Saturday, January 30, 2010

Will Greece default?

Remember the East Asian crisis of 1997-8? The crisis was sparked by the famous "fall of the baht", when Thailand was unable to maintain the peg to the dollar, causing a run on the country's short-term debt. This in turn sparked scrutiny of nearby counties with similarly mismatched external positions (too much short-term dollar debt, too little dollar reserves). 

Creditors turned on Korea, Indonesia and even Malaysia (which wasn't mismatched, but was in the wrong neighborhood). Ultimately, the Clinton administration and the IMF organized rescue packages that ended the runs, but not before the virus infected Russia, which did default. 

One of the many lessons of the crisis was "put out the fire before it spreads to the rest of the neighborhood". 

We may now be witnessing the beginning of another financial crisis in what had been one of the most stable parts of the world: the eurozone. 

I think that it is only a matter of time before Greece loses the confidence of the international capital markets and is unable to refinance. This would force the EU to confront an almost impossible situation: either let Greece go, sparking contagion to other weak eurozoners (Italy, Portugal, Spain, Ireland); or, cobble together a rescue mechanism that might need to be extended to others. This is clearly causing huge angst in Brussels.

The Times (UK) reports today that:
Leaked documents have revealed Brussels will publish a plan for Greece this week, under the headline “Urgent measures to be taken by May 15, 2010”.The package includes demands to “cut average nominal wages, including in central government, local governments, state agencies and other public institutions”. 

This isn't going to work. The Greek (socialist, union-dominated) government is in no position politically to implement such a scheme. Most indebted governments have three choices: default, devalue or deflate. Greece can't devalue because it (like Michigan) has no national currency, and it can't deflate by raising interest rates over which it has no control (also like Michigan). The only way it can restore competitiveness is to use fiscal policy to force a deflationary recession, which is politically impossible. 

This leaves Brussels two unpalatable options: default or bailout. If they are smart, they will choose bailout (with strict conditionality). But right now it appears that there is no EU consensus on this question. It should also be noted that the EU has very limited federal revenue and a tiny balance sheet. Any rescue will have to be funded by Germany and France, so this will ultimately be up to Nicholas and Angela. Gordon (not in the zone) has signaled that he will sit this one out.

Friday, January 29, 2010

The senators who voted no on Bernanke

Below is the dishonor roll of senators who voted against Ben Bernke's confirmation as Fed chairman:

Begich, Alaska; Boxer, Calif.; Cantwell, Wash.; Dorgan, N.D.; Feingold, Wis.; Franken, Minn.; Harkin, Iowa; Kaufman, Del.; Merkley, Ore.; Specter, Pa.; Whitehouse, R.I.;  Sanders, Vt.

Brownback, Kan.; Bunning, Ky.; Cornyn, Texas; Crapo, Idaho; DeMint, S.C.; Ensign, Nev.; Grassley, Iowa; Hutchison, Texas; Inhofe, Okla.; LeMieux, Fla.; McCain, Ariz.; Risch, Idaho; Roberts, Kan.; Sessions, Ala.; Shelby, Ala.; Thune, S.D.; Vitter, La.; Wicker, Miss.

Thursday, January 28, 2010

Sarkozy accuses the US of "monetary dumping"

From today's FT:
President Nicolas Sarkozy on Wednesday stepped up his calls for a new Bretton Woods system to stabilise global exchange rates, promising proposals for reform of the international monetary system when France takes over the presidency of the G8 and G20 next year. 

“The prosperity of the postwar era owned much to Bretton Woods … we need a new Bretton Woods,” he told the World Economic Forum in Davos. “We cannot preach free trade and tolerate monetary dumping. France, which will chair G20 in 2011, will place reform of the monetary system on the agenda.”

Translation: The US, as the global monetary hegemon, should not be allowed to debase its currency ("monetary dumping"). From a moral perspective, he is right. But from a practical perspective, he is heading out to sea. 

