Tuesday, October 9, 2007

How the Government Fosters Market Instability

The U.S. government promotes instability in the financial markets. Not intentionally; but its policies have that effect. Here’s how.

Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.

Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.

The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.

Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.

Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.

Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.

The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.

The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.

The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.

In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.

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