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.
Resource:
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.”