This sterile debate is now almost 40 years old. The Europeans criticize the US, which does nothing because the Europeans have no leverage in this arena. The dollar is the reserve currency of choice because of its liquidity, not because the US forced foreign central banks to buy it. 

Sarkozy is essentially calling on the Fed to peg to the euro, thus surrendering US monetary sovereignty to Trichet and his deflationist accomplices at the ECB. US monetary policy would thus shift from targeting price stability to targeting the value of the dollar in euros. This is never going to happen. 

However, there is nothing to prevent the ECB from pegging the euro to the dollar, which is what in my opinion they should do. But this would mean that the eurozone would surrender its monetary sovereignty to the Fed, which would be anathema to the Germans. 

So this whole discussion is a complete waste of everyone's time, which is entirely appropriate for the G-8 and G-20 gabfests. "It's our currency, but it's your problem."

Saturday, January 23, 2010

Throwing Bernanke and Geithner over the side

There is growing opposition in the Senate to Ben Bernanke's reconfirmation on both sides of the aisle, and there is increasing pressure on Tim Geithner as well. 

I can certainly think of a few reasons why they might be thrown overboard:
  • They let Lehman go, an event from which we have by no means recovered;
  • They have signally failed to make a persuasive case for TBTF and the so-called bailouts;
  • Bernanke has failed to persuade the FOMC to adopt inflation-targeting as Fed policy;
  • Bernanke has presided over the first annual decline in nominal GDP in 60 years;
  • Geithner has insufficient clout in the White House to stand up to the Emmanuel bank-bashing populists.

But none of the above are among the crimes for which these men are being pilloried. Instead, they are accused of "bailing having out Wall Street while doing nothing for Main Street". This criticism reveals either willful ignorance or disingenuous populism. 

Let's do a thought experiment. Let's imagine that, instead of rescuing the financial system, they had simply allowed events to take their course. The financial system and the money supply collapse. Debts become due as they mature with no hope of refinance. Nominal GDP declines by 25%. 

Haven't we been here before? Doesn't this sound a lot like the Hoover administration in general and Andrew Mellon in particular? Is this the history we want to repeat?

Bernanke and Geithner took enormous personal risks to rescue the financial system, employing their authorities and powers to their utmost, and beyond. Did they do this for personal gain? Did they benefit in any way, other than to be subjected to show trials on Capitol Hill? How much do Barbara Boxer or John McCain know about the conduct of monetary policy during a financial crisis?

Personally, I don't think that Bernanke has done enough with respect to fighting deflation and growing nominal GDP. I think the reason for this is not that he doesn't get it--considering the fact that he wrote the book on the subject. 

Instead I think that his failure to do more is due to his desire to maintain a degree of consensus on the FOMC, bringing the inflation hawks along with him as the data unfolds. He lacks Greenspan's clout and is uncomfortable with close votes on huge decisions. This is extremely unfortunate, but I do not see how someone else could possibly do a better job. (...Although, if Bernanke goes, Chairman Summers might be willing to grab the hawks by the throat.)

How to make the credit contraction worse

I believe that it is fair to say that sustained economic growth cannot resume in the US until the credit contraction ends and banks begin lending again. The continuing decline in the credit aggregates is short-circuiting the Fed's efforts to stimulate growth. (Shades of Japan.) 

Despite quantitative easing resulting in an increase in the monetary base from $800 billion to $2 trillion, the real economy remains stalled and prices are flat. This is because, despite massive increases in free reserves, bank loan portfolios continue to contract, and also because the private sector securitization engine remains broken. 

C&I loans are declining at a rate of almost 20% (by far the steepest rate of decline since the Depression), and household indebtedness is also contracting. 

The hole left by the private sector is currently being made up by the government:
  • The federal government is growing its debt at an average annual rate in excess of 20%;
  • The federal government and the Fed are keeping Fannie and Freddie on life support with capital and unlimited credit;
  • The Fed is supporting the ABS markets via the TALF.

Essentially, the economy is in the ICU on oxygen and glucose. The patient is still alive, but is not showing signs of sustainable recovery. 

