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Too Big to Fail?

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by

Iain Murray

on 11 August 2015

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Transcript of Too Big to Fail?

The 2008 Crisis
Causes?
Preconditions
Precipitants
Triggers
Misconceptions
The Response
How should we regulate the system?
Too Big to Fail?
Regulating the Financial System
Iain Murray
July 2015

Preconditions
Monetary policy
Moral hazard
Modern financial technology
International regulatory environment
Accounting standards
Dowd and Hutchinson 2010

From 1720 to 2008

Rampant speculation*
Government involvement
Monetary policy
Bad regulation
Financial innovation
Common Features of Financial Crises
US Federal Reserve used monetary policy to "stimulate" economy after 2001
Fed has "dual mandate"
Interest rates reduced to near zero to encourage spending
Saving became uneconomical so savers looked to other investments
Real estate became source of speculation
Monetary Policy
Deposit insurance introduced in US 1933
Only 12 countries in 1974
113 in 2014
Deposit insurance discourages savers from paying attention to actions of banks
Encourages banks to take risks
Moral Hazard
New technologies led to "quant" phenomenon
Value at Risk models were a pretense of knowledge
VaR a Gaussian model so ignored "tail risk"
VaR encouraged use of very risky instruments
If you don't know what you're doing and play with fire, you will get burnt
Financial Technology
1973 - Herstatt Bank collapse led to calls for international regulation
1988 - Basel I
2004 - Basel II
"Risk-weighting" of assets
OECD - Basel accords led to unconventional banking practices designed to skirt regulations
International Regulation
Precipitants
Government Housing Policy
Zoning
Rating Agencies
SEC Actions
Legacy of Jim Crow had led to discrimination in housing lending
Community Reinvestment Act of 1977
Banks encouraged to lend to minority communities
Meanwhile, Fannie and Freddie drive banks out of "prime market"
Banks developed products to make "subprime" lending profitable
Housing Policy
Randal O'Toole: American Nightmare
States with strict urban planning controls suffered worse in housing crisis
California - prices doubled then collapsed
Georgia - Prices up 25%, no decline
Zoning creates artificial scarcity, constraining supply
Zoning
In US, regulators demanded CDOs have risk ratings set by one of three agencies
Banks employed the agencies, not the purchasers of CDOs
Systemic overrating of CDOs
Buyers routinely failed in due diligence (others didn't)
Rating Agencies
Sarbanes-Oxley (box checking)
Financial disclosures meaningless
With Eliot Spitzer, destroyed investment research model
Banks started trading their own capital instead of clients'
So encourage higher leveraging
SEC Regulations
Triggers
The subprime bubble
Bear Stearns
Fannie & Freddie
Lehman Brothers
AIG
Accounting standards issue
How do you account for the value of an asset that changes over time?
Mark-to-market says you value according to the current market value
This does reveal real losses but...
Creates accounting bubbles and crashes
Mark-to-Market
Misconceptions
Fractional Reserve Banking
Were derivatives to blame?
Shadow Banking?
Contagion?
What about deregulation?
The Response (US)
"Too Big To Fail"
Bailouts
Dodd-Frank
FSOC
CFPB
Deposit insurance
rise
ZIRP
The Response (Int'l)
Basel III
Financial Stability Board
International regulatory cooperation
Stress Tests
The Eurocrisis
A Liberal Response?
Reduce perverse incentives
"Skin in the game" (prudential, not mandated)
Competition - more banks
Abolish deposit insurance
Government out of housing policy
"Bundesbank" monetary policy
Repeal death taxes
Note: speculation not a bad thing
January 2006 - "eye-popping 43% of first-time home buyers purchased their homes with no-money-down loans" (Nat Assn Realtors)
Bellwether Index of construction, mortgage and investment firms shows bubble popped about then
White House - "soft landing" Ha!
The SubPrime Bubble
BS actually increased its exposure in 2006-7
Leverage ration went from 5:1 to 36:1
after the bubble had already burst
Two subprime funds lost all value July 2007
March 2008 - Fed Bailout (Cox: "lack of confidence")
Volcker: Fed actions "extend to the very edge of its lawful and implied powers"
