Friday, May 9, 2014

After the music stopped – “Yet another work about the crisis and its aftermath”?

This is the question that Alain S. Blinder itself asks at the beginning of his book. On the one hand, he is right, and I hesitated reading the book for exactly this reason: Haven't I read enough on this stuff in the past years? But I admit that the book is still worth reading, especially if you are interested in getting an overview of the U.S. financial system and its recent history.

What caused the financial crisis and what we should learn from it.

The book starts off describing the main causes of the 2007/08 financial crisis and finishes describing the lessons we should learn from it. Both topics are linked and, therefore, the elements Alain S. Blinder points out somewhat overlap:

  • Too much leverage in the system: Banks and other stakeholders in the economy simply borrowed super-abundantly instead of using own equity to buy financial assets.
  • Too much complexity of financial products: Complexity creates opacity and confusion. Why are financial products always that complex then? Alain thinks, the reason is that complexity is a profitable business. The more complex and customized a security is, the harder it becomes to compare its price. And without comparison there can be no effective competition.
  • Too much liquidity and credit: The primary example here is lending to sub-prime mortgage borrowers.
  • Too little regulation and oversight: In the financial sector, we lacked both good laws and their efficient execution. Alain S. Blinder specifically writes that excessive faith in the efficient markets hypothesis and self-regulation by the industry cannot replace good regulation.
  • Wrong remuneration incentives: They relied too much on volume instead of quality of loans financial institutions generated.
  • Keep financial assets on your balance sheet (and not off-balance sheet, to avoid regulatory capital charges).

I like both the beginning and the end of the book. The author's conclusions are perhaps not brand new but he has the merit of describing these complex issues very smoothly.

How the financial crisis developed in the U.S. and reshaped the local banking landscape.

If I had to stick to one argument for reading the book, it would be this part. Alain reports the history of the crisis easily understandable for everybody and gives a good overview of the U.S. banking sector before and after the 2008/09 financial crisis. He describes the following main events:

  • 13 BUSD emergency loan to Bear Sterns by J.P. Morgan, using FED funds: With a strong activity in mortgage origination and securitization, Bear Sterns failed mainly because it refinanced itself with cheap and very short-term funds and ran out of liquidity. In the reasoning of the author, the FED helped Bear Sterns not because it was “too big to fail” but because the FED feared Bear Sterns could be “too interconnected to fail”.
  • Lehman Brothers bankruptcy: Alain S. Blinder describes four reasons that made the U.S. government refusing a bail-out of Lehman Brothers: Markets had enough time to prepare for the bankruptcy, Lehman Brothers seemed less interconnected to fail than Bear Sterns, the U.S. Government lacked the legal authority to organize a bail-out, and it wanted to avoid moral hazard spreading around.
  • Failure of AIG: Due to its AAA rating and extremely lax regulation in the insurance sector, AIG heavily engaged in trading credit default swaps. The FED helped the insurance company by granting a 85 BUSD loan.
  • Sale of Merrill Lynch to Bank of America: After heavy lending to mortgage originators, Merrill Lynch had to write down, during the financial crisis, these loans substantially.
  • Sale of Washington Mutual to J.P. Morgan due to extensive sub-prime mortgage lending by the former.
  • Merger of Wachovia into Wells Fargo

Monetary and economic recovery programs in the U.S.

Alain S. Blinder details the options that the FED had to safeguard the economy, i.e. injecting capital directly into banks, buying toxic assets, refinance banks and their toxic assets, or guaranteeing toxic assets. He develops the following operations initiated by the FED and the U.S. government:

  • 700 BUSD Troubled Assets Relief Program (TARP): Contrary to the U.K. which invested exclusively in banks' equity, the U.S. opted for a mix of the repurchase and equity injection solution. The author reports the political process of adopting the TARP program in the U.S.. Against criticism (namely as regards a missing solution of excessive compensation in the banking sector) by others, he views the TARP program as successful. In my view, the book goes too much into the details of the political process here. I would have been more interested in exploring the pros and cons of the different options to save the banking sector.
  • 200 BUSD Term Asset-Backed Securities Loan Facility (TALF): The FED made non-recourse loans to institutions which were willing to buy certain asset-backed securities.
  • QE1 (Quantitative easing 1): The FED bought debt obligations from Fannie Mae and Freddie Mac.
  • American Reinvestment and Recovery Act of 2009 (ARRA): Overall, Alain S. Blinder judges the economic stimulus package satisfactory as measures have been taken timely, were targeted to stimulate aggregate demand, and temporary.
  • Other quantitative easing programs such as QE2 and Operation Twist: Overall, the author has a positive view on these programs.

In addition to the above, a merit of the book is its clear description and distinction of conventional and unconventional monetary policy measures as well as the moment when central banks switch from the first policy set to the latter. As Alain explains, a switch should be made when interest rates get close to zero.

Too big to fail debate

The author starts off with a very simple solution to avoid banks being too big to fail: Break up financial giants and, thus, simply avoid the existence of systemically important financial institutions. However, the author rightfully rejects this simplistic and unrealistic solution.