However, the outlook for a recovery in credit growth is very bleak. It appears that it is the policy of the government to take measures intended to further contract the credit available to businesses and households. 

  • Capital and loss-reserve standards are being raised, not lowered, forcing banks to shrink their balance sheets.
  • The Obama administration has proposed limiting bank size, forcing a reduction in loan portfolios.
  • The administration has proposed a tax on uninsured bank liabilities.
  • The IASB and the FASB want to consolidate off-balance sheet vehicles and to require additional capital against derivative exposures, both of which would put renewed pressure on bank capital ratios.
  • The TALF is inexplicably scheduled to end at the end of March.
  • Populist attacks on bankers, the banking system and bank compensation are not helping to retore animal spirits in the financial system.

These factors suggest that credit will continue to contract, cancelling out the effects of monetary and fiscal stimulus. Contracting credit will pull nominal and real growth downward, reducing federal and state revenue, and increasing the deficit.

    Thursday, January 14, 2010

    Some questions for the Crisis Commission to ask Wall Street CEOs

    1. How much were your total writedowns on securities and how much by type of security?

    2. Why was your bank holding such a large amount of unsold securities?

    3. Were your huge RMBS and CDO exposures flagged by your risk management system and your risk management professionals?

    4. If so, why didn't you seek to hedge or reduce these exposures?

    5. If not, please explain your understanding of the words "robust risk management".

    6. Is it the policy of your firm to "originate to sell" or to "originate to hold"?

    7. What did your firm's internal capital models indicate with respect to capital adequacy at the end of 2007?

    8. How did your capital models perform in 2008?

    9. What did your firm's internal liquidity models indicate at the end of 2007?

    10. How did those models perform in 2008?

    11. How don you explain the utter failure of your firm's risk management, capital adequacy and liquidity models and policies in 2008?

    12. How would you define "competent management" in the context of your industry?

    13. In view of your industry's near collapse and rescue by the government, do you support strict regulation of risk management, capital adequacy and liquidity?

    How long will the ECB remain independent?

    During the run-up to monetary union, the Germans would only agree to exchange the DM for the euro if they were assured that member states would not be able to pressure the ECB to inflate. They got what they wanted: Europe is now governed by an apolitical, unelected, "independent" central bank that is hawkish on inflation, dovish on deflation and oblivious to growth or employment: a blue-eyed BoJ. 

    Clearly this arrangement has been a bad thing for peripheral Europe, where low interest rates fueled a debt-financed boom/bust and which today has no ability to devalue or fight deflation. 

    But today's paper reports that Germany's GDP shrank by 5% in 2009, which raises the question as to whether the ECB isn't bad for core Europe as well. Certainly this has been the French view for some time. 

    By its own admission the ECB is undershooting its inflation target, and it is certainly not delivering economic growth or full employment. How would it rate its performance against any set of objective criteria? Are deflation, stagnation and high unemployment exogenous phenomena, like bad weather or bad luck? 

    I predict that before this cycle is over, there will be a major debate over the ECB's governance and the political relationship between the ECB and the Commission. With growth of negative 5%, maybe even the Germans will come around.

    Another brilliant idea from the D.C. pitchfork brigade

    The Nobel Prize-winning geniuses on Capitol Hill have come up with another bi-partisan scheme to improve our financial system. They--Sens. John McCain (R) and Maria Cantwell (D)-- want to restore Glass-Steagall and prohibit banks from being in the securities industry and vice versa. 

    Please recall that the standalone investment bank was invented by Senator Carter Glass(D-Va) in 1934. Thus the US became unique in the world by placing its capital market into the hands of Wall Street broker/dealers who were supposed to intermediate billions in capital flows with no core funding, minimal capital and no lender of last resort. This prescription for disaster finally bore fruit  in the fall of 2008, when the standalone investment bank model finally died a well-deserved death

    When Lehman failed, there was a funding run on the remaining investment banks (Goldman, Morgan Stanley, Merrill). Although they had plenty of good collateral, the money markets were closed tight. No one wanted their name. This impelled them to merge with or convert to bank holding companies in order to come under the Fed's umbrella (and, ultimately, to develop sources of bank-like core funding, God willing).

