How To Stop The Next Financial Crisis

Are financial crises unpredictable or can we put simple financial indicators in place that will warn us before it is too late? An early detection system for financial danger that accurately pinpoints the type of danger we are facing could help prevent the next crisis. See the following post by Mark Thoma for more on this topic.

David Levine "aggressively argues":

our models don't just fail to predict the timing of financial crises - they say that we cannot.

The San Francisco Fed's Bharat Trehan says:

simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances. ... [W]e have taken two simple indicators off the shelf and shown that both would have signaled impending trouble prior to the current crisis. That makes it harder to argue that financial crises are, by their nature, unpredictable. And it shows that such simple indicators can be useful ... as signals of rising levels of risk in the economy.

See here. Or here.

We ought to be able to say, at the very least, something like:

If you keep eating that junky credit instead of a healthier financial diet, your monetary circulatory system is likely to have severe problems at some point in the future.

Many people had a sense things were out of balance and that at some point it would cause us problems, but the indicators most people looked at pointed to a diagnosis involving exchange rate movements and an international unwinding. The discussion centered on issues such as whether we would have a hard or a soft landing as this process unfolded, there was little discussion of the type of crisis that actually occurred.

So we need two things. First, we need indicators such as those identified in the SF Fed article that can tell us when danger is building in the financial sector.

But that is not enough. Though many people had a sense from the indicators they looked at that things were out of balance, the indicators pointed to international financial issues rather than the true problem, and hence most of the analysis and policy discussions were devoted to guarding against problems related to international financial flows.

Thus, the second thing we have a need for is a set of indicators that do a better job of telling us where the problems are likely to occur. That is where we made the biggest mistake, misdiagnosing the type of crisis that was coming. Having indicators that can do a better job of identifying the type of financial crisis we are facing will allow us to design and implement effective policy responses rather than wasting time analyzing and planning for the wrong type of crisis.

This post has been republished from Mark Thoma's blog, Economist's View.

Have We Learned Nothing From The Financial Crash?

A year after the Lehman fiasco, it seems as if Wall Street has learned nothing from the financial implosion. Banks are still growing larger and risk taking behavior has returned. Stanley Bing from The Street explains why we should not be surprised.

The news is full of pundits, analysts and even a president opining on the state of the finance business one year after the big plotz. Consensus is that we've all learned nothing. The big banks are getting bigger. Risky instruments are reappearing. The Street is once again getting on its high horse about over-regulation. Thinking people, quite naturally, are worried. We're not even out of the woods yet and here come the same old players starting to sing the same crazy tune.

The critics just don't get it. Wall Street isn't a rational, thinking creature. Oh sure, it's got charts and graphs and metrics and fetrics. But if you want to know the way things really operate, you have to look at a creature that isn't driven by its brain, but by its heart... and by any other organ that responds to that beat.

In short, Wall Street has all the sentience, maturity and emotional self-control of a teenager... or maybe of a 50-year-old guy with a tiny ponytail and a red BMW Z4.

Last year, before the breakup, he was so excited. Love was in the air, and with it lots of money. Love involves risk, of course. But that's at the core of what's so exciting! No risk? No passion. Particularly for an entity whose emotions are quite immature, who needs daily stimulation to remain engaged, who requires the tang of danger to feel fully alive. Those were great days! Ah, to be rich and in love!

Then... the unthinkable happened. The big breakup. Poor Street's heart was broken and what was worse, his belief that the risk was worth taking ever again was smashed to pieces. Poor guy. He languished for months, afraid to grant credit, terrified of incurring debt, sleeping much of the day away, waiting for nighttime when it was permissible to drown his sorrows.

And yet, the heart of the crazy, irrational Street is strong. He can't live without that rush of endorphins that comes with the high-wire act! So now he's coming back, ready to love again, to make the plunge, to take those risks, even the stupid ones he knows will lead to his destruction again.

It this wise? Is this the behavior of a thoughtful, mature person? Certainly not. He's a mad, impetuous fool! He can't live without the thrill of the chase, the agony of anticipation, the ache, the yearning, the oasis of glory and satisfaction in the desert of life! He won't! Step aside, world! Love is in the air! He's apt to do just about anything!

Can't anybody keep an eye on him, for his own good?

This post has been republished from The Street.

Overleveraged Economy Not To Blame For Financial Crisis

According to MIT economics professor Ricardo Caballero, leverage is not the real problem that led to the financial collapse, but rather excessive concentration of risk. If he is right, could policy makers be chasing the wrong culprit as they create new regulation for the financial system? The following post from Economist's View, discusses this alternative view.

Ricardo Caballero hasn't given up on his argument that it was the excessive concentration or risk, not leverage, that caused problems in financial markets (and it's an argument I'm sympathetic to):

Economic Witch Hunting, by Ricardo Caballero, Commentary, Economists Forum: Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis. Understandably, pressured politicians and policymakers rush to find culprits... All too often they find a ready supply of these in preconceptions and superficial analyses of correlations. This time around the scapegoats are global imbalances and leverage.

Global imbalances are the victim of preconceptions: Many economists and commentators argued before the crisis that large global imbalances would lead to the demise of the U.S. economy... The crisis indeed came, but rather than destabilizing the US economy, capital flows helped to stabilise it, as flight-to-quality capital sought rather than ran away from US assets. ...

