Financial Markets Meltdown

[TPS]

I've mentioned several times that my economic views were heavily influenced by the late Hyman Minsky. Attached is an article (somewhat lengthy) by one of his former students on the current financial crisis from a "Minskyian perspective." It may be a bit daunting for those who aren't as familiar with finance.

 

 

A Minsky(ian) analysis

[GG]

At least he got the introductory passages right, which should be relatively easy as he's restating history. He also should get credit for correctly identifying individual pieces and how we got here. But that's about it. Anyone who agrees with the statement -- that "wiping out financial wealth so that only equity ownership remains," shouldn't give opinions on financial system structure, as equity is always the first to get wiped out in any calamity. The reason you're simplifying the system right now is to prevent the debt from weighing down on the entire financial system. As demonstrated in Bear Stearns, debt holders were rescued, equity holders basically got wiped out. Financials everywhere are killing their equity values seeking new capital to pay off debt obligations.

 

It's no surprise that he believes that more heavy-handed regulation will lead to less severe shocks. But he should also be frank that if more regulation follows, US would lose financial system dominance to Britain, or to Hong Kong.

 

Securitization is the root of the current debacle. But, the biggest problem is that many of the models and underwritings were treating them as equity derivatives not as debt. There has never been a meltdown in debt securitizations similar to massive corporate defaults, where banks have a history of default rates & recoveries. More regulation isn't going to solve the problem that wasn't borne out of nonexistent regulation. If regulation was the answer, you wouldn't have had a problem with the regulated savings & loans in the '90s.

 

The solution is not nationalization, like Wray proposes, but to eliminate the alphabet soup of regulators, acknowledge the idiocy of separating financial companies by industry sectors and most importantly work to come up with models and underwriting standards of securitizations that better reflect potential defaults. At their core, securitizations do serve a valuable function to the debt market and they do spread the risk and lower financing costs. Junk bonds didn't kill finance, and neither will securitizations.

[TPS]

At least he got the introductory passages right, which should be relatively easy as he's restating history. He also should get credit for correctly identifying individual pieces and how we got here. But that's about it. Anyone who agrees with the statement -- that "wiping out financial wealth so that only equity ownership remains," shouldn't give opinions on financial system structure, as equity is always the first to get wiped out in any calamity. The reason you're simplifying the system right now is to prevent the debt from weighing down on the entire financial system. As demonstrated in Bear Stearns, debt holders were rescued, equity holders basically got wiped out. Financials everywhere are killing their equity values seeking new capital to pay off debt obligations.

I'll have to find that passage and see the context again.

 

It's no surprise that he believes that more heavy-handed regulation will lead to less severe shocks. But he should also be frank that if more regulation follows, US would lose financial system dominance to Britain, or to Hong Kong.

So I'm not sure where you stand now? You support regulation or not?

 

Securitization is the root of the current debacle. But, the biggest problem is that many of the models and underwritings were treating them as equity derivatives not as debt. There has never been a meltdown in debt securitizations similar to massive corporate defaults, where banks have a history of default rates & recoveries. More regulation isn't going to solve the problem that wasn't borne out of nonexistent regulation. If regulation was the answer, you wouldn't have had a problem with the regulated savings & loans in the '90s.

NOt sure where you get this? The S&Ls were deregulated starting in 1980. It's one of the reasons always cited for the crisis. I disagree a bit on the "biggest problem with the models." You've got the industry creating models to estimate risk based upon past behavior. Two inherent problems: one, the industry is profit driven, so there's always a bias to under estimate risk; two, past data (which models are typically built upon) can't estimate the risk of the new types of securitized "assets." I do agree for a different reason about your "borne out of nonexistent regulation" point. The history of financial innovation is related to regulation. Once you create a regulation, finance finds a way around it in order to generate more profits. Securitzation, as Wray pointed out, was a way to circumvent regulation (capital requirements). Make the loans, generate fees from said loans, then "securitize and sell." Over the past 20-30 years, banks have been focusing on generating more "fee income" than interest income.

 

The solution is not nationalization, like Wray proposes, but to eliminate the alphabet soup of regulators, acknowledge the idiocy of separating financial companies by industry sectors and most importantly work to come up with models and underwriting standards of securitizations that better reflect potential defaults. At their core, securitizations do serve a valuable function to the debt market and they do spread the risk and lower financing costs. Junk bonds didn't kill finance, and neither will securitizations.

Don't necessarily disagree with the first part. The second, I'd say that finance always creates instability (that's the main point in minsky). There will always be another "fad" where "finance" underestimates the risk because of the desire for greater profits.

 

Thanks for the response. I wasn't trying to generate any discussion with this, just thought some might find it interesting. Minsky was one of the few "practical theoreticians" of his time, and I'd certainly recommend picking up his book "Can IT Happen Again?" A collection of his articles, which are still relevant today.

[GG]

So I'm not sure where you stand now? You support regulation or not?

 

I support coherent regulation of the industry that is not hamstrung by failed post-depression reactionary acts. Maybe one day someone will explain the common sense of securities firms not being allowed to use "bank" in their name, while "banc" is perfectly fine.

 

NOt sure where you get this? The S&Ls were deregulated starting in 1980. It's one of the reasons always cited for the crisis.

 

Not all deregulation is created equal. Just like the California energy "deregulation" you cannot deregulate demand, while still regulating supply. S&Ls were a half-assed deregulation, where the capital standards didn't follow with the deregulation of the markets to be served nor investments they could sell or hold. Which is exactly where the current regulation needs to go. Financial innovation has made a mockery of the distinction between a bank and a securities firm (a distinction that is only prevalent in the US)

 

I disagree a bit on the "biggest problem with the models." You've got the industry creating models to estimate risk based upon past behavior. Two inherent problems: one, the industry is profit driven, so there's always a bias to under estimate risk; two, past data (which models are typically built upon) can't estimate the risk of the new types of securitized "assets." I do agree for a different reason about your "borne out of nonexistent regulation" point. The history of financial innovation is related to regulation. Once you create a regulation, finance finds a way around it in order to generate more profits. Securitzation, as Wray pointed out, was a way to circumvent regulation (capital requirements). Make the loans, generate fees from said loans, then "securitize and sell." Over the past 20-30 years, banks have been focusing on generating more "fee income" than interest income.

 

Don't necessarily disagree with the first part. The second, I'd say that finance always creates instability (that's the main point in minsky). There will always be another "fad" where "finance" underestimates the risk because of the desire for greater profits.

 

Thanks for the response. I wasn't trying to generate any discussion with this, just thought some might find it interesting. Minsky was one of the few "practical theoreticians" of his time, and I'd certainly recommend picking up his book "Can IT Happen Again?" A collection of his articles, which are still relevant today.

 

But that's the whole point. You cannot agree with the construct that financial innovation to evade regulation is what got us here and then propose that the best way to fix it is through more regulation! If Minsky believes that financial innovation runs in fads, then he's simply stating that finance echoes human nature of progress and discovery. There have yet been set of rules introduced that are totally effective in protecting people from themselves.

 

Minsky & acolytes' proposals go to the root of capital constraints in order to prevent bubbles. Yet, capital is like a gas that will fill up the available space. When you constrict its space in one area, it will find an opening to go somewhere else. Keep in mind that capital is the most fluid commercial activity, and erecting barriers to financial growth in one market will push the capital to other markets. In the end, you will not end up helping the people you ostensibly want to help, because you'll be left with stodgy institutions that are only a brief step removed from state-run enterprises and unwilling to take any risk.