    If we are lucky, a silver stake has been driven for good into the heart of the wholesale-funded investment banking model.  If, by some horrifying circumstance,  the Glass-Steagall Act were to be  restored by the Senate's  Know-Nothing caucus, the government will mandate the resurrection of these misshapen creatures (a financial version of The Night of the Living Dead), and the US will inevitably face another wave of failures and bailouts. 

    Citi will disgorge Salomon/SmithBarney, BofA will  gift us with Merrill, and JPM will rebirth Bear Stearns. And what, dare one ask, will happen to Goldman and Morgan Stanley when they are pushed out of the Fed's nest to fend for themselves? Are they expected to self-liquidate before or after they pay their penalty taxes?

    This whole idea would fall under the "unthinkable" category if we didn't have the pitchfork crowd in Washington today. Are we truly condemned to relive bad history every 75 years? 

    Wednesday, January 13, 2010

    The problem with the BoJ

    The new Japanese finance minister, Naoto Kan, has called on the Bank of Japan to support the government's efforts to weaken the yen. His remarks have been criticized for weakening the independence of the BoJ. 

    It completely eludes me how the shibboleth of central bank independence can be viewed as more important than ending deflation and growing the real economy. The BoJ's record as an independent central bank has been one of utter failure, with flat nominal GDP growth for two decades, compensated for by massive fiscal deficits. 

    An erosion of the BoJ's independence would be a very good thing.

    Monday, January 11, 2010

    China and the dollar

    China has called upon the US to redress "global imbalances" by spending less and saving more. This is part economics and part politics. The Asians want to put the US on the defensive because of our twin deficits, both of which they are financing involuntarily. They want to be able to lecture us, after all of the unwanted "advice" coming out of Washington over the years.

    But their arguments are entirely one-sided. The deficit countries (us) have to make all the adjustment. The surplus countries don't have to do anything because "exchange rate appreciation of surplus country currencies has not proven to be effective in adjusting current account imbalances" which is true only at the margin. Freely floating exchange rates will over time result in balanced trade. But the RMB doesn't float; it is pegged to the dollar--by them, not by us.

    The Chinese want us to pursue sound policies that will support a strong dollar in relation to other currencies: in other words, we should peg to the world instead of vice-versa. All the adjustment should occur in the US. The exchange-rate value of the dollar should be an objective of US monetary policy. 

    The Chinese are right that we need to spend less and save more. But the way to get there is not an exchange-rate anchor. Such an anchor requires extraordinary national discipline and consensus that the external value is more important than growth or inflation/deflation. Hong Kong has been able to do it because it is not a democracy, and the dollar peg is supported by consensus.

    If China is so unhappy about US economic policies, all they have to do is to unpeg the RMB from the dollar and peg to something else (the SDR, the euro, the yen, a basket) or float, which is what both Japan and Korea have done. But they havn't done this. Why? Because the US is the Importer of First and Last Resort, and they want their products to be cheap in US$. They want us to run a big trade deficit so they can fill it with their goods. They are classic mercantilists, except the mercantilists accumulated gold while the Chinese collect (depreciating) paper dollars.

    There is no such thing as virtue in international financial relations, only self-interest. The Chinese aren't bad nor are we. We are all acting in our own self-interest. The G-20 will call on the US to balance its budget (which we should) and on the Chinese to appreciate the RMB (which they should). China and the US will do as they please. China will threaten to sell dollars, which they won't. The US will put tarriffs on Chinese products, but not enough to deprive us of what we want to buy. Nothing will change. Ten years from now the Asians will own a mountain of Treasuries, but that won't force a change.

