Over the last thirty years, we have steadily moved from a bank lending credit system, to one in which capital markets have become the primary form of credit intermediation. Unfortunately, our regulatory apparatus has not kept up. The result has been a series of improvisations: filling gaps in the regulatory framework via bailouts and the steady expansion of moral hazard.
This is important because, as one of the first of the speakers at the Institute of New Economic Thinking (INET) conference, Professor Perry Mehrling, noted, the ultimate backstop implied by repeated government rescues created a set of expectations on the part of capital market participants. For any given trade in the securitized markets, there arose an assumption that an institution or individual could readily find a counterparty willing to do a trade at a price near to the last quoted price. As Mehrling noted, when the system was working, that counterparty was typically an investment bank (like Bear or Lehman) acting as a swap dealer, taking the opposite side of your trade for a fee: “They were willing to do this in part because they were committed to supporting the CDO market more generally. But they were not crazy. Ultimately they were market makers, willing to buy or sell the index at a price, but quite careful about their own net exposure.”
This meant that sustained pressure on one side of the market would be met by falling prices, and that is exactly what happened in the early stages of the crisis. The freefall happened when the failure of Lehman and AIG took a key market maker, and the key ultimate seller of insurance, out of the system. Had someone else, perhaps the government, stepped in to do what Lehman and AIG had been doing, even at a high price, the freefall could likely have been stopped in its tracks and the extent of the subsequent global financial fallout considerably mitigated.
Mehrling’s ultimate conclusion: Have the central bank become “Dealer of the Last Resort”, in effect backstopping the system by being the ultimate market maker or “insurer of last resort”.
Here’s the idea, which Mehrling delivered in his presentation dealing with the Anatomy of the Crisis. In essence, he proposed a modern day version of the old “Bagehot Rule“ — lend freely, but at a high rate, in a crisis. Mehrling argued that simply floating the system with money market liquidity, which is what the Fed initially did, failed to mitigate the intensifying financial crisis, because it wasn’t getting to the capital markets. That’s why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. In Mehrling’s view, the 21st century equivalent of the Bagehot Rule should be: Insure freely but at a high premium.
The Fed, in other words, should be backstopping the market for securitized products simply because the government is the only entity which can freely create new net financial assets and thereby cover the potential insurance liabilities during a crisis, in a way which AIG clearly could not.
Now, personally, we tend to be more sympathetic to the view that instruments that create such huge systemic liabilities and instability (such as credit default swaps) should be outright banned. Higher capital ratios (as suggested by many of today’s participants) capital ratio rules will not in themselves solve the problem. The system was gamed by the banks via securitization and accounting subterfuge, which suggests that optimal regulation is best achieved via regulation of the ASSET side of the bank’s balance sheet, not the liability side (we received some sympathy for this view from former BIS central banker, William White, whom we had the pleasure of meeting at this conference).
The objective should not be to create reactive buffers (or “insurance policies”) when the banks’ complex derivatives products begin to go bad. Rather, the activities which fail to promote public purpose should be banned outright. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. Why not ban (or heavily tax) the activities that caused the really bad downturn in the first place?
Nonetheless we are aware that there is a distinct lack of political will to enact serious regulatory reform or impose significant legal sanctions on errant management given the contemptuous ease with which Wall Street has successfully gutted the reform bill spawned in both the Senate and House of Representatives. Mehrling’s proposals might well offer the most politically achievable and effective alternative in a way that the Volcker proposals, for example, do not (largely because Volcker does not even touch the issue of securitization).
If securitization is the problem, argues Mehrling, then insurance is another viable policy response. The financial system did insurance wrong during the run-up, and as a consequence we got an unsustainable boom and a nearly unstoppable freefall when the bubble burst largely because the “premiums” charged for the insurance via AIG were absurdly low in relation to the risks being undertaken. As Mehrling noted when we spoke to him: “If AIG is selling you systemic risk insurance for 15 basis points, that price is too low. Charging a price closer to a reasonable rate prevents people from creating financial catastrophes.”
But if we do insurance right, we can make securitization functional again, as well as deterring outright dangerous speculation by making the “premium” on such activities to be so high as to be uninsurable. It might not be ideal, but it’s far less disruptive to the existing financial plumbing and could well work more successfully than what we have today. And in contrast to insurance for “Acts of God”, the right sort of prices established by the Fed as “dealer of last resort” could well prevent an earthquake in the way that our seismologists cannot.