A sound banker, alas! Is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.
John Maynard Keynes, “The Consequences to the Banks of the Collapse in Money Values,” 1931
We are currently experiencing a major shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitization products and credit markets more generally. Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto their balance sheets), but losses that the banks have suffered limit their capacity to absorb those risky assets. The result is a reduction in aggregate risk capacity in the financial system – a bank credit crunch caused by a scarcity of equity capital in banks – as losses force those who are used to absorbing risk to have to limit those exposures.
This essay considers the origins of the subprime turmoil, and the way the financial system has responded to it. There are both old and new components in both the origins and the propagation of the subprime shock.
With respect to origins, the primary novelty is the central role of agency problems in asset management. In the current debacle, as in previous real estate-related financial shocks, government financial subsidies for bearing risk seem to have been key triggering factors, along with accommodative monetary policy. While government encouragement of risky borrowing and loose money played a major role in the current U.S. housing cycle, investors in subprime-related financial claims must share the blame for making ex ante unwise investments, which seem to be best understood as the result of a conflict of interest between asset managers and their clients. In that sense, sponsors of subprime securitizations and the rating agencies – whose unrealistic assumptions about subprime risk were known to investors prior to the runup in subprime investments – were providing the market with investments that asset managers demanded in spite of the obvious understatements of risk in those investments.
With respect to the propagation of the shock, much is familiar – the central role of asymmetric information is apparent in adverse selection premia that have affected credit spreads, and in the quantity rationing of money market instruments – but there is an important novelty, namely the ability of financial institutions to have raised more than $434 billion (as of the end of the third quarter of 2008) in new capital to mitigate the consequences of subprime losses for bank credit supply. The ability and willingness to raise capital is especially interesting in light of the fact that the subprime shock (in comparison to previous financial shocks) is both large in magnitude and uncertain in both magnitude and incidence. In the past, shocks of this kind have not been mitigated by the raising of capital by financial institutions in the wake of losses. This unique response of the financial system reflects the improvements in U.S. financial system diversification that resulted from deregulation, consolidation, and globalization.
Another unique element of the response to the shock has been the activist role of the Fed and the Treasury, via discount window operations and other assistance programs that have targeted assistance to particular financial institutions. Although there is room for improving the methods through which some of that assistance was delivered, the use of directly targeted assistance is appropriate, and allows monetary policy to be “surgical” and more flexible (that is, to retain its focus on maintaining price stability, even while responding to a large financial shock).
In light of these new and old elements of the origins and propagation of the subprime turmoil, the essay concludes by considering the near term future of financial and macroeconomic performance, and the implications for monetary policy, regulatory policy, and the future of the structure of the financial services industry.
Downside risks associated with the credit crunch increased in the wake of the financial upheaval of September 2008. At this writing, a comprehensive plan to recapitalize the financial system is being considered by Congress. An intervention based on preferred stock injections into banks would be preferable to the Fed-Treasury TARP proposal of government purchases of bank assets.
Although credit conditions are a major concern, dire forecasts of the outlook for house prices reflect an exaggerated view of effects of foreclosures on home prices.
Inflation and inflation expectations have risen and pose an immediate threat. Monetary policy should maintain a credible commitment to contain inflation, which would also facilitate US financial and nonfinancial firms’ access to capital markets.
Regulatory policy changes that should result from the subprime turmoil are numerous, and include reforms of prudential regulation for banks, an end to the longstanding abuse of taxpayer resources by Fannie Mae and Freddie Mac, the reform of the regulatory use of rating agencies’ opinions, and the reform of the regulation of asset managers’ fee structures to improve managers’ incentives. It would also be desirable to restructure government programs to encourage homeownership in a more systemically stable way, in the form of down payment matching assistance for new homeowners, rather than the myriad policies that subsidize housing by encouraging high mortgage leverage.
What long-term structural changes in financial intermediation will result from the subprime turmoil? The conversion of Morgan Stanley and Goldman Sachs from standalone investment banks to commercial (depository) banks under Gramm-Leach-Bliley is one important outcome. The perceived advantages of remaining as a standalone investment bank – the avoidance of safety net regulation, and access to a ready substitute for deposit funding in the form of repos – diminished as the result of the turmoil. Long-term consequences for securitization will likely be mixed. For products with long histories of favorable experiences – like credit cards – securitization is likely to persist and may even thrive from the demise of subprime securitization, which is a competing consumer finance mechanism. In less time-tested areas, particularly those related to real estate, simpler structures, including on-balance sheet funding through covered bonds, will substitute for discredited securitization in the near term, and perhaps for years to come.
Originally published at the AEI and reproduced here with the author’s permission.