    The Dollar: Our currency, your problem

    What to do about the weak dollar? The world is unhappy with us. Even though our currency is the bedrock of their international reserve positions, they have no leverage over us. And anyway, if the Fed started raising interest rates to support the dollar, the consequences for global growth would be awful. It's not an option.

    No, the solution goes in the opposite direction: they need to engage in competitive devaluation, target a desired exchange rate, and start buying dollars until they get there. Not only can they stem the appreciation of their currencies, but also they can prevent deflation and negative nominal GDP growth in the bargain. (One of the false lessons of the Depression was that the "beggar thy neighbor" devaluations were somehow bad. To the contrary, they were the engine by which deflation was reversed and nominal growth resumed.)

    Given the contradictory roles that the dollar plays as an unanchored national currency and as the global de facto reserve currency, and given the US's large role in international trade, it is very hard for other countries to ignore the dollar value of their currencies. The yen has appreciated from 360 in 1971 to 92 today. This is highly deflationary.

    Any country with a strong currency and large dollar reserves can peg to the dollar and prevent further appreciation by buying dollars with the country's unlimited supply of its own currency. The BoJ and the ECB have an unlimited ability to buy dollars with their currencies until the targeted relationship is achieved. This is what HK and China have been doing for years, and which has served them well.

    The problem with the 1949-1971 Bretton Woods system was that it sought to discipline the hegemonic currency by allowing surplus countries to exchange their unwanted dollars for gold. This was intended to force the hegemon (us) to raise interest rates, which Nixon was unwilling to do.So Nixon said "enough!" and ended convertibility.

    Under a Bretton Woods 2.0, the dollar is not freely convertible into gold or anything else. If you're in surplus and you want to avoid inflation, revalue. Like Japan, the ECB can't allow the euro to steadily appreciate; they will have to intervene, resulting in higher eurozone inflation, which is desperately needed anyway (especially in the south).

    None of this addresses the lack of discipline on the hegemonic currency issuer. But it does address the problem of undesired appreciation. Unfortunately, such a policy in not within the power of the affected to governments to implement. This is because they (Japan, Europe) have placed their monetary sovereignty into a blind trust known as the "independent central bank". Prime ministers and finance ministers can whine, but they have no monetary power--because they have given it away. The lesson of the Great Inflation was that governments should keep their hands off of the monetary faucet. The lesson of the recent past suggests that, left to their own devices, central banks are very conservative institutions, more concerned with their own prestige than with growth policies.

    Being Ben Bernanke During the Minsky Moment

    A large proportion of the growth during the 2002-07 period was debt-financed demand as evidenced by the substantial rise in the ratio of public sector debt to GDP (as well as the declining ratio of incremental growth to debt growth). While the credit boom included both corporate debt (+$3 trillion), most of the debt growth occurred in the household sector (+$5 trillion).

    Most of this incremental household debt found its way into the credit market in the form of securitization (RMBS, ABS). Historically, highly-rated securitizations were valued using in-house intrinsic-value models due to the absence of a secondary market for structured product (due to its opacity and complexity). This convention worked as long as structured product performed in accordance with expectations and credit losses were within the ranges suggested by their ratings.

    Two shocks brought the securitization engine--and credit markets more generally--to an abrupt halt. These shocks were (1) the poor performance of subprime-related mortgage backed securities and their CDO derivatives; and (2) a coincidental and highly disruptive change in the accounting paradigm for structured product from "mark to model" (intrinsic value) to "mark to market". 

    This accounting change, imposed at the end of 2007, disregarded the absence of an efficient, liquid secondary market for hard-to-value complex securities. While some intrinsic-value models may have been over-optimistic, the futile and fictitious mark to market convention created massive paper losses which exceeded the earnings capacity and capital resources of the financial system, thus transforming a credit problem into an accounting-driven capital crisis.

    The closing of the securitization market meant that household debt could no longer grow in the double digits as it had from 2002-06, but would in fact have to contract due to mortgage amortization and defaults. The debt-financed growth engine was thrown into reverse. The Minsky Moment had arrived, when, unable to refinance, corporate and household borrowers were forced to sell assets in order to meet debt obligations. 

