagation
At
this point, we just explained the roots of a mortgage crisis. What is still
missing is the way it has spread throughout the financial system. Once again,
bad laws are to blame.
First,
this crisis shows how risky the bank’s business model, grounded on low
equity and very high leveraging ratios, has become unsound in these time of
high volatility of some assets. Some will blame banks for this, but you
should be aware that before the creation of the FED in 1913, most
banks’ business models were based on equity levels over 60%: the shift
from a high equity to a low equity model comes first from tax policies which
have, in nearly every country of the world, severely taxed capital gains, but
encouraged debt by deducting the interest payment from the corporate tax
base. The second reason is that central banks, as “last recourse
lenders,” usually with a state’s warranty, have themselves
favored this shift to a highly leveraged model: borrowing money was de
facto a cheaper resource than raising capital to finance operations.
But of
course, this doesn’t explain how a 10% default risk on a credit niche
market (the subprimes), totaling less than 10% of the total housing debt (12
trillion at the end of 2007), itself less than one fifth of the total assets
being exchanged on American financial markets, generated such turmoil.
The
culprits must be sought within a set of rules --- whose latest version is
known as “Basel II” --- and their declinations in local laws in
most countries, aimed at regulating the activities of banks or insurance
companies. In some cases, poorly designed accounting rules may have
contributed, too.
Basel
II rules — and the like — mandate
banks and insurers to hold a diversified portfolio of assets aimed
at providing them the liquidities they need to face hard times: for a bank, a
major loss of customers; for insurers, a series of major disasters. These
rules were supposed to “protect” investors from reckless
diversification policies. So institutional investors were mandated to own
only high quality bonds, or to value some kinds of assets, like stocks, with
a weighting that de facto prevented their securities from handling such
assets directly.
But
banks and insurers needed the yields of “lower quality” bonds, or
even stocks, to remain attractive to private investors. Otherwise they
wouldn’t have been able to beat the performance of state labeled bonds,
and thus wouldn’t bring any added value to their customers, forcing
them out of the market.
So the
late 80’s and the 90’s saw the onset of a huge market of
“derivatives,” all based on the following principle: lower
quality assets (like subprime based securities bonds) are put together in
another security, which itself sells new bonds sliced into several
“tranches.” The first slice, the “z-tranch,” is a
very risky one, which is aimed at bringing a higher yield to unregulated
investors as hedge funds but must absorb primarily the first percentages of
any losses of the security. Other tranches bear a lower risk but serve a
lower yield. The “cushion effect” of the high risk tranch allows
the lower tranch bonds to receive an AAA rating from rating agencies,
particularly if they are covered against credit default by a special
derivative called a “credit default swap,” allowing lender and
borrowers to reinsure themselves against defaults on their bonds. And there
can be other “derivatives of derivatives” involved in these
designs. In many cases, institutions issuing AAA tranches guaranteed the
payment of the corresponding bonds.
So the
current situation is that many institutional investors do not hold many real
stocks or bonds in their portfolios. They mostly hold a majority of
derivatives.
But
all this incredibly complex financial engineering not only is extremely
costly, but has one perverse effect: while reducing the probability of AAA
tranches to default, it actually makes the amount of the risk higher in the
event that losses are high enough to impact the AAA tranches. And all these
complex designs of derivatives make it increasingly difficult to understand
where the risks are located in complex securities mixing prime mortgages,
subprime mortgages, and other kinds of credits. So when an AAA tranch is
impacted by higher than forecast losses, nobody really knows what is the
resulting worth of the best tranch if it has to be sold. Is it 95% of the
nominal? 60%? Nobody seems able to value these bonds reliably.
So
when the mortgage debtors began to be insolvent in a higher proportion than
usual, the losses on subprimes derivatives began to exceed the “cushion”
effect of Z-tranches. AAA bonds were impacted. Some holders of these bonds,
forced to sell off in panic in order to get cash, couldn’t find
purchasers, except some highly speculative funds that toughly negotiated the
price.
But
then, because of inflexible accounting laws, all institutions holding the
same kind of toxic assets had to write down the values of these assets in
their balance sheets, even if their treasury level didn’t force them to
proceed to a fire sale of these assets. So they might have been declared
virtually insolvent even if actually they were not. This affected their
ability to borrow on short term liquidities markets, and thus led some of
them ultimately to file for bankruptcy.
If no
regulatory limitations had been placed on the assets that banks and insurers
could hold, it is likely that they would not have found the use of exotic
derivatives so attractive, and that early difficulties in subprime credits
would have resulted in clear signals prompting securities managers to recompose
their portfolios. Some investors’ failures could have occurred earlier,
but would not have reached such proportions.
Big
Government is the culprit
So, at
the root of every mechanism identified as a catalyst of the current crisis,
we can find a bad federal or local regulation.
Does
this mean that private institutions have no moral and technical
responsibility in the current mess? Certainly not. They’ve deliberately
chosen to take advantage of these poisonous regulations instead of fighting
them, even though some of the underlying risks were clearly identified. Many
of them ifnored warnings issued by economists like Nouriel Roubini, or
atypical politicians like Ron Paul, and preferred to listen to reassuring
assessments of the soundness of the system written by star economists like
Joseph Stiglitz. People don’t like dream breakers.
Competition
to overturn bad regulations doesn’t exonerate financial private
institutions from having failed to do so properly. Whatever conditions are
created by the states, firms must act wisely. Many of them obviously did not.
But in the ranking of responsibilities, states’ inaccurate and
inordinate regulations obviously rank highest. Had its diverse regulations
and interventions focused on principles (honesty in contracts, no concealment
of malpractice, full disclosure of operations, respect of property rights)
and court litigation; had they let private individuals or enterprises decide
what was good for them without trying to curb their behaviors in particular
directions, none of the elements that allowed this crisis would have been in
place.
Government’s
economic interventions in human interactions once again have proved
counterproductive and finally wrought havoc. This should make people very
careful about government claims that new interventions are necessary to solve
the crisis and avoid the next one!
Vincent
Bénard
Objectif Liberte.fr
Egalement par Vincent Bénard
Vincent Bénard, ingénieur
et auteur, est Président de l’institut Hayek (Bruxelles, www.fahayek.org) et Senior Fellow de Turgot (Paris, www.turgot.org), deux thinks tanks francophones
dédiés à la diffusion de la pensée
libérale. Spécialiste d'aménagement du territoire, Il
est l'auteur d'une analyse iconoclaste des politiques du logement en France, "Logement,
crise publique, remèdes privés", ouvrage publié
fin 2007 et qui conserve toute son acuité (amazon), où il
montre que non seulement l'état déverse des milliards sur le
logement en pure perte, mais que de mauvais choix publics sont directement
à l'origine de la crise. Au pays de l'état tout puissant, il
ose proposer des remèdes fondés sur les mécanismes de
marché pour y remédier.
Il est l'auteur du blog "Objectif
Liberté" www.objectifliberte.fr
Publications :
"Logement: crise publique,
remèdes privés", dec 2007, Editions Romillat
Avec Pierre de la Coste : "Hyper-république,
bâtir l'administration en réseau autour du citoyen", 2003, La
doc française, avec Pierre de la Coste
Publié avec
l’aimable autorisation de Vincent Bénard – Tous droits
réservés par Vincent Bénard.
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