On 14 September, Alan Greenspan, once a figure of mythic proportions as chairman of the US Federal Reserve, observed that the US was in a “once-in-a-century” financial crisis. As if we hadn’t already noticed. What started all this was, of course, the housing bubble, which was associated with fraudulent mortgage loan practices and shoddy credit rating techniques, unsuitable for the complex securities that were being created and pushed by financial firms of all types. The demise of some old-style financial intermediaries may be good for the future of financial markets.
In May 2005, Greenspan acknowledged that there were a lot of local housing bubbles, but he didn’t see a national housing bubble, and said that the economy was not at risk. He was Fed chairman then, and maybe his position did not allow him to be more forthright. But in October 2006, several months after he stepped down and could speak freely, he said of the housing market, the “worst of this may well be over”. And he still seems to miss the essence of what happened. He has recently said that the problem was not in the mortgage loans themselves, but in their securitization and sale to a wide range of investors. This denies the core problem, of dishonest, unsustainable loans. Ultimately, Greenspan was the Ostrich, with his head in the sand. He had the opportunity to be more forceful about the risks and needed regulatory responses at the time, but chose not to be. Now, with the storm at full blast, he looks up and acknowledges the reality.
Contrast all this with the position of Nouriel Roubini, a professor at New York University’s Stern School of Business, and head of Roubini Global Economics. In August 2006, he wrote, “The scariest thing is that the gambling-for-redemption behaviour…are not the exception in the mortgage industry; they are instead the norm. …If this kind of behaviour is — as likely — the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of…sub-prime lending institutions may thus be the proverbial canary in the mine — or tip of the iceberg — and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession.”
Roubini went on to say, in 2006, “One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage-backed securities market and triggers severe losses for the two huge GSEs (government-sponsored enterprises), Fannie Mae and Freddie Mac.” Talk about prescience. In August this year, the New York Times (NYT) dubbed Roubini “Dr Doom”. This was after the failure of Bear Stearns, which he had also foreseen. Three weeks after the NYT piece, Fannie Mae and Freddie Mac bit the dust, effectively being nationalized.
A bit earlier, in July, Roubini had said that Lehman Brothers would need a buyer: it soon did, but didn’t find one, and is now bankrupt. He didn’t stop there. He predicted in July that Merrill Lynch, Goldman Sachs and Morgan Stanley would also not survive as independent firms. Lo and behold, Merrill Lynch is now set to be owned by Bank of America. Forget the Ostrich. When Roubini talks, people should listen.
The beauty of Roubini’s predictions is that they are based on crystal clear economic analysis. He argues that the independent broker dealer model (epitomized by the former big four firms) is fundamentally flawed. These firms use the same business model as banks: they borrow short and lend long. But they borrow on even shorter time frames, use more leverage, and do not have explicit government backing (as banks have had since the Great Depression). If one accepts this analysis, then the last quarter century, after a spate of deregulation, has been a transitional phase, and the new institutional model for the sector will involve more diversified financial intermediaries, more careful regulation, more explicit lender-of-last-resort provisions, and a different risk-reward trade-off. More specifically, Goldman Sachs and Morgan Stanley will also (within a few years, according to Roubini) need saviours.
But this is nothing like the end of financial capitalism, as some windy observers have claimed. Fraud (lending practices that created toxic financial products) and incompetence (rating methods that helped diffuse them all through the global financial system) are not necessary consequences of capitalism. Greed does flourish under such a system, but greed always has to be managed (for example, safety rules, liability laws, disclosure provisions and requirements to honour contracts).
One might even go further, and argue that many of the Western financial institutions are vestiges of a time when financial products were idiosyncratic, liquidity could be fragile, informal trust and social networks mattered, and information was hard to come by. Information technology may offer opportunities to replace some old-style intermediaries with automated exchanges for a broader range of financial products than hitherto possible. Financial markets may actually become more efficient.