Floyd Norris in the New York Times has an interesting article that laments the fact that, unlike past financial crises, no one has stepped forward to encourage the sort of risk-taking needed to restore order to the markets.
Even though I enjoyed the piece, ultimately, the effort to look for a single agent to rally the industry misses the peculiar and deeply-rooted nature of our current mess. After all, Hank Paulson has repeatedly waded in to try to find solutions to pressing problems with very little success. Admittedly, the Treasury is a comparatively disadvantaged position, but nevertheless Paulson have endeavored to play the very role that Norris calls for.
So what is different now? The is one element Norris alludes to but does not tease out sufficiently: the financial markets have grown so large and complicated that the number of financial firms involved and the number of big problems they face are too large to be tackled. Just look at the monoline mess. You have several insurers, each with its own set of financial players that will be hurt in the case of a loss. Moreover, you have a large free rider problem. It’s impractical to involve all the exposed parties in a bailout effort; the number is easily in the thousands. But limiting the salvage operation to the ones who will be hurt the most means that they are aiding the rest too.
Now in the past examples that Norris cites, bankers stepped forward even though they no doubt faced similar free rider issues. He makes the mistake of attributing action back then to leadership. I would argue the failure of firms to step forward now is due to a shift in values.
The generational change in orientation towards markets and self-interest as primary guides for behavior has has a very destructive effect on action in support of the collective good. It’s difficult to imagine many children from upper middle class families today doing what young people did in the 1960s, demonstrating against the war (and risking going to jail), going to the South to register blacks to vote (risking their lives). Too many of the people I know who give time and money to charities are motivated to a significant degree by the networking opportunities.
In the old days, most people in the markets felt they had duties, and those might entail taking losses for the sake of the industry and one’s reputation. As we have discovered, individuals and firms are now willing to chuck reputation if the costs get too high and duty is a four letter word. It’s for fogies and fools.
But there is a bigger problem than the shift in values. Due to the complexity of the markets and the instruments and the number of flashpoints, there is insufficient capacity to analyze the problem and negotiate solutions.
We commented upon this last year with a vastly simpler crisis scenario (this is a small section of a considerably longer discussion):
So what could happen now? Let’s say we have another day like Feb 27, but Bernanke isn’t able to reassure markets. We see further ratcheting down and panic spreading to other markets.
….the lack of an LTCM in a that kind of meltdown is vastly worse. You can’t get people into a room, knock heads together, and force a solution. The problem is too big and spread out for that to work….
Now imagine that it isn’t a single institution, but even a handful of medium sized ones that add up to the market presence of a big one. Or a large institution plus a few middling ones. You get the picture. The diversification of the current system in most cases will reduce the risk of systemic failure. But with derivatives, with the right (meaning wrong) conditions, like another 1998, I am not at all confident that we are better off now.
In the scenario above, we argued that the simultaneous failure of multiple large-ish hedge funds would be too managerially demanding for Wall Street to manage. There wouldn’t be enough top executive and legal bandwidth to handle multiple crisis negotiations in parallel.
Now consider: what we were worried about was a mere hedge fund rescue. That is actually not a hugely complicated operation (the big issue is the fighting among the creditors and the need to reach agreement pretty quickly, because these firms can go down fast). That is far less complicated than figuring out what to do with problems that involve not just the financial dealers, but end investors and (ultimately) flawed structures and bad incentives.
In parallel, we have a subprime/housing crisis (which one might call a securitization crisis) which has led to wide-scale problems in affiliated markets, such as SIVs, asset backed commercial paper, and potentially the credit default swaps market if the monoline problems are not resolved. And if the securitization machine remains broken (likely) banks will be forced to carry more loans on their balance sheets, which will lead to a systemic reduction in leverage on an ongoing basis. We also have an auction rate securities crisis. Leveraged loans and commercial real estate aren’t quite at the crisis level, but they will lead to further balance sheet damage.
There are too many problems on too many fronts for the regulators or the industry to analyze and come up with solutions. Each is fiendishly complex. So instead we are getting patchwork, symptom-oriented approaches.
And the worst is even if the industry knew what to do, there isn’t enough capital in the large institutions to execute a rescue, even in one crisis area. They’ve been forced to go begging to the sovereign wealth funds, who are already signaling that they are not keen to extend themselves any further. And they are far from done with taking writedowns.
So that’s a very long winded way of saying Norris’ piece misses the depth and complexity of our current situation.
From the New York Times:
Where is the next J. P. Morgan?