    The withdrawal of credit to the household and corporate sectors pushed the real economy into the sharpest and steepest recession in the postwar era, which further threatened the performance of the securitized product of the boom era.

    Following the collapse of Lehman and the near-collapse of the financial system as a whole, there was no longer a private market bid for private sector debt. In order to prevent another Depression, the central bank and the federal government stepped in to maintain credit flows. 

    The Fed increased its balance sheet by ~$2 trillion (still small in the context of $14.5 trillion GDP) and the Federal Government increased its liabilities by ~$2 trillion. The GSEs were kept afloat by capital from the government and securities purchases by the Fed.

    Massive lending by the Fed and the GSEs and deficit spending by the US have prevented a meltdown. But the private credit markets for household debt have not reopened. Instead of buying mortgages or RMBS, institutional investors are buying government and corprate debt. The real economy won't recover unless household deleveraging can be reversed.

    The challenge facing the Treasury/Fed and their brain-dead socialist dependencies (FNMA, FHLMC, GNMA, VHA, FHLB) is whether they can or will continue to buy mortgages on the scale required to sustain recovery. Already the hawks on the FOMC are pushing for an exit strategy long before victory is even in sight. This would be analogous to FDR asking Eisenhower for an exit strategy the day after D-Day. 

    Because the securitization market has not revived, not only is there no viable exit, it may prove necessary to grow the FRB/GSE balance sheet by another $1 trillion in 2010. There is no public discussion of this need. All eyes are on the exit. 

    The central issue is not whether massive easing this is good or bad in a platonic public policy sense, or whether it could prove inflationary, or whether there is an easy exit strategy. The issue is whether the authorities mean it when they say that they will do whatever is necessary to restore and sustain economic growth.

    Few economists understand these issues better than Chairman Bernanke. He has studied and criticized the nonfeasance of both the Depression-era Fed and the post-bubble BoJ. In both cases he has made clear that deflation is a monetary phenomenon and a measure of central bank failure. 

    The problem is, as I see it, is that he desires to (1) maintain FOMC consensus, which gives the irresponsible hawks a veto; and (2) retain respect and support for the Fed on Capitol Hill, Wall Street and abroad. The radical measures that Bernanke may be required to take threaten both of these goals. 

    It may be remembered that it took the total collapse of the US economy and financial system for the government to abandon the gold standard, the shibboleth of the day. Hopefullly, it will not require the collapse of Western civilisation to wean the FOMC from its death-wish embrace of "price stability". 

    Sunday, January 10, 2010

    Valuing structured securities

    Letter to the FT published in August:

    A fraction of Tarp money is needed to enhance stability
    Published: August 21 2009

    From Mr Christopher T. Mahoney.
    Sir, I think most capital market participants would agree that generic securities with liquid markets (stocks, corporate and government bonds) should be carried at fair value (“Disclose the fair value of complex securities”, August 18).
    While the market price and intrinsic value may diverge, there is sufficient transparency for both the buyer and seller to have sufficient information to form an opinion, which is what makes markets.
    However, structured securities are not generic and are generally opaque, especially complex derivatives such as collateralised debt obligations. No one can value a CDO-squared, which is why they don’t trade. Therefore, there is such a wide disparity between seller and buyer opinion of value that there is no meaningful market, and thus a very weak datapoint for valuation.
    What should be incumbent upon all participants (but especially the financial regulators) is the creation of a public, robust structured-securities database and cash-flow based valuation methodology so as to provide an estimate of intrinsic value to be weighed against the noise in the mark-to-market valuation.
    It is surprising that this need has been visible for over two years, enormous damage has been done, and yet there appears to be little progress in developing such a database. If a small fraction of the troubled asset relief programme had been spent on this, financial stability would have been considerably enhanced.
    Christopher T. Mahoney,
    New York, NY, US
    Retired vice-chairman, Moody’s

