Crisis Due to Trust Destruction not Wealth Destruction
When the dot com bubble burst in 2000, technology companies proceeded to lose $5 trillion in capitalization. That is a huge loss, and it hurt. It destroyed a lot of companies and even damaged the portfolios of those who didn’t have a lot of technology exposure. It also plunged the US into a recession.
But it was not the end of the world. When the technology sector blew up, it was relatively easy to tell who had what exposure to the mess. So if you were bank A, you could tell whether bank B or company C had toxic levels of exposure to the the technology market, which would allow bank A to properly price the credit risk for loans to those organizations. While there was a lot of pain in the market while it worked the bubble out of its system, the basic grease of capitalism continued to function normally allowing new businesses to form and old healthy ones to grow.
The cause of the current crisis is not the huge losses due to the bursting of the housing bubble. If there was complete transparency in how much these securities were worth and who owned them, this would just be a repeat of the tech crash (remember the NASDAQ went down 80% post bubble).
The problem is the ability to do risk assessment for credit lending has been destroyed. In the past, you could either rely on a credit rating or knowing the borrower to determine the credit risk. Unfortunately, the credit rating agencies have revealed they don’t perform the kind of due diligence people assumed they were doing, so that measure has become useless. The other metric people would use is the “that company is so big we don’t need to worry about it”. With the recent failures of huge institutions, that metric has also gone by the wayside.
So if you have money you want to lend, how do you price the credit risk for a particular borrower? If you can’t do that, you don’t lend the money or assume the risk is very high. This is why people are talking about the credit markets freezing up. With all the unknowns, short term treasury bills have become the asset of choice.
To avoid a meltdown we need to rebuild trust in lending risk measures.
The recently passed bailout plan doesn’t address this problem directly, but should provide some help. By letting companies get rid of all their toxic assets, when bank A is deciding whether to lend to bank B or company C, it can be confident B and C don’t have toxic assets so some of the old measures of credit worthiness can be brought to bear again. For this work, a company will have to publically purge itself of those assets so that it can again become one of the trusted ones. It is not clear how many companies will be willing to do this however.
Do I think this is the best way to solve the “trust” problem? No, but that train has left the station and I’m not going to spend a lot of time on trying to sell better alternatives. Unfortunately, I think most people (lawmakers included) are too focused on “saving” companies and not on rebuilding trust in the credit markets.
Whenever the government takes action, ask yourself whether the action would make creditors more or less confident. If it’s the latter, they are probably making a mistake. For example, in the takeover of Washington Mutual not only did they strip value from the equity owners but they also wiped out all the unsecured lenders. That does not encourage further lending during uncertain times. In the Wachovia case, however, they only wiped out the equity stakeholders leaving the lenders in tact (much better).
What is needed to keep this from happening in the future?
You can’t stop bubbles from happening. That is not where regulation efforts should be focused.
Greater transparency is a good thing however. One of the missed opportunities was bringing CDOs under regulation in 2001. Just like public securities, derivatives need to be traded on central exchanges where ownership and price can be publicly recorded. And those writing and holding these derivatives must meet capital requirements.
During any stable economic period there will be a desire to leverage up as high as possible to increase profits. The financial engineers will go to work and figure out how to accomplish that in ways that dodge current regulation. The government’s job is to watch the financial environment and when they see a financial product achieve a critical mass of use, require that it be moved to an exchange and have associated capital requirements.
The goal would be to prevent the systematic levering up of a whole industry in an opaque way. Yes, there will always be companies that figure out how to level themselves up higher, but in isolation that generally only endangers themselves. It is when a technique begins to propagate to many companies or is adopted by a sufficiently large sum of money that the regulators need to step in and make sure companies don’t run with scissors.