In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction.
In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.
Such moves involved persuading people to take steps that seemed to go against their own private interests. Buy stocks when everyone wants to sell? Lend money to a bank in danger of failing, when your own bank might need the money tomorrow? Join with others to buy securities from a desperate seller, rather than try to maximize your own profits from his precarious position? It goes against the basic principle of markets, that your job is to look out for yourself.
But all those things have happened in the past. Unfortunately, nothing like them is happening in the current crisis.
In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run.
The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, “The Panic of 1907,” were “convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them.” Morgan said that would simply assure that all would fail, one by one.
Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash.
In 1987, on Tuesday, Oct. 20, it appeared that the crash of the previous day was going to get worse. Market makers had little capital and less appetite to risk it, and one by one trading in the shares of major companies was halted because there were no buyers. In Chicago, the futures market was talking about halting trading in stock index futures because there were not enough stocks trading to know what the futures were worth.
That changed when two major brokerage firms — Goldman Sachs and Salomon Brothers — sent word to the New York Stock Exchange floor that they would buy any stock in the Standard & Poor’s 500 if their orders were needed to keep the shares trading. Just after that word was sent, the market turned around.
In 1998, when a possible hedge fund failure seemed to threaten the financial system, it was the Federal Reserve Bank of New York that called in all the major financial institutions and organized a bailout.
But efforts to organize concerted action this time have been limited. Treasury Secretary Henry M. Paulson Jr. has sought to get agreements in two areas — renegotiating mortgages and putting together a fund to deal with one of the early manifestations of the problem, the threatened collapse of odd financial instruments called structured investment vehicles — but there has been no visible effort to deal with the underlying problem.
In part, that may reflect the slow realization of what is at stake. For many months, we called it the subprime mortgage crisis, because that was where the problem first became apparent. But that label is far too narrow, and serves to obscure what is at stake.
“Rather ominously, borrowing costs for even the most creditworthy of firms have started to rise,” said Paul Ashworth, an economist with Capital Economics in London. Homeowners who can still get mortgages have seen rates rise in recent weeks, and banks say they are tightening their standards for both credit cards and commercial real estate loans.
“The principal cause for concern today is the paralysis of the credit markets,” Martin Feldstein, a Harvard economist and an adviser to President Ronald Reagan, wrote in The Wall Street Journal this week. “The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.”
The latest area of crisis is one that Morgan would have recognized in 1907. The major Wall Street houses — from Morgan Stanley and Goldman Sachs to Citigroup and Merrill Lynch — have refused to commit capital to the auction-rate market, a market that was supposed to allow investors to sell each week, via an auction that set interest rates.
Now many auctions are failing. That has left customers unable to sell securities that were supposed to have virtually guaranteed liquidity, and it has left the issuers — who paid fees to the banks to conduct the auctions — paying ridiculously high interest rates. It’s not easy to get both borrowers and lenders feeling angry and abandoned, but Wall Street has managed the feat.
When the crisis storms gathered in late 2007, much of the problem was with complicated securities — collateralized debt obligations, for example — that were extremely difficult to analyze. The failure of buyers to step up may have been rational. But that is not true with some of the auction-rate securities. They represent loans to borrowers that by any standard should be deemed good credits.
But the big banks were unable or unwilling to either buy the securities or find customers to buy them. That lack of action has damaged the reputation of each of the houses, in ways that would have been unthinkable a few months ago. But the bosses are scared. They no longer are sure just how adequate their capital is, and they are afraid to commit it while the financial crisis swirls around them. Some got their jobs because their predecessors were too willing to take risks.
It is not clear what the Fed or the Treasury could, or should, do now. The players can no longer be gathered into a single room, and they are regulated in different countries around the world, if they are regulated at all. Things are far more difficult because many of these markets are unregulated, making it difficult to gauge who is at risk and for how much.
But it is hard to see this ending until something is done to, in Mr. Feldstein’s words, assure “that necessary extension of credit.” Lowering interest rates will not, by itself, do that so long as the banks and investors are too scared to lend money at any rate.
In their book on the Panic of 1907, published last year before the crisis began, Mr. Bruner and Mr. Carr hailed Morgan’s actions, as well as the Fed’s 1998 move to salvage the hedge fund. But they warned, presciently as it turned out, that the current environment might hamper similar efforts in a new crisis.
“In a globally complex financial system, will such collective action be possible if the crisis is triggered beyond the reach of any of today’s regulators?” they asked.
So far, it appears the answer is no.