Creating financial harmony: lessons for China.

AuthorDorn, James A.
PositionReport

The current turmoil in global financial markets, which began with the U.S. subprime crisis in 2007, has shed a bad light on market liberalism. But it was the socialization of risk not private free markets--that precipitated the crisis. Government sponsored enterprises (GSEs), not private enterprises, politicized investment decisions and overextended credit to high-risk households by buying up and guaranteeing subprime and Alt-A mortgages. (1)

Financial innovation and the information revolution allowed greater specialization and diversification of risk, but government backing of GSE debt created a moral hazard problem and, together with loose monetary policy and flawed regulations, led to excessive risk taking and overinvestment in housing. When housing prices began to decline in 2007, defaults spread and banks failed. Toxic assets rapidly mounted and the housing crisis morphed into a general credit crisis.

The central issue this article addresses is how to structure institutions and incentives to promote financial harmony. The notion that the subprime/credit crisis stemmed from "market failure" diverts attention from "government failure." To remedy that diversion, this article examines the sources of the present financial crisis and finds that the free market is more the victim than the culprit. (2) The lessons learned from the U.S. subprime/credit crisis can help China confront the challenges it faces in creating a "harmonious society."

Sources of the Present Crisis

History has taught that sound money and financial stability go hand in hand. Today we have a pure fiat money standard and fractional reserve banking. There is no convertibility principle at play, as under the gold standard, and central bankers prefer discretion to a hard monetary rule. In such a world, the long-run value of money is uncertain, and there is always the threat that the fiscal hand of government will reach out and pull the monetary lever to stimulate economic growth. Yet, the first lesson of economics is "There is no free lunch." If printing money created prosperity, we could all be rich in an instant. One need only look at the chaos in Zimbabwe to reveal the reality of what happens when sound money is debased and government profligacy reigns.

In a world of pure fiat money, there must be effective limits to its creation. China was the first to discover the benefits of paper money, but also learned that excessive money creation is ruinous to the economic and social fabric of a nation. Today, the challenge is to achieve monetary and financial stability so that money can retain its purchasing power and people can regain trust in financial institutions. Without such trust, liquidity will diminish and market transactions will be constrained. Economic prosperity will suffer as a result.

A safe and sound financial system depends on mast. In a small private setting, with only a few borrowers and lenders, where everyone knows each other and reputation effects are strong, transparency will be high and default risk low. Yet, such a small-scale financial system does not allow for innovation and specialization in risk taking, and thus limits liquidity. The ability to diversify and globalize risk is beneficial so long as the network of contracts is anchored in trust. Once that trust is lost, crisis man set in.

Financial contracts have become so complex that computer models are needed to price risk. Face-to-face dealings in small capital markets have given way to millions of computer screens in trading rooms around the world, and to trust in abstract risk-assessment models for derivative instruments based on the underlying assets. Those models appeared to price risk prudently when housing prices were rising, but in the summer of 2007 the boom in housing peaked and the models failed.

In his recent congressional testimony, former Federal Reserve chairman Alan Greenspan (2008) admitted that the risk-assessment models were flawed: "The whole intellectual edifice collapsed ... because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria." (3) Indeed, he recognized that flaw as early as March 1999, when he recommended "stress testing" of risk-assessment models (Greenspan 1999).

Forecasting is not a science, and markets are not omniscient. Yet no one has improved upon the spontaneous feedback mechanism of competitive markets based on private property rights and individual responsibility. The failure of the models to correctly price risk associated with mortgage-backed securities (MBSs) could be called a "market failure," but only in the sense that the model-builders ignored the possibility of widespread declines in U.S. housing prices. What Greenspan did not admit was that the Fed erred in creating too much liquidity and kept interest rates too low for too long beginning in 2001. According to monetary historian Anna J. Schwartz (2008), "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset." The present crisis is no exception (see White 2008). Market pricing and risk assessment work best when monetary stability is the primary objective of central bank policy.

The huge leveraged positions of many investment banks holding MBSs and other collateralized debt obligations (CDOs) came under tire as housing prices fell and defaults increased. A small change in the value of the underlying--now rotten--assets (houses) could easily wipe out the capital of a highly leveraged financial firm, as it did to Bear Stearns, Lehman Brothers, and others.

Those who bought credit default swaps (CDSs) to insure against default risk placed a low probability on such risk, and firms like AIG were willing to sell contracts to insure against that risk because management thought it would be profitable. What happened?

The Role of Fannie and Freddie

The story really begins with the distortions in the U.S. housing market created by Fannie Mae and Freddie Mac, the two giant housing finance firms. (4) With an implicit (now explicit) promise that the federal government would guarantee their debt, those two GSEs were able to borrow at low interest rates and crowd out competitors. In the process, Fannie and Freddie became "too big to fail." As creatures of Congress, they poured millions of dollars into lobbying to protect their privileged positions, and Congress used them to pursue the goal of "affordable housing," as expressed in the Community Reinvestment Act (CRA). (5)

After the accounting scandals at Fannie and Freddie in 2003 and 2004, Congress and shareholders (seeking higher returns) put increasing pressure on management to expand purchases of subprime and Alt-A mortgages. Fannie nearly tripled its guarantees of risky Alt-A loans during 2005-06 relative to all previous years (Figure 1). Moreover, little attention was paid to risk. One former loan officer remarked, "We didn't really know what we were buying" (Duhigg 2008: 1).

Meanwhile, in 2004, Henry M. Paulson, then head of Goldman Sachs, along with other top investment bankers went to Washington to lobby for relaxing the net capital rule, which required large trading firms to hold reserves against their investments. That rule limited leverage and, hence, profits. Paulson's lobbying efforts succeeded in having the Securities and Exchange Commission (SEC) revoke the net capital rule (Labaton 2008). As a result, the door was open for further increases in the market for MBSs, CDOs, and CDSs, which helped funnel even more money into the already overheated housing sector.

Compounding the problem was that Standard & Poor's and other rating agencies relied on Wall Street models to access risk, just as the SEC did, and made large profits by rating the risky securities at investment-grade level. When defaults started to increase, the charade ended and the deleveraging process began.

The absence of a clearinghouse for over-the-counter (OTC) derivatives linked to the housing market meant that trust was absent, and trading virtually came to a standstill. Balance sheets were affected as ratings fell, calls for collateral increased under mark-to-market accounting rules, and losses mounted. Bank failures and the disappearance of long-established financial giants revealed the depth and breadth of the toxic assets and the overborrowing that had occurred.

Actuarial trust was therefore tarnished, just as it was during the failure of Long-Term Capital Management.

When the Treasury took over Fannie and Freddie in September 2008, the implicit guarantee...

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