The fact that the actual mechanism behind the crisis had nothing to do with that which was used to explain the forecast of doom has long being forgotten, false idols have been erected,... global imbalances have been indicted for witchcraft, and ever more exotic rebalancing and currency proposals make it to the front pages of newspapers around the world.

Leverage is the victim of superficial analyses of correlations: In my view one of the main factors behind the severity of the financial crisis was the excessive concentration of aggregate risk in highly-leveraged financial institutions. Note that the emphasis is on the concentration of aggregate risk rather than on the much-hyped leverage. The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy... The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements. ...

We shouldn't assume that the next potential financial crisis will be identical to this one in terms of how it comes about or how it expresses itself, so we need to ensure that the system can withstand different types of financial shocks. Given that these shocks can come from unexpected places, it's not clear to me that insurance discussed above will stop all of the ways in which financial market problems can lead to harmful deleveraging. Hence, we may want to put the type of insurance plan Ricardo Caballero would like to see instituted in place, and then buttress that protection with enhanced capital requirements to safeguard against unexpected causes of harmful deleveraging.

This post has been republished from Mark Thoma's blog, Economist's View.

Is Alan Greenspan The Main Villain Behind The US Housing Bubble?

Peter D. Schiff argues that Alan Greenspan will go down in history as the main villain in creating the financial house of cards that resulted in the historic crash. Greenspan, who was rarely challenged during his reign as Fed Chairman, may have inadvertently created conditions that resulted in the economic crash of 2008. For more on this, read the following article from Schiff as published on Money Morning.

Back during the U.S. invasion of Iraq, when the U.S. government issued its now-famous deck of playing cards featuring pictures of the 52 arch villains of the Iraqi police state, Saddam Hussein’s face adorned the Ace of Spades. If the Barack Obama administration wanted to engage in a similar public relations campaign - this time with a focus on the U.S. real estate crisis - that top card should be reserved for former Federal Reserve Chairman Alan Greenspan.

In a speech before the National Association of Realtors last Tuesday, Sir Alan “the-bubble-blower” Greenspan claimed that his low-interest-rate policies in the early and middle years of this decade had no effect on mortgage rates or real estate prices. As a result, he claims no responsibility for the subprime mortgage crisis. But even current Treasury Secretary Timothy F. Geithner - who shared interest-rate-policy responsibility as governor of the New York Fed during the Greenspan regime - recently admitted that overly accommodative policy helped inflate the bubble. So what does Greenspan know that everyone else doesn’t?

Greenspan’s primary defense is that mortgage rates were a function of long-term interest rates that were simply not responding to the movement in short-term rates, which he did control. While it is true that the flow of capital from foreign creditors with excess dollars did keep long rates low despite rising short rates, this “conundrum” was not the leading factor in the housing bubble. Although rates on 30-year-fixed-rate mortgages are based on long-term bonds, by 2005 such loans had become an endangered species. The housing bubble was all about adjustable-rate mortgages (ARMs) with teaser rates of one to seven years - which are primarily based on the benchmark Fed Funds.

The rock-bottom teaser rates, permitted by the 1.0% Fed Funds rate, were the primary reason that many homebuyers were able to qualify for mortgages they couldn’t otherwise afford - which, in turn, enabled them to bid U.S. home prices up to “bubble” levels. By pushing down the cost of short-term money, the U.S. central bank enabled homebuyers to make big bets on rising real estate prices. Without the Fed’s help, few borrowers would have “qualified” for these risky mortgages and real estate prices never would have been bid up so high.

Greenspan expresses exasperation now, as he did then, that his careful nudging of interest rates higher by quarter-point increments did not translate into corresponding increases in long-term rates. Unfortunately, according to Greenspan, the markets would not cooperate with his wise guidance, and to his dismay, mortgage rates fell despite his best efforts.

As they say in Texas, that dog just won’t hunt. If the “measured pace” of his quarter-point rate hikes were too slow to produce the desired effect, why didn’t Greenspan jack up the pressure? With interest rates far below the official inflation rate for so many years during the bubble, he certainly had plenty of room to maneuver. The claim that he was unhappy with the ultimate results of his rate hikes - despite his having done nothing to adjust that policy - is ridiculous.

In addition to his colossal errors on interest-rate policy, there were many other ways Greenspan blew air into the real estate bubble. One example was what the market called the “Greenspan put.” By creating the perception in word and deed (that has since proven accurate) that the Fed would backstop any major market or economic declines, lenders became more comfortable making risky loans.

In an often-quoted 2004 speech, Greenspan went so far as to actively encourage the use of adjustable-rate mortgages and praised home-equity extractions for their role in contributing to economic growth. In fact, rather than criticizing homeowners for treating their houses like ATM machines, he often praised the innovative ways in which such homeowners were “managing” their personal balance sheets.

In short, Greenspan was as much a proponent of leverage for homeowners on Main Street as he was for bankers on Wall Street.

The bottom line is that Greenspan fathered the housing bubble and now he refuses to acknowledge kinship with his wayward child. His denial of responsibility is an act of stunning bravado, and is a testament to his ability to turn even the simplest of situations into an impenetrable tangle of theories and statistics.

“The Maestro” easily trumps the private sector jokers who now hold top dishonors in our pack of economic villains. The fact that Greenspan still has any credibility shows just how little understanding the general public - including Wall Street and the media - actually has about this crisis.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.