Can It Be Fixed — Permanently?

The Financial World According to Inya Column,
by Inya Ivkovic, MA

Financial crises are nothing new. Since the first Wall Street crash of 1792, financial crises have occurred with almost uncanny regularity. Of course, some are remembered more than others. Obviously, no one can forget the market crash of 1929, when two-fifths of U.S. banks failed, leading to the Great Depression. We are living through one such crisis right now. It appears that the Obama Administration has pulled just about every trick out of its hat to fix whatever went wrong this time. But to think that any of it would prevent future collapses from occurring ever again — sorry, that’s not going to happen anytime soon. Sometimes, the adverse factors converge in such a manner that there is nothing anyone can do to stop the
mayhem. Sometimes it is simply all pain and no gain.

Lack of imagination is the likely reason why even someone as smart and resourceful as President Obama couldn’t have prevented the walls from crumbling in. It would be as if an honest man were trying to prevent a thief from breaking into his bank; a task inherently impossible, because an honest man doesn’t think like a thief. In parallel, before a crisis, no one is clairvoyant enough to foresee potential problems, to foresee bubbles forming, to foresee the aftermath of bubbles bursting. But when the lights go out, no one knows what to expect, so they expect the worst. This is a time when the power to reason shuts down and all that’s left is panic.

Even though we are not completely out of the woods yet, some signs of things stabilizing are here, which economists and market observers are using to try and untangle how we got into this mess to begin with. Subprime mortgages have been largely blamed for the current financial and credit crisis, which would be true if we were talking about the symptoms only. Supporting this classification is the fact that subprime mortgages did not suddenly and unexpectedly yield catastrophic losses. Losses, yes, but not catastrophic losses.

Everyone knows that alleviating the symptoms does not cure the disease. And the diseases were not subprime mortgages and not even the complex, securitized derivative products based on them. After digging in deeper, many economists and market observers are pointing in a different direction — towards the “repo” (repurchase agreements) market.

What are repos? Repos are short-term loans, typically made overnight, which require the borrower to offer collateral for cash, usually bonds, which are then repurchased as a way to repay the loan. One thing about the repo market is that it is very mysterious, because no one knows its size. There are some figures out there indicating that it is perhaps as big as $10.0 trillion on any given day.

Banks are the largest players in the repo market. But the trouble was that people started doubting the quality of the collateral used for repos and what ensued was panic of global proportions. Suddenly, this enormous market came to a standstill and loans either completely vanished or became too expensive to carry. Starving for credit, Bear Stearns and Lehman Brothers collapsed, while many others became extremely vulnerable. The losses could have been bearable…perhaps. But we will never know, because the panic had taken over, paralyzing us with fear, becoming the crisis itself.

Once the collective psyche became immersed in panic, all faces and hopes turned to world governments. Government has many powerful tools at its disposal. It can haul in revenues like no other entity and it has the comprehensive ability to regulate. And just because the government doesn’t have a working crystal ball, doesn’t mean that it is completely helpless or unable at least to alleviate the impact of any future crises.

The Obama Administration has come up with some interesting proposals. One would be to give the Federal Reserve the power to identify which financial institutions are too important to financial stability to be allowed to fail. But it wouldn’t just mean that such institutions would have their own personal credit tap and safety net, courtesy of American taxpayers. They would also be subject to substantially more stringent capital requirements.

In addition, President Obama proposes to create a government agency that would police any funny lending practices and make sure that ordinary people signing on the dotted line of every mortgage and every car loan understand what they are getting themselves into.

Finally, things would have to change in the financial markets. Obama doesn’t want to completely kill the idea of securitized bonds (those would be the ones where a bunch of mortgages are bundled together, or a bunch of car loans or other types of credit). But for financial institutions engaging in them, he proposes that they retain at a minimum a five percent on their books themselves. In other words, those wanting to sell securitized issues had better do their due diligence, because, if the securities are garbage, some of it will have to stay in their own backyards.

All this sounds very reasonable, given the circumstances. But there are dangers as well, such as larger firms, pegged by the government as too important to fail, squashing smaller ones. Also, regulating consumer protection sounds great, but its costs could lead to more expensive credit. And there is always the possibility that too much regulation could choke the normal risk-taking that every economy needs to grow.

So the debate continues on how to fix what was broken. Perhaps the problem this time around was the lack of imagination and not the lack of regulation. Perhaps not. And perhaps the next crisis will be a result of the foolishness of government, and not the financial markets. Perhaps not. At this point, let’s just hope that the next crisis won’t be spawned by the current one.