    The only way to end Japanese deflation is to repeg the yen to the dollar

    A particular interest of mine (and of Bernanke's) is Japanese monetary policy. Below is a letter published in November by the FT:

    Yen devaluation is not whole answer
    Published: November 20 2009 02:00
    From Mr Christopher T. Mahoney.
    Sir, Marc Ostwald states that “a sharp devaluation of the yen would appear to be a textbook way of dealing with some of Japan's problems” (“The Japanese bond outlook is not as dire as it appears”, Insight, November 17). Clearly this is part of the short-term solution to Japan’s growth and deflation problems. But, as Stanford professor Ronald McKinnon has argued for some time, the long-term solution must involve a stabilisation of the nominal relationship between the yen and the dollar (as existed for 25 years under Bretton Woods). This would break deflationary expectations and allow Japan to import US inflation. Most western economists would agree that the Bank of Japan's monetary policy since 1989 has been inept. A dollar-support policy would force the BoJ to engage in quantitative easing on a scale not yet seen. A return to a dollar peg (formal or informal) would clearly be preferable to what we have witnessed over the past two decades.
    Christopher T. Mahoney,New York, NY, US

    Market discipline is not the answer

    In November Barron's published my article "Market discipline is not the answer". Due to space considerations, it has to be edited to fit. Below is my original draft, that covers a bit more:

    Market discipline is not the answer

    Christopher T. Mahoney

    There’s a growing consensus on both sides of the Atlantic that market discipline must be reintroduced into the financial system. Regulators have advocated that steps be taken to make it possible for large banks to fail, at a loss to depositors and other creditors—to reduce or eliminate the concept of “too big to fail.”

    This view, while appealing to adherents of free markets, is nonetheless very dangerous. At times of crisis, the failure and default of a systemically important institution will lead to contagion and a run on the financial system, necessitating a system-wide rescue or precipitating a financial collapse with unknowable consequences. And, wishes and dreams notwithstanding, it is simply not possible to uncreate systemically important financial institutions by slimming them down or breaking them up.

    The history of financial crises is the history of the threatened failure of financial institutions previously considered systemically unimportant, but nonetheless threatening to cause a contagious run on the entire system. Runs occur on solvent banks during panics because there is insufficient information in the public domain to allow depositors to discriminate between the strong and the weak. Bank accounting is complicated, backward-looking and inexact. Who really knew in September 2008 what Lehman's true solvency was, or Goldman's for that matter?

    Every financial crisis in the past two centuries began with the threatened failure of a second- or third-tier institution: Barings in 1890, Knickerbocker Trust in 1907, Bank of United States in 1931, Sanyo and Yomura Securities in 1997, Long Term Capital Management in 1998 and in the most recent crisis: IKB, Northern Rock, Hypo Real Estate, Bear Stearns, AIG, and Lehman.

    In every case, either the authorities allowed the threatened institution to fail, resulting in a full-blown systemic crisis (Bank of United States, Sanyo Securities, Lehman) or the authorities blinked, ignored their own rules, and mounted an extra-legal rescue to protect the system.
    Leading up to crises, the regulatory emphasis has been on market discipline (indeed, even going so far as to ban bailouts), but by mid-crisis, the entire system ends up under the safety net. No one would ever have imagined in 2006 that every building society in the UK was “too important to fail,” but they were so deemed.

    If systemically unimportant institutions have to be rescued to prevent panic and mass contagion, obviously the largest and most complex institutions have to be rescued, whether or not they are banks and whether or not such rescues are allowed by law. Additionally, it is silly to suggest that every bank should be made so small that it can be allowed to fail in the midst of a crisis without systemic consequences. Such an atomized financial system would neither function nor be safe. The US had an atomized financial system in 1930-33, and the result was catastrophe.

