The news that 10 banks were given permission to emerge from under TARP last week, and that several banks may actually do so as early as last week, has many breathing a sigh of relief that the banking crisis is over. Unfortunately, the very measures taken to end our latest crisis all but guarantee that we’ll shortly witness another round of financial catastrophe.
This isn’t the kind of news people want to hear these days. When I’m chatting with friends at a saloon or a dinner party, people ask me what fixed the financial sector. They aren’t very interested in hearing that the sector isn’t actually fixed, much less that the apparent fix is actually making things worse.
Unhealthy Financial Institutions Rally
Let’s begin with the basic fact that no one can quite explain why or how we ended the bank crisis. The financial sector faces almost all the same challenges it did last autumn—uncertainty about profits, outdated business models, heavily leveraged balance sheets, self-dealing short term thinking by bonus hungry executives, ineffective regulation and—perhaps most of all—a huge amount of credit assets of extremely questionable value. Many things have actually gotten worse. It’s not just subprime debt anymore. It’s not even just home mortgages. The entire range of debt products that seem shaky—from credit cards, student loans, corporate loans to commercial real estate.
Making matters worse, the banks are still dependent on short-term debt for funding. As Gretchen Morgenson explains in her column today, some $172 billion of debt will mature this year, and $245 billion next year. Still in the midst of a credit crunch, this should be viewed as a ticking time-bomb for the financial sector.
But it isn’t. The market seems to have a renewed confidence in financial institutions. Since March, financial stocks have rallied sharply. Several firms once viewed as on their death beds have raised billions of dollars in new debt and equity. Some have had to rely on explicit government guarantees of their debt to issue new bonds but several have issued so called ‘non-guaranteed’ debt at costs that are far from unbearable.
Even the government seems to have confidence in the financial sector. Broad regulatory reforms are being pared back, in favour of minor tweaks that will largely leave the existing structure intact. Banks are being allowed to pay back the TARP, escaping the closest level of scrutiny. Government assistance programs to the financial sector are being allowed to quietly fade into the background. Shelving some of the more ambitious programs—such as Treasury Secretary Tim Geithner’s public private partnerships to buy troubled assets—isn’t seen as the crisis it might have once been. It’s OK that their unworkable because the work they were meant to do seems already done.
The ‘No More Lehmans’ Rally.
What really seems to have happened is not that one policy or another fixed the sector. It’s not even the total effect of them that renewed confidence. Rather, it’s a kind of meta-policy, a shadow program that repaired things. And that policy is that the government will do whatever it takes to prevent the collapse of a major financial institution. There will be no more Lehmans. Failure is not an option.
Obviously, the policy of No Failure helps banks raise debt. Holders of bank debt have been protected in each of the rescues. Unlike the bondholders of Chrysler or General Motors, the government did not fight to upend the traditional structure of payouts in failed financial firms. Quite the contrary, the creditors of banks were made whole in almost every case.
This creates a very strong incentive to allocate capital toward the financial sector and away from less secure sectors. Investors still wary of credit markets find the financial sector more attractive because of the guarantee that the debt is backed by the US government. Importantly, this is true even for debt that is not explicitly backed by the US government. The policy of No Failure means that banks enjoy a cheaper cost of capital the same way Fannie Mae and Freddie Mac did in their heyday. Every major financial institution is now a Government Sponsored Entity.
Beyond access to the credit markets, this implicit guarantee helps the banks do business. Counter-parties on trades can be confident that whichever institution they do business with will be there to make good on the trades. The exogenous risk of modern day bank runs is gone, and the confidence of customers provides new opportunities for profits.
Both of these also drive up the price of banks stocks. The implicit guarantee of bank debt takes away two of the major risks to holders of financial stocks. First, the government backed access to new credit dramatically reduces the liquidity risk that took down both Bear Stearns and Lehman Brothers. Second, the reduced liquidity risk diminishes the risk that government will be forced to take over a financial institution. The rally in financial stocks is partly a result of adding back value that had been discounted to account for these risks. Add to this the fact that the business model risk is diminished, and you have a recipe for a strong rally in bank stocks. Call it the “No More Lehmans” rally.
The Lurking Risk Management Disaster
At first glance, the process just described would appear to be a resounding endorsement of the business of government bank assistance. The usual objections appear either doctrinaire or just churlish. Free marketeers will object that the government is too involved, and taxpayers are still on the hook for bank losses. Profits are being privatized and risk socialized. Moral hazard is increased by the presence of government insurance.
None of these typical objections captures the most important danger created by the implicit guarantees—although the concept of moral hazard comes close. ‘Moral hazard’ is used as short hand for the notion that people and institutions will be tempted to engage in risky behaviour if the costs of those risks will be borne by others. When those risks are correlated with rewards that can be held privately, risk taking is even more tempting. A kind of phony, government ‘Alpha’ is created by insurance—excess gains obtained without taking on commensurate levels of risk.
