Tags: barry | elias | Economic | Risk | Financial | Mistrust

Economic Risk Leads to Financial Mistrust

By    |   Friday, 10 December 2010 07:26 AM

My Nov. 12 blog described how modern economists severely miscalculated the economic realities, which fueled the 2008 financial crisis.

Five days after this piece was published, the Institute for New Economic Thinking (INET) issued a grant to a team of experts: The mission is to derive a computational model that would represent the underlying dynamics of the financial crisis.

This esteemed team includes the following individuals: Dr. J. Doyne Farmer (Santa Fe Institute); Dr. George Axtell (George Mason University); Dr. John Geanakopolos (Yale University); and Dr. Peter Howitt (Brown University).

In 2008, Dr. Kenneth C. Kettering presented a paper entitled “Securitization and its Discontents: The Dynamics of Financial product Development.” He suggests that financial institutions (paraphrased) circumvent rules en mass to redefine system, then claim systemic risk will ensue if the new system is removed and legal action taken (essentially permit more risk and leverage to optimize revenue and profit and if system breaks down, the institutions will be reinforced externally to continue the same pattern of behavior; enable moral hazard and irresponsibility).

Dr. Kettering cites three examples during the past three decades that illustrate this contention: standby letters of credit (bank guarantee of liabilities), repurchase agreements, and the Commodity Exchange Program (CEP) involving off-exchange derivative transactions. In each case, risk is essentially transferred to another entity in a subterranean-type fashion without being reflected as a cost to the entity transferring the risk. Ultimately, the risk is borne by other entities, such as the taxpayer, who had no interest in the transaction.

Regarding the 2008 financial crisis, former Clinton-era Labor Secretary Robert Reich states, “The underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.”

A century ago, bankers met to conceive the plans for the U.S. Federal Reserve Bank. This clandestine operation took place at the Jekyll Island Club Hotel on Jekyll Island, Ga. Last month, this historic island was visited by financial luminaries to pay homage to this event. At the conference, Alan Greenspan, former Federal Reserve Bank chairman under Presidents Ronald Reagan, George H. W. Bush, and Bill Clinton, confirmed what William Black, James Galbraith, Joseph Stiglitz and George Akerlof have previously suggested: the economy can't recover if fraud isn't prosecuted and if the big banks know that government will bail them out every time they get in trouble.

“Many of these fancy instruments became popular over recent years precisely because they circumvented financial regulations, especially rules on banks’ capital adequacy. Big banks created all these off-balance-sheet vehicles because they allowed the big banks to carry less capital,” Greenspan said.

Banks operated with less capital because of an assumption they would be rescued by the government, he said. Lehman Brothers Holdings Inc. wouldn’t have failed with adequate capital, he said. “Rampant fraud” was also an issue, he said.” “Fraud creates very considerable instability in competitive markets,” Greenspan said. “If you cannot trust your counterparties, it would not work.”

You may recall in late the 1990s, Greenspan articulated a sentiment that was diametrically opposed to the aforementioned: At the time, he claimed that fraud didn't require regulation nor attention [an error in judgment, indeed].

Some argue fraud perpetuated by the large financial institutions was prevalent: mortgage fraud, appraisal fraud, mortgage-securitization fraud, security rating fraud, accounting fraud (e.g., repo 105), with little prosecution or justice performed.

Economist Anna Schwartz, co-author of a leading book on the Great Depression with Milton Friedman, said, “The Fed … has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”

“So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not,” Schwartz said.

“This uncertainty, says Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.”

Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”

Testifying before the Financial Stability Oversight Congressional Panel, Simon Johnson, MIT School of Management Professor stated: “There is nothing anti-business about wanting to enforce the Volcker Rule. Quite to the contrary, the severity of the financial collapse in the fall of 2008 was very much about how big banks acquired and managed huge risks — not all of which were within officially designated prop-trading groups — and in the process damaged the rest of the financial industry and the broader economy.”

“State Street and the other big banks mostly just want to be left alone. 'We’re responsible adults and we can take care of ourselves' is their refrain. This was exactly the operating philosophy of Alan Greenspan, circa 1997: 'As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures' (as quoted in 13 Bankers, p.101)."

“Please do not repeat Mr. Greenspan’s tragic and costly mistake. We need a real firewall between custodian banks and the funds with which they are connected in any form. The Volcker Rule, if properly and rigorously applied, can do just that.”

“Not surprisingly, there is a great deal of agreement among leading academics, financiers, and other business people on the need to rein in – as much as possible – reckless risk-taking by very large banks.”

“The fact that our biggest banks want to become even larger and even more global should worry us a great deal – particularly as there is no cross-border resolution mechanism for banks on the horizon.”

“There is no way to handle the failure of global megabanks because there is no cross-border resolution mechanism or bankruptcy procedure that can handle their failure, a point I made with co-author James Kwak in 13 Bankers. The idea that too big to fail has been legislated away is simply an illusion.”

Excess risk-taking further enabled the moral hazard that caused the systemic malfunction and insufficient trust amongst financial entities.

Before this crisis, insurance companies were highly regarded for their financial safety and guarantees. In 2007, AIG was one of the largest insurance firms, with $1 trillion in assets, $100 billion of annual revenue, and $13 billion annual profit. In 2008, it managed to lose nearly $100 billion, wiping out the profit from the previous 17 years.

Subsequently, the U.S. taxpayers provided AIG with $182 billion in loans, guarantees, and/or equity. With 100,000 employees, this compensation is the equivalent of roughly $1.8 million per employee.

Back to the panel convened by the Institute for New Economic Thinking to study the underlying dynamics of the 2008 financial crisis. It would be highly recommended that they incorporate behavioral elements into the computation.

Decision-making behavior is a function of many domains: psychology, emotion, sociology, history, politics, and others.

I submit, when a framework promotes fairness, responsibility, and growth potential, proper behavior is empowered and everyone is a winner.

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My Nov. 12 blog described how modern economists severely miscalculated the economic realities, which fueled the 2008 financial crisis. Five days after this piece was published, the Institute for New Economic Thinking (INET) issued a grant to a team of experts: The mission...
Friday, 10 December 2010 07:26 AM
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