"moral hazard from implicit or explicit financial guarantees."

Here's a post expressing some of my views. Lawrence H. White on Cato Unbound:

"William K. Black’s interesting contributions to this symposium, and in particular his drawing parallels to the S&L fiasco of the 1980s, prompt me to wonder what role financial safety nets, like the deposit insurance that fostered the S&L fiasco, have played in fostering the current crisis."

I believe that the S & L Crisis was a main cause of this crisis.

"Professor Black focuses on the growth of deceptive (or fraudulent) accounting and ratings practices. Supervisors asleep at the switch enabled both. But why did the practices begin to grow? Their main purpose, according to a very informative working paper, “The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats” by Gerard Caprio, Jr., Aslı Demirgüç-Kunt, and Edward J. Kane (CDK), was to mask overleveraging and excessive risk exposures from creditors and safety-net supervisors. (Note that Ed Kane was the analyst who warned about the developing S&L crisis years before it hit the newspapers.)"

If they did "mask" the overleveraging and excessive risk, then a legal investigation needs to be undertaken immediately.

"If they are right, then a key question becomes: what prompted the overleveraging and excess risk-taking in the first place? CDK argue that an important contributor was “safety-net subsidies,” i.e., moral hazard from implicit or explicit financial guarantees."

I agree with this completely.

"CDK write:

During the last forty years financial institutions in the US … became increasingly aware of opportunities to shift the deep downside of their risk exposures onto the safety net. … [In recent years] financial institutions increasingly concentrated on creating instruments and structures with which to exploit loopholes in the regulation and supervision of financial-institution leverage. (p. 6) … Securitization increased these firms’ access to safety-net subsidies not just by increasing their size, complexity or geographic footprint, but also and most importantly by concealing increases in effective leverage. (pp. 6-7) ( I AGREE )

In tolerating an ongoing decline in transparency, supervisors encouraged the very mispricing of risk whose long-overdue correction triggered the crisis. (p. 9) ( I AGREE )

Why were the deceptive practices especially keen in mortgage financing? And why were the supervisors asleep at the switch? The Federal Reserve’s cheap-money policy and its positive impact on housing prices contributed. Everything looked fine as long as house prices continued to rise: “Low interest rates and increasing housing prices encouraged an overly friendly regulatory environment both for highly leveraged mortgages and for securitization structures based on them.” (p. 12) ( FINE )

Like the FSLIC that practiced excessive forbearance toward zombie thrifts, hoping for the best, it is clear in retrospect that the FDIC practiced excessive deference toward the AAA risk ratings of mortgage-backed securities. It should have raised deposit insurance premiums or insisted on higher capital requirements for insured institutions heavily invested in MBS’s. Likewise the OFHEO practiced forbearance toward Fannie Mae and Freddie Mac when it should have insisted on adequate capitalization for their risky portfolios. ( TRUE )

I wonder whether Professor Black finds the CDK analysis complementary or contrary to his own."

The Implicit And Explicit Government Guarantees To Intervene In A Financial Crisis are the main cause of this crisis, in that they were the underpinning of our actual financial system and the underlying basis and context that the market and investors were actually acting upon. However, the lesson was not simply that this or that program insured certain losses. The problem was rather that the S & L Crisis showed that the government would intervene, and many believed effectively, in a financial crisis. It was an underlying broad-based presupposition that all the actors in our drama were relying upon.

The FDIC insurance is a good idea. It was important in limiting our current crisis. It was certainly an element of the government guarantees considered, but the main problem was the confidence in a global solution, if you will. In order to understand this, you need to free yourself of the belief that these actors were Free Market Fanatics. They believe and rely on government guarantees, and, indeed, believe that they pay for it. The government purse is their insurance policy. I believe that they have been proven correct.

"So ends he who evil did. The death of a sinner always reflects his life"

In my continuing search to blame actual human beings for our current difficulties, I might have to add an addiction to opera and skiing:

"Canada’s Carney Says Some Bankers Focused on Opera, Not Lending

By Greg Quinn

Nov. 22 (Bloomberg) -- Bank of Canada Governor Mark Carney said the global financial crisis was caused in part by banking executives who thought about opera and ski trips instead of risks in their loan portfolios.

Regulators and executives were “seduced” by the idea that risk was “spread thinly around the world” by packages of loans, Carney told the British Broadcasting Corp. in a radio interview broadcast today.

Carney, 43 and a former Goldman Sachs Group Inc. investment banker, also said he was troubled by talks he had with bank executives during the past five years.

“If you were having a conversation with a central banker like myself, and the chief executive drifted into opera or the ski slopes of Davos or some type of social setting, that’s an issue,” Carney told the London-based network."

A bit off topic, I'd say.

“There is vicious natural selection going on right now in the financial services industry, and it’s appropriate,” Carney said in the interview. “Those who weren’t on top of things are gone or going.”

He sounds delighted. A kind of ebullient Herbert Spencer. I agree, but don't want to dance on their graves.

