Think Twice Finance

Four Credit Crisis Fallacies: Why We are Not Solving the Problems of The Financial System

Most citizens, we are told, take a cynical view of both Wall Street and Washington. It has given life to the candidacy of Barak Obama, perhaps. Do people of experience with The Street trust Washington to fix the problem? I don’t. I’ll tell you why. We are addressing problems we can’t solve and burying the problems that matter. Here are four things “high priority” reforms that won’t work.

1. Bailing out folks in mortgage trouble. The underlying reason mortgage borrowers got into trouble is that the entire financial system, from mortgage borrower to holders of money market mutual fund shares, believed that unlike any other price, housing prices could never enter a serious, prolonged slump. That can only be explained as a failure of Finance educators, or perhaps too much coffee and sugar per capita. It’s nonsense. And it can happen again. That we thought of our financial institutions as “diversified” is just embarrassing. By bailing mortgage borrowers out, we encourage this collective state of denial.
2. Folding a troubled investment bank into a large unprofitable New York bank. I do not believe Bear Stearns was rescued because of system problems. I believe that rescuing Bear Stearns was a government orchestrated publicity stunt. It is the cornerstone of their argument that they need to regulate investment banks, and that is why they got so heavily involved. If government officials had not intervened as early as they did, it is far from clear that the market would not have picked up the pieces in a more orderly way. Instead we have yet another historically profitable risky investment bank folded into an historically unprofitable large New York bank. And hasn’t that been a great idea in the past?
3. Using Bear Stearns as an excuse to increase the number of regulated institutions. There is zero evidence that regulated institutions pose a lesser risk to taxpayers than unregulated institutions. There is, on the other hand, evidence that unregulated financial institutions are more profitable than regulated institutions. The problem is that regulation simultaneously stifles creativity and puts pressure on the regulators to “manufacture” profitability using gimmicks like Mortgage Conduits. Those “derivatives” were created by the Fed during the Enron debacle, a fact the Fed seems disinclined to own. What is going to happen is that the investment banks will go on the dole with the banks and creativity will go where the creative people are going, to private equity firms and hedge funds, because they are unregulated.
4. Expecting reform of the Rating Agencies to make a difference. There is one fundamental fact about the Rating Agencies that needs focus is that they have become a collection of computer programmers. Given the magnitude of their job, there is no alternative to this, but credit risk management is too complex to be handed over to a machine. The Rating Agencies provide necessary assistance in the credit evaluation process, but there was too much money being invested based only on ratings and yield. The Rating Agency reform won’t make them better and making them better isn’t important.