What's the alternative then? Stronger regulating the financial system. This is exactly what the Dodd Frank reform does. Alain S. Blinder touches upon every important topic here – from separating investment and commercial banking, over skin-in-the-game requirements for originators of securitized financial assets and capital and liquidity requirements for banks to executive compensation.

The author describes and criticizes the regulatory process following any new law on financial regulation (i.e. proposal of regulation, comments and input by the public, fixing of the regulation). In his view, this process is fundamentally flawed because it is not the general public that gives input but only biased parties and lobbyists.

Exiting extraordinary monetary policy.

For the author, it is a given that the FED must revert to a normal monetary policy in the near future. Otherwise, it would risk fueling the next bubble, namely through interest rates close to zero and excess reserves of banks with the FED.

The question is just when and how. Obviously, this part of the book has been, to some extend, run over by the FED's exit strategy, now being in place since a few months.

Additional topics of the book include the spread of the 2007/08 financial crisis into Europe and the European sovereign debt crisis from late 2009 to 2012. These parts, even though well written, are clearly not Alain S. Blinder's main focus. I would recommend reading the book if you are interested in the U.S. stuff. There are certainly other books out there which treat the European topics better and more extensively.


Additional Quotes

“A bubble is a large and long-lasting deviation of the price of some asset – such as a stock, a bond, or a house – from its fundamental value. Usually it's an upward deviation. The definition of what is large and what is long-lasting makes it difficult to predict and recognize bubbles. The fundamentals always win out in the end, the question is just when.”

“Risk spreads were irrationally small [in the run-up to the financial crisis] and therefore had to widen.”

“Leverage is a double edge sword. It does magnify returns on the upside, which is what investors want. But it also magnifies losses on the downside, which can be fatal.”

“The result of extreme leverage is predictable, though its timing never is.”

“When times are good, asset value are rising, and loan defaults are rare, it is all too easy to forget one of the laws of financial gravity: What goes up too fast usually comes crashing down.”

“Complexity and opacity are potential sources of huge profit.“

“Had Wall Street not concocted a system that was long on complexity and short on liquidity, the panic might have been contained.”

“The fallout from the bankruptcy of Lehman Brothers was the exception that proved the rule [that exceptional adverse economic events do happen].”

“The TARP was among the most successful – but least understood – economic policy innovations in our nation's history.”

“Credit is a coward. It struts around when times are good and lending risks are low, but runs and hides whenever risk rises. Since credit is critical to any modern economy, that's a problem.”

“The financial crisis gave hedge funds a bad name, probably a worse name than they deserved.”

“But no matter how lengthy and complex the law, it is virtually never more than a skeleton. The sketchy, sometimes thematic content of each regulatory statute must be translated into concrete, detailed regulations by the agencies involved.”

“In a capitalist society, rearranging property rights outside of well-established legal channels, such as bankruptcy courts and foreclosure proceedings, is a nasty process – something to be avoided except under extreme circumstances.”

“The more things change, the more they stay the same.”

“The cure [a blueprint for financial reform through the Dodd Frank Act] was being prescribed long before the diagnosis was in.”

“It seems that the FED's exit strategy has to be not too fast and not too slow, but just right. The FED is human; it won't get the timing exactly right. Rather, it will err in one direction or the other. But magnitudes matter.”

“The truly horrendous budget problems for the U.S. come in the 2020s and 2030s, and beyond. The projected deficits are so huge that filling most of the hole with higher revenue is simply out of question. Spending cuts must bear most of the burden. Over the long term, controlling spending means controlling health care spending. It's that simple – and that complex.”

“The story won't be complete until the “exit” from the European sovereign debt crisis comes. And that may be a long way off.”

“Europe dragged its collective feet, each time kicking the can just far enough down the road to get to the next summit meeting.”

“The new LTRO looked like a game changer. But it did not solve the sovereign debt crisis. The central bank can't do that, of course, any more than the FED can solve the U.S. government's mounting debt problem. Only governments can – by cutting spending and raising more revenues.”

“Moral hazard is now an undesirable feature of the financial landscape. One important aspect of Never Again is convincing financial markets that the government will not rescue them from future mistakes. The game of “heads you win, tails the taxpayer loses” is not one we want to keep playing.”

“When the good times roll, investors expect them to roll indefinitely. But they don't.”

“We need real regulation, zookeepers watching over the animals.”

“What you don't know can hurt you.”

“High profits are often illusory, the product of applying high leverage to ordinary investments.”

“Modern finance thrives on complexity; indeed, you might say that the central idea of financial engineering is complexity. But ask yourself whether all those fancy financial instruments actually do the economy any good. Or are they perhaps designed to enrich their designers?”

“Bubbles will be back. So will be high leverage, sloppy risk management, shady business practices, and law regulation. We need to put in place durable institutional changes that will at least make financial disruptions less damaging the next time the music stops.”