"The credit crisis might have been prevented if other countries had regulations like Canada’s, Carney said. The country’s banks were rated the strongest by the World Economic Forum last month. "

Could be.

“It’s like many things -- it’s excess,” Carney said in the radio interview. “Fundamentally, the ideas were sound, but they got applied too widely and ultimately by people who had forgotten about the fundamentals, or never knew the fundamentals of what they were doing.”

I agree. Maimonides. The Golden Mean. They're still forgetting the fundamentals.

"Carney spoke in London on Nov. 19, saying regulators should avoid worsening a worldwide recession by forcing lenders to stockpile more capital while economies are slowing."

I think that's what I'm saying.

"He also said countries need to bolster domestic regulations to improve the “transparency” of new types of securities, and should strengthen international bodies to better monitor emerging strains in financial markets."

I agree here as well.

"We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises.

Here's a pretty good argument for putting Derivatives on an exchange or Clearinghouse from Benn Steil in the FT:

"The global financial crisis is rightly prompting calls for a rethink of how we regulate financial institutions and markets. Most such calls are focused on what might be called “fail-safe” regulations, designed to reduce the risk that institutions will make reckless lending and investment decisions. Even libertarian-leaning policymakers and thinkers, such as Alan Greenspan, are now concerned with the capacity of our globally connected financial system to spread failures of risk management from one institution to another."

I hadn't heard them called Fail Safe Regulations until now, but the point is well taken. We want regulation to keep these kinds of financial crises from occurring. A global approach makes sense to me. No, it's not global government.

"In this crisis, institutions that bought up buckets of complex mortgage-linked securities found themselves facing huge losses as house prices fell. Their counterparts and clients, fearing the worst, provoked the worst by ceasing to do business with them. Others who wrote insurance against their failures-to-pay (credit default swaps) then lost huge sums as well, fuelling the fires of system-wide panic and default. But better regulation of lending standards and risk management, the argument goes, will prevent such systemic problems in the future.

History does not provide much comfort here. In financial markets, there are always new risks to take and new ways for risk management models and procedures to break down. Fail-safe approaches can also go too far: witness Japan in the early 1990s, when heavy-handed government intervention effectively shut down financial innovation. Furthermore, government policy promoting imprudent risk-taking – witness long-standing US congressional support for failed mortgage giants Fannie Mae and Freddie Mac – can overwhelm regulations intended to control it."

I think that the cause of the problem was the search for investments that needed less capital requirements, not the investments themselves.

His two main points I agree with:

1) It's hard to stop financial innovation, since its intent is to evade current regulations

2) Over-regulation is a serious problem

"The key is to supplement prudent fail-safe interventions with safe-fail ones: interventions that recognise that institutional failures will continue to occur and that focus on limiting the systemic damage after they do."

Here's "prudent" again, meaning nothing specific, but it will work.

"A case in point is the mammoth global derivatives markets. Despite wild swings in prices, derivatives exchanges have not contributed one iota to market instability. This is because exchange-traded contracts are centrally cleared and trader defaults – which are rare because of continuously adjusted margin requirements – are absorbed by well-capitalised clearing houses. Compare the 2006 collapse of hedge fund Amaranth, whose derivatives exposures were on-exchange, with the 2008 collapses of Lehman Brothers and AIG, both of which had large exposures in non-cleared, over-the-counter CDSs. Amaranth’s derivative defaults had trivial systemic ripples, while those of Lehman and AIG created major shockwaves. AIG invisibly built up huge under-collateralised sell positions on the back of a faulty credit rating. Yet if those contracts had been transacted on a trading platform with central clearing, margin calls would have short-circuited the strategy well before the company’s September collapse. US and European regulators (whose institutions comprise the vast bulk of OTC trading) should require central clearing once volume barriers in a contract are breached. This will not prevent an institution from losing large sums in derivatives trading, but will stop its default from spreading big losses to others that may be far removed from the original transactions."

This is the argument for an Exchange or Clearinghouse. It's pretty convincing to me.

"There are safe-fail macroeconomic counterparts as well. In August 2007, former Salvadoran finance minister Manuel Hinds and I spoke out at a Reykjavik conference in favour of Iceland unilaterally “euroising”. At the time, the country had more than enough foreign exchange reserves to redeem all the krona in the country for euros at the then-current exchange rate. This would not have stopped the three large Icelandic banks from overextending, but it would have prevented national financial catastrophe. Countries that have adopted one of the two main internationally accepted currencies – the dollar (Panama, El Salvador and Ecuador) or the euro (think in particular of Italy, Portugal and Greece) – have effectively eliminated the risk of currency crisis (that is, not being able to pay short-term foreign debts for lack of access to “hard currency”)."

That's interesting. It seems that the choice is between the Dollar and Euro. But eliminating a currency crisis is important.

"If we are wise and fortunate, in the future we will have corporate governance, capital standards and monetary policy regimes that better constrain the dangerous build-up of excessive leverage among consumers, banks and governments. But that is not enough. We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises."

