The crisis in the financial markets is the result of accumulated errors in risk management over a period of years, ineffectiveness and inefficiency of financial regulation and supervision, and a liquidity crisis.
The sequence of failures of investment banks clearly shows that these institutions were not being managed appropriately for today's world, with its large scale flows of capital that can be triggered in a minute. The structure of financial markets in the U.S. was flawed and the primary regulator of the investment banks was unable to do what was necessary to assure a stable financial system. The system broke down as at least two instruments complicated risk management both for the banks/investment banks and the regulators: the complex mortgage backed securities and their sell-offs, and the credit derivatives.
In the case of mortgages, the first problem was that many mortgage loans, the sub-primes, were made that should not have been made. They were made on the assumption of continuing good economic times and continuing strength in the prices of housing. The managers and overseerers were looking the other way as these loans were made. This was the greed stage of the problem.
Then, the disconnect between the lenders and the borrowers and the intermediaries meant that when trouble struck, no one knew what the basic facts were or how to deal with them. The weak loans were then sold off, so that when people were unable to meet their obligations there was no easy way to renegotiate. Packages of loans of different types were sold off, and the complexity caused by the diversity of loans, plus the weakness in particular loans, meant that risk assessment in a meaningful way was impossible.
The crisis did not strike at one moment, but built up, with Bear Stearns being the initial victim. This run was by wholesale institutions, by hedge funds, investment banks, banks and others, but it was a run like runs have existed in the past. Except that the amounts of money were huge and the spillover effects were considerable.
This crisis of confidence was driven by liquidity, but, with the question of mortgages and credit derivatives outstanding, it became one of solvency. That is, the complexity of the risks involved, the impossibility of clarifying them in any short period of time meant that the market no longer could trust Bear Stearns. The solution was to provide liquidity, through the Federal Reserve, and to find a strong partner, Morgan Guaranty, to take over, at a much reduced price that would allow some room to deal with the unknown levels of risk.
None of the fundamentals of the weakness in the financial sector in the U.S. were dealt with by the rescue and the structural weakness outlined above persisted. The model was there so all in the markets knew that the next time they would need to move very quickly to withdraw from the prospective victim. Due to the structural weakness, in regulation and supervision, of the large investment banks, and the low capital position/high leverage, the next victim would be another U.S. investment bank, and this was the weakest of the remaining ones, Lehman Brothers.
The process was similar, but the decision by the authorities was not to save the institution, but to put it into the bankruptcy court. In one sense this was not a solution, as it means that the resolution will have to be played out over months and years, to see what the actual risks are.
Merrill Lynch realized that it was next and it took a preemptive move so that it would be linked with a commercial bank. The commercial banks, and holding companies, had not come under pressure, in large part because they were regulated and supervised under a different and more robust regime than the investment banks.
That left Morgan Stanley and Goldman Sachs as the only two remaining U.S. investment banks and they quickly realized that they needed to change their status, which they did by applying to become bank holding companies. They will be regulated by the Federal Reserve and will come under the "protection" of the Federal Reserve.
The lesson of the last weeks is that the pressure that the markets can bring to bear on any financial institution are tremendous and it is not easy, even maybe not possible, to quiet solely by providing liquidity. The classic solution for a liquidity crisis, it to provide liquidity easily, and much of it. The markets are currently in a crisis state, in order to quiet the crisis there must be decisive action by the authorities and at this point this means international authorities in addition to the U. S. Strong leadership is necessary to stop the panic. This has been lacking, or compromised, by various political conditions. Each week that the crisis continues will mean a much longer period before the U.S. economy can regain its position of early 2008.
ANDREW HOOK, who owns a cabin in the Crosby area, is professor of economics and business at the newly formed American University of Afghanistan. He has 30 years of experience in banking, finance and economic development throughout the world and has worked for the World Bank, the International Monetary Fund and the Federal Reserve Bank of New York.
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