Where do we go from here?

Last week I had the opportunity to opine on this question at a lively conference on the financial crisis sponsored by the Federal Reserve Bank of Chicago and the World Bank.  Since I spoke about things I’ve been meaning to blog about for some time, I decided to post the transcript here.  Apologies that the tone is more Fed-esque than the usual posting, but here goes…

Where do we go from here?

“You never want a serious crisis to go to waste.  And what I mean by that is an opportunity to do things you think you could not do before.”  Rahm Emanuel, Feb. 2009

I would like to touch briefly on two issues in answer to the question posed for this session:  first, the integration of housing finance into the financial and regulatory mainstream; and second, the need to modernize budgetary and regulatory accounting.   I chose these topics for several reasons: they are important; they get less attention than is deserved; and I have thought quite a bit about them from both an academic and policy perspective.

Smoke and Mirrors at the FDIC

” ‘Sheila Bair would take bamboo shoots under her nails before going to Tim Geithner and the Treasury for help,’ said Camden R. Fine, president of the Independent Community Bankers.” — New York Times, Sept 22, 2009

We learn today from the New York Times that the FDIC — the independent government agency that insures your bank accounts — is effectively insolvent. It is going to ask insured banks to prepay three years worth of deposit insurance premiums in order to raise $45 billion to replenish the FDIC insurance fund.

Break the Buck!

Here’s a wonderful idea for a financial product: raise trillions of dollars from investors, invest in a variety of risky assets, and then lie to investors about what the shares of the fund are worth. Just to make this easy, claim that each share is worth $1, even if it’s really worth less. To support this fiction, redeem shares at $1. If prices fall and investors suspect that the shares are actually worth less than $1, they will race to withdraw their funds. The first to withdraw receive $1, the last receive whatever is left, perhaps nothing.

You can be forgiven for thinking that I’ve just described Bernie Madoff’s investment fund. In fact, I’ve described the operation of money market mutual funds in the U.S. (Note that these are mutual funds, not insured “money market accounts” offered by banks.)

The Empire Strikes Back

As nightmarish memories of September 2008 fade, the financial industry is gearing up to fight new regulations. The battle lines are being drawn and became more visible this week.

There’s Just No Accounting For Federal Bailouts

In the last few months, the federal government has intervened in financial markets to an extent unparalleled in U.S. history. A partial tally includes the $29 billion, no-recourse loan from the Fed to rescue Bear Stearns; the federal takeover of Fannie Mae and Freddie Mac and their exposure to the credit risk on $5 trillion of residential mortgages; loans in excess of $100 billion to insurance giant AIG, and of course, open-ended Congressional authority for U.S. Treasury Secretary Henry Paulson to purchase up to $700 billion in troubled assets from financial institutions, part of which has already financed the purchase of over $250 billion of preferred bank stock.

Whatever you think about the wisdom of these interventions, one fact is indisputable: The government is not saying how much it expects all of this to cost us. The dearth of official estimates has, on one hand, led to Pollyannaish claims like “taxpayers could actually make money on this.”. On the other hand, it has stoked fears that taxpayers may be on the hook for trillions of dollars in losses.

The End of the Beginning

“Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”—Winston Churchill, November 10, 1942

When Churchill made his famous statement following the allied victory at El Alamein in North Africa, he was warning the public not to be too optimistic, and to expect the war to continue for a long time. It now seems clear that the financial crisis will last a long time. I want to suggest here that we are at the “end of the beginning” of the financial crisis, about to enter a new phase. Unfortunately, this is not an optimistic statement, merely an assessment. The government is fast running out of policy options that bear any resemblance to “free market” policies. What remains is for the federal government to run everything. And this is what is gradually occurring. The challenge will then be for the government to undo all of its intervention as quickly as possible.

The Noble Ostrich and Other Investment Myths

While sophisticated bankers and their wealthiest clients continue to take a pass on investments with even the slightest hint of risk, it seems strange that many investment advisers continue to sing the same soothing lullaby to individual investors:  “No need to panic, remember, you’re investing for the long run.  And that is what stocks are for!  If you get out now, you will miss the ups as well as the downs.”

Now I am certainly not advising you to panic (in fact, I am not advising you at all, because I am a mere finance professor, not a certified investment advisor).  But it does seem like a good time to revisit what we know (and don’t know) about personal investments and asset allocation, and to try to reassure you that there is no dishonor in prudence.

What Do They Know That We Don’t Know?

The problem with commenting on the financial rescue plan is that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson Jr. have not told us all that they know about the financial crisis. Specifically, we don’t know about the financial health of banks individually or in the aggregate. In this entry I will offer a guess: There is widespread bank insolvency and the point of the rescue plan is to use asset purchases to save banks that are good and, just as important, to facilitate closing banks that are bad. If this is right, the rescue plan is a sensible response to the crisis. In effect the plan has a secret component: widespread and controlled bank closings.

In Paulson We Trust?

The root cause of the liquidity freeze on Wall Street is clear:  Financial institutions, for various bad reasons that have been discussed at length elsewhere and are beside the point here, made huge bets that house prices would continue to defy gravity.  They didn’t.  Now the losses from those failed bets keep on popping up in unexpected places; no one knows who can be trusted.  For a bailout to solve the trust problem, it has to reveal who just got singed by the housing fallout, and who is still hiding third degree burns.  Until that uncertainty is resolved, investors are going to be justifiably cautious about putting their capital at risk.

The Week of Living Dangerously

We seem to have entered a new phase of the credit crisis. We spent a number of months learning just how much house prices would fall and which institutions had exposure to mortgage loans. Now, as credit problems cascade and liquidity remains scarce, events seem to have moved beyond mortgages. Now we are concerned, for example, about which firms are exposed to other firms via credit default swaps.

In this entry I will make some observations about a few of the extraordinary events of the last week, specifically about money market funds, short sales, and the need for centralized clearing of financial products.