    There is nothing wrong with maintaining “constructive ambiguity” about the size of the safety net, so long as this ambiguity is jettisoned when a system is in general crisis. It is safer and easier to throw the safety net over the system before the first failure than it is to stop a mass run. That is the critical lesson of the catastrophic failures of the Bank of the US in 1931 and Lehman Brothers in 2008. The banking panic of 1931-33 would have been averted had the Fed rescued Bank of United States, and the panic of 2008 would not have occurred had Lehman been rescued and the safety net been extended to Wall Street, as indeed it was only a month later.

    The European attitude toward this matter (notwithstanding toothless EU rules against state support) has been more pragmatic that that of the U.S. In Europe, when the recent crisis loomed, there was little consideration given to the “orderly default” option. Indeed, so far only one small bank has been allowed to default in continental Europe. In his book In Fed We Trust, David Wessel quotes an ECB official as saying “We don't let banks fail. We don't even let dry cleaners fail.” True, refreshing, and wise. The Europeans understand this issue.

    In the U.S., the problem is complicated by a legal and regulatory regime designed to allow banks to fail, intentional ambiguity about the size of the safety net, laws that are intended to prevent bailouts, a large regulatory distinction between banks and nonbanks, and strong political opposition to bailouts. U.S. bank regulation is designed to deal with small banks; there is little legal or regulatory distinction between Citbank and the third largest bank in Peoria.

    This unfortunate legacy resulted in the (unwise and incorrect) conclusion by the Treasury that it lacked the legal authority to rescue Lehman, a nonbank. Indeed, in the public dialogue concerning regulatory reform, there has been no discussion of the need to widen and strengthen the safety net. Consequently, when the next crisis occurs in the US, history will repeat itself.
    The only solution to the systemic risk paradox is that countries must realize that:
    --They are on the hook for their entire financial systems whether they like it or not.
    --The ultimate solvency of the financial system is a contingent liability of the government.
    --Transparency and market discipline have never worked.
    --The only practical solution is a strong safety net and competent prudential regulation of the entire financial system.

    Since governments can’t get off the hook for the financial system, then the system must be much better regulated. This means insisting on less leverage, less reliance on market funding, more numerous and intrusive regulators, and intellectual parity between regulators and the regulated. In the regulatory arms race, the banks have ICBMs and the regulators have muskets. Big banks have armies of PhD's paid millions to build and defend their complex risk management and capital adequacy models; the regulators have underpaid government employees who lack the tools to deconstruct and second-guess those models.The cost of competent prudential regulation is much less than the cost of systemic bailouts. The Federal Reserve System's total annual expenses are less than $5 billion and the UK FSA's are less than $1 billion.

    This not an argument that financial institutions should not be allowed to fail. At times of systemic uncertainty and fear, financial institutions may be allowed to fail so long as they do not default on deposits, derivatives and senior debt. There is no reason why a failing institution cannot be seized, cleaned and sold, wiping out stockholders, management and many employees, as was done in the case of Bear Stearns, and should have been done with Lehman. Credit markets can accept such a form of resolution so long as it does not set off a tidal wave of defaults.

    Unfortunately, there is little likelihood that the structure and quality of US or European financial regulation will improve. No one wants to admit that the safety net is so big, because it would cost governments money, and because the financial industry would oppose a regime that would regulate the unregulated, force a reduction in leverage, and unleash armies of smart, tough regulators who can't be intimidated or captured. What is more likely is a return to business as usual and another crisis down the road.

    The author is a retired vice chairman of Moody's Investors Service.


    Welcome to my blog. My plan is to comment on finance, markets, economics and public policy, keeping politics to a minimum. While I am not an economist, I have an MBA and I worked on Wall Street covering the finance sector for 30 years. I retired in 2007 as vice chairman of Moody's. Topics that I plan to cover include:
    >The financial crisis: etiology and prognosis (I'm a bear).
    >The public policy response to the crisis (past and future).
    >Financial regulation, how to fix it.
    >Systemic stability and TBTF.
    >Monetary and exchange rate policy (US and foreign).
    >The outlook for sovereign risk, particularly the fiscally challenged countries in the developed world: Japan, UK, etc.
    I hope to be both provocative and persuasive. Ideas matter.