Tuesday, October 07, 2008

Money Makes The World Go Round

Do you get the image of Liza Minelli in a top hat when you read that title for this post? The point of the song wasn't quite to tell us that firms and consumers need liquid assets, something that can be used to ease transactions in general and to make barter unnecessary, something that allows a firm to pay its employees this month while waiting for its customers to pay it next month. Money or short-term credit.

It is short-term credit which appears to have almost dried up in the financial markets of many countries and the injections of money into the system are an attempt to oil the gears sufficiently so that somehow the markets for short-term credit get going again. Whether it works is a big question mark.

Paul Krugman, among others, has argued for a while that the crisis we are living is not a liquidity crisis but one about lack of capital, and if that is right the liquidity injections will not work. Now he has written a short paper (pdf) about the reasons the crisis globalized so very rapidly. (You can skip the squiggles and just read the bits in English if you don't like squiggles.)

He concludes that the financial markets are a whole lot more global than we have thought, or at least more global in ways we did not prepare for. They allowed the exporting of the American crisis more rapidly and efficiently (sarcasm) than many economists expected.

Then to the House Oversight Committee which has discussed the sad story of the Lehman Brothers' demise:

Prior to the hearing, Republican members of the Oversight Committee released a report in which they concluded that deregulation is not to blame for the current trouble in the financial system.

The report goes on to discuss the net-capital rule, which is a regulation limiting the amount of debt that financial institutions are allowed to take on. In the report, House Republicans argue that there should be no such rule, because bankers will just "find ways around" it:

Banking regulations require financial institutions to limit their asset risk per unit of capital, but writing regulations that simply mandate an appropriate level is unlikely to work for very long because it is in the interest of bankers to find ways around these requirements in pursuit of profit.

However, the report completely fails to note that financial institutions carrying huge debt-to-capital ratios contributed to the recent meltdown. Furthermore, it was the Bush administration, through the auspices of the Securities and Exchange Commission, that actively relaxed the debt-to-capital regulation.

In 2004, the SEC loosened the rule mandating "that broker dealers limit their debt-to-net capital ratio to 12-to-1." The five investment banks that qualified for an alternative rule - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - were allowed "to increase their debt-to-net capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1."

According to the New York Times, the investment banks themselves lobbied for the rule change, because it would "unshackle billions of dollars held in reserve as a cushion against losses on their investments." However, when the subprime mortgage bubble burst, the investment firms no longer had enough cash on hand "to weather the storm."

Chairman of the Oversight Committee, Rep. Henry Waxman (D-CA), said this lax regulation "proved to be a temptation" that the investment firms "could not resist," but "when asset values decline — as the subprime market did — leverage rapidly consumes a company's capital and jeopardizes its survival.

Barry Ritholz wrote that the SEC exemption is "in large part responsible for the huge build up in financial sector leverage over the past 4 years — as well as the massive current unwind":

It's always interesting that the "law-and-order" Republicans are so very unwilling to have any laws apply to the marketplace and that they justify this by saying that the clever buggers would just get around them. This reminds me of George Bush telling us how there's no point in trying to really tax the rich as they'll run rings around the government and take their money abroad.

I still think that the whole financial markets fiasco is because of lack of proper oversight and proper regulatory rules. For instance the credit default swaps were insurance, but they were not subjected to the rules insurance companies had to follow.