Notice the focus on excess leverage. That's the main point, I believe.

Chairman Bagehot's Response

Chairman Bernanke gave a speech on "The Future of Mortgage Finance in the United States":

"The financial crisis that began in August 2007 has entered its second year. Its proximate cause was the end of the U.S. housing boom, which revealed serious deficiencies in the underwriting and credit rating of some mortgages, particularly subprime mortgages with adjustable interest rates. As subsequent events demonstrated, however, the boom in subprime mortgage lending was only a part of a much broader credit boom characterized by an underpricing of risk, excessive leverage, and the creation of complex and opaque financial instruments that proved fragile under stress. The unwinding of these developments is the source of the severe financial strain and tight credit that now damp economic growth."

The financial crisis was caused by the end of the housing boom. This boom showed problems in mortgages:
1) Poor underwriting ( True )
2) Poor credit ratings ( True )
3) Allowing subprime mortgages with variable interest ( True )

A good start. 3 obvious principles that investors forswore at their own peril.

However, the general problems are:
1) underpricing risk ( What caused this? )
2) excessive leverage ( True )
3) complex investments ( ? )
4) not transparent investments ( ? )

Okay. I think 1 and 3 and 4 go together, but that's me. Now he says this:

"To address these issues, we must consider both the part played by securitization in the mortgage market and the role of the government and government-sponsored entities in facilitating securitization."

Here I don't agree. I've already considered securitization with the help of Derivative Dribble.

Here's why they're worthwhile:

"The ability of financial intermediaries to sell the mortgages they originate into the broader capital market by means of the securitization process serves two important purposes: First, it provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits; second, it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks associated with holding mortgages to maturity, thereby reducing the overall costs of providing mortgage credit."

Okay. They give:
A: Originators more sources, e.g., retail deposits
B: Originators risk decreased on:
a: interest rates
b: credit
c: Prepayment
d: Holding mortgages to maturity
And these lower costs of providing mortgage credit.

This sounds good. The only things needed for using securitization properly are:
1) Ultimate investors invest in good quality mortgages and underwriters
2) All investors in process must be able to manage risk
3) Must be transparent, because hard to price

Here's the thing: These are all common sense and not complicated. I'm sorry, but this is investing 101.

He gives a bunch of remedies, but, I'm sorry, it wasn't the products. It was the investors. The question is why did these investors take these risks? So, all the remedies are last year's news to me. Go ahead and fool around with regulating these things. Good luck.

I believe that investments involving shifting risk to third parties or magnifying risk, often with complicated models, should be looked into or regulated, but the principles need to be broad to capture future innovations.

In any case, we need better investors, and having government guarantees makes that impossible.

Here's Beranke's conclusion:

"Conclusion
Regardless of the organizational form, we must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but that does not create institutions that pose systemic risks to our financial markets and the economy. Government likely has a role to play in supporting mortgage securitization, at least during periods of high financial stress. But once government guarantees are involved, the problems of systemic risks and contingent taxpayer involvement must be dealt with clearly and credibly. Achieving the appropriate balance among these design challenges will be difficult, but it nevertheless must be high on the policy agenda for financial reform."

I agree that government has a role to play. I just gave one area above.
I agree that if government is guaranteeing these investments, they should be highly regulated and limited in risk in order to keep the risk to the taxpayer at small as possible.

Is there any better plan?

I believe that there is.
First, I accept what I call Bagehot's Principle: If the B of E exists, it will be the ultimate guarantor, and that must be taken into account. Given the Fed and our government, they are the ultimate guarantors and must be taken into account. And, following Bagehot, I would like to see the following:

A: Real moral hazard for banks or financial entities far short of a crisis. No propping up.
B: General supervision as I recommended above. Minimal, but effective.
C: Serious penalties if these businesses need government help. I recommend effectively taking them away from them,i.e., nationalization, which is why I favored a Swedish type plan, that would divest these nationalized entities back into private concerns as soon as possible. But such conditions as TARP are not nearly onerous enough.

These principles have been known since Bagehot, and, since him, we have known that a pure free market plan is not real, as long as certain financial and government entities exist. It's time we follow his advice.

Some Regulation To Deal With Leverage

Via Naked Capitalism, some regulation:

"Better late than never, I suppose. Finally the powers that be acknowledge the role of leverage in our financial crisis and vow to do better next time.

From the Independent:
The governments of the world's largest economies have moved decisively to prevent any recurrence of the collapse of the global financial system.

The Financial Stability Forum, an umbrella body that comprises individual governments and central banks as well as international bodies such as the IMF, has proposed that, in future, banks will be prevented from borrowing – or creating "leverage" – on the scale seen in recent years, and will have to set aside more of their own resources, or capital, so that they can withstand any future turbulence. Mario Draghi, chairman of the forum and governor of the Bank of Italy, said it had taken an unprecedented financial crisis to drive home to financial institutions that they have to have "less debt, more capital". Firms have resisted because they refused to believe "profits are going to be lower in the future" in the financial sector."