The usual solution to this kind of moral hazard is a combination of risk regulation and profit sharing. Government steps in to make sure the bets made aren’t too risky, and it takes a share of the excess gains made from the government alpha. This profit sharing can reduce risk all by itself, since if done right it takes away the incentives for risky behaviour.
But this notion of moral hazard—and this way of ameliorating it—misses an even deeper and more systemic problem created by the implicit guarantee. The problem, to put it in extremely abbreviated way, is that the implicit guarantee and the knock-on effects described above make risk management and business planning almost impossible. They take away the market signals that could instruct a financial firm about the market’s collective wisdom about the risks a firm has taken on and the potential for a firm’s business model. The executives running banks are essentially left flying blind, guessing about the correct altitude and speed because the market processes that would be their guidance instruments have ceased functioning.
Traditional risk management isn’t quite useless, but it is nearly so. Even somewhat sophisticated measures such as “Value at Risk” that banks employ don’t really work very well. The banks themselves admit this, and their failures provide strong corroborating evidence. The problem is that these measures of risk are too subjective, and involve too much guess work.
The real test of risk management is provided by the financial Darwinism of the markets. By reading market signals about products—pricing of assets, pricing of insurance on those prices—banks develop models that can inform them about risk. By reading market signals about their own financial health—their cost of capital, their borrowing cost, the cost to insure their debt, the willingness of customers to enter into trades—risk managers get a view about the risks of their own portfolios and the strength of the business model.
The “No FMore Lehmans” rally, however, scrambles these signals. Shareholders, bondholders, counterparties can become indifferent to risk. Business models can seem more effective than they actually are. In this situation, financial executives cannot appeal to the external market to determine whether they have the right business models, asset portfolios or capital structures. They just have to guessitimate.
Students of the history of economics may recognise the similarities between this situation and the old ‘socialist calculation debate.’ That debate centered on the question of whether central planners were able to correctly figure out how much of something should be manufactured in an economy without price signals. Most everyone today agrees that pricing is absolutely central to the ability to make calculations about how to expend limited resources.
With the implicit guarantees in place, the bank executive trying to decide how to change his firm’s business model or what it’s risk portfolio is in the position of a socialist planner. He lacks the ability to calculate risk and reward because his access to the judgment of an external market is cut-off.
This calculational chaos is far worse than simple ‘moral hazard.’ It doesn’t matter what regulations are in place, or how closely supervised a firm might be. After all, the regulators and supervisors suffer from the same blindness of the bank executives. And even if bank executives are well-intentioned and untempted by moral hazard, they still cannot properly decipher the risks in their business. There’s no process for decoding risk except market processes, and we’ve thrown a giant monkey wrench into that process. In short, our implicit guarantees are wrapping the mystery of risk inside the enigma of bailouts.
It was this calculational chaos that brought down Fannie Mae and Freddie Mac. Even when closely supervised by regulators and with well-intentioned executives in place, the mortgage agencies were unable to properly evaluate the size of their balance sheets, the content and quality of their portfolios or the appropriateness of their business models. They were the original ‘flying blind’ financial institutions, operating under the benefits and hazards of ‘No Failure’ even before the collapse of Lehman Brothers.
And there is every reason to believe that this calculational chaos will also bring down financial institutions covered by the government’s implicit guarantee. The question is not, really, whether banks will fail like Fannie and Freddie. The question is how many will fail. Or, perhaps, how many will be able to avoid the fate through some bit of luck. Financial prudence and managerial skill will not be enough.
Policy makers face a tough problem here. In order to restore the health of the financial sector, they need to remove the blinders that the implicit guarantees place on those running these firms. But they never succeeded in doing this with Fannie and Freddie, despite years of denial that any guarantee existed. After the market was proved correct about Fannie and Freddie—there was a guarantee after all—the government simply lacks credibility on this point. No one seriously believes these days that a firm like Morgan Stanley or Goldman Sachs would be allowed to fail, much less a mega-bank like Citi or Bank of America.
Perhaps something as dramatic as the seizure of Citigroup is necessary to restore the credibility of markets in the financial sector. This, actually, is exactly what the Wall Street Journal’s editorial board recommended last week. But we need to be cautious: the market has already responded to the guarantees in so many ways that if they were effectively removed, the process would be painful to many investors and the ripple effects are unknowable. We might even set off a new round of financial panic, as the markets suddenly tried to work out which institutions were viable on market processes without guarantees.
This much we know: the scheme to save the banks through implicit guarantees is doomed to failure. What we should do about this, and if we can do something about it before it’s too late—well, those should be the questions we’re talking about.