Bear Stearns
Purpose is to expand mortgage market by securitizing morgtages
"Government-sponsored"
Had line of credit but never used
Underwrote half of all mortgage market
$15 billion losses by July 2008
Congress passed act to create FHFA and bail FF out in July 2008
Bailout total up to $360 billion
Fannie and Freddie
Competitor of Bear Stearns
Posted big losses July 2008
Share price cratered
In September, filed for bankruptcy
Expected bailout so did not plan for bankruptcy risk
No bailout - why?
Fed felt this was a solvency issue not a liquidity issue as with BS
But...
Lehman Bros
Major insurance firm
London office had diversified (Man Utd)
$58 billion "AAA" subprime assets
Credit rating downgraded
Losses magnified by mark-to-market
Liquidity crisis
Sept 2008 Fed bailout of $85bn with stock as collateral
AIG
Big debate in libertarian circles (Rothbard v Mises)
Murray Rothbard claims FRB is fraudulent and an abuse of property rights
Mises - cannot enforce 100% reserve banking
Posner - a deposit at a bank is a loan
Contract rights apply, not property rights
All banks do offer 100% guaranteed deposits
Fractional Reserve Banking?
Most derivatives are created to reduce risk
Although face value might be $1 billion, actual risk is probably $10 million
They are a zero sum game - for every loser there is a winner
Large houses mismanaged risk
Real problem was misrating
Derivatives
Name is a pejorative for the unregulated nondepositary sector
Money had been forced into unregulated sector by overregulation
This includes large public pension funds like CALPERS
Ditto Fannie and Freddie
So large amounts not backed by deposits
Shadow Banking
AIG bailout was mainly about protecting counterparties
Goldman Sachs was largest counterparty
Goldman claims it had hedged the risk
Why "save" Goldman from a non-problem?
Why "save" Goldman and not Lehmann?
Hank Paulson and DC connections
Cronyism not contagion?
Risk of Contagion?
Financial deregulation is an extraordinary myth
SarbOx had vastly increased US regulation
Only real deregulation was government housing policy
UK - "deregulation" of 1980s in fact introduced government regulation
Alphabet soup of regulators
Deregulation?
Concept based on contagion argument
Also applied to GM and Chrysler (why?)
Result was Dodd-Frank Act
All sorts of extraneous measures added
TARP was not used for troubled assets but for bailouts
Neal Barofsky SIGTARP
"Too Big to Fail"
FSOC is a super-regulator
Has power to designate SIFIs - "Systemically Important Financial Institutions"
Entrenches "too big to fail"
Large banks want SIFI status
Insurance companies caught up as "cash cows" to pay for bailouts
FSOC and SIFIs
Idea of Elizabeth Warren
Financial equivalent of CPSC
"Loans are not toasters"
Immense power
Immune from checks and balances
Cracking down on any form of lending
But fines finance firms for not lending to the right people
CFPB
Deposit insurance raised to $250,000
So obvious increase in moral hazard - vicious circle with other regulations
Has also prompted regulators to exercise their powers more
"Operation Choke Point"
Deposit Insurance
Continued lack of real recovery has led to sustained ZIRP
Companies are not borrowing to expand but to buy back shares
Consumers - evidence mixed
Main beneficiary has been government borrowers
So how can ZIRP ever end?
ZIRP
Even more complicated version of Basel II
Same problems apply
Forcing consolidation of medium-sized banks
Those banks then become large banks...
Bank of England (Andy Haldane) - regulatory discretion is necessary
Basel III
International super-super regulator
Coordinates international regulatory cooperation
Two degrees removed from accountability
Is driving harmonization of regulation
Rohac/Sinclair - result could be next crisis will be deeper and wider
The FSB
Stress Tests are being used all over the world
Iceland 2008 - passed
Ireland 2010 - passed
Cyprus 2013 - passed
December 2014 - UK banks pass...
Problem: lower risk-weighted asset scores do not mean lower risk
Problem: single, weak scenario
Kevin Dowd
Stress Tests
Not the place to go into detail
Important to note that banks purchased huge amounts of sovereign debt after 2008 using Basel II guidelines
Sovereign debt proved to be very risky
Banks passed stress tests
The Eurocrisis
Full transcript