Tuesday, October 21, 2008

It just ain’t so! (amv)

Larry White on regulation failures, the solvency vs. liquidity problem, and Krugman:

The teaser:

The Federal Reserve’s interventions in the recent subprime-mortgage crisis have included—at its own initiative, without precedent, and without congressional oversight—the extension of credit lines to investment banks and the lending of Treasury bills to “primary” securities dealers. The traditional role of the central bank as a “lender of last resort” is to make loans only to commercial banks, because the traditional rationale is to protect the economy’s payment system. The hope of the traditional last-resort lender is to avoid a collapse of the economy’s money stock by injecting reserves into the commercial banking system when there is an extraordinary “internal drain” of reserves (namely bank runs). In the recent crisis, by contrast, there has been absolutely no threat of a shrinking money stock. Investment banks do not issue checking deposits, are not subject to bank runs, and are not part of the payment system. Neither are securities dealers. The Fed’s expansions of its own role therefore had nothing to do with protecting the payment system or stabilizing the money supply. The Fed’s new moves were rather made in the hope of protecting investment banks and securities dealers from the consequences of holding portfolios overweighted with mortgage-backed securities, or exotic derivatives based on such securities, while keeping levels of capital inadequate for such portfolios. The reason that some financial institutions have been having trouble rolling over their debts is fundamentally the market’s uncertainty about their solvency. It is not a liquidity problem.

By blunting the market penalty for financial imprudence, the Fed is breeding a new kind of moral hazard. If the next crisis is worse than this one, moral hazard —not failure to regulate—will be high on the list of suspects. The Fed is currently lending hundreds of billions of Treasury securities from its portfolio and taking junk assets as collateral. In a few years we will be able to tabulate the losses to the American taxpayer.

Krugman declares: “We now know that things that aren’t called banks can nonetheless generate banking crises, and that the Fed needs to carry out bank-type rescues on their behalf. It follows that hedge funds, special investment vehicles and so on need bank-type regulation. In particular, they need to be required to have adequate capital.” It just ain’t so. Solvency problems for hedge funds and investment banks do not constitute a banking crisis as normally understood. What we now know—and already knew—is that financial firms, especially if they believe they can count on a government bailout, can get into trouble by holding highly leveraged portfolios of risky assets. The way to alleviate the problem is to cure them of that belief by letting them and their counterparties take their lumps.The potential for failure of a hedge fund, investment bank, or other financial institution is no rationale for new legal restrictions on them. Their shareholders and those who lend to them can and should determine how much capital is adequate.

Source: The Freeman