Post by unlawflcombatnt on Apr 30, 2009 15:57:20 GMT -6
from Nouriel Roubini's rgemonitor.com
Too Big to Fail or Too Big to Save?
by Simon Johnson
Apr 30, 2009
"Testimony before the Joint Economic Committee of the US Congress hearing, "Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions" April 21, 2009
The depth and suddenness of the US economic and financial crisis today are strikingly and shockingly reminiscent of experiences we have seen recently only in emerging markets: Korea in 1997, Malaysia in 1998, and even Russia and Argentina, repeatedly.1
The common factor in those emerging-market crises was a moment when global investors suddenly became afraid that the country in question wouldn't be able to pay off its debts and stopped lending money overnight. In each case, the fear became self-fulfilling, as banks unable to roll over their debt did, in fact, become unable to pay off all their creditors.
This is precisely what drove Lehman Brothers into bankruptcy on September 15, and the result was that, overnight, all sources of funding to the US financial sector dried up. From that point on, the functioning of the banking sector has depended on the Federal Reserve to provide or guarantee the necessary funding. And, just like in emerging-markets crises, the weakness in the banking system has quickly rippled out into the real economy, causing a severe economic contraction and hardship for millions of people.
This testimony examines how the United States became more like an emerging market, the politics of a financial sector with banks that are now "too big to fail," and what this implies for policy, particularly the pressing need to apply existing antitrust laws to big finance.
How Could This Happen?
The United States has always been subject to booms and busts. The dot-com craze of the late 1990s is a perfect example of our usual cycle; many investors got overexcited and fortunes were lost. But at the end of the day we have the Internet, which, like it or not, profoundly changed the way we organize society and make money. The same thing happened in the 19th century with waves of investment in canals, railroad, oil, and any number of manufacturing industries.
This time around, something was different. Behind the usual ups and downs during the past 25 or so years,*there was a long boom in financial services, something you can trace back to the deregulation of the Reagan years, but which got a big jolt from the Clinton administration's refusal to regulate derivatives market effectively and the failure of bank regulation under Alan Greenspan and the George W. Bush administration. Finance became big relative to the economy, largely because of these political decisions, and the great wealth that this sector created and concentrated in turn gave bankers enormous political weight.*
This political weight had not been seen in the United States since the age of J. P. Morgan (the man). In that period, the banking panic of 1907 could only be stopped by coordination among private-sector bankers, because there was no government entity able to offer an effective counterweight. But the first age of banking oligarchs came to an end with the passage of significant banking regulation during and in response to the Great Depression. But the emergence of a financial oligarchy during a long boom is typical of emerging markets.
There were, of course, some facilitating factors behind the crisis. Top investment bankers and government officials like to lay the blame on low US interest rates after the dot-com bust, or even better, for them, the flow of savings out of China. Some on the right of the spectrum like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader home ownership. And of course it is axiomatic to everyone that the regulators responsible for "safety and soundness" were fast asleep at the wheel.
But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common, even though some are traditionally associated with Democrats and some with Republicans: They all benefited the financial sector. The underlying problem was that policy changes that might have limited the ability of the financial sector to make money, such as Brooksley Born's attempts at the Commodity Futures Trading Commission to regulate over-the-counter derivatives such as credit default swaps, were ignored or swept aside.
Big banks enjoyed a level of prestige that allowed them to do what they liked, for example with regard to "risk management" systems that allowed them to book large profits (and pay large bonuses) while taking risks that would be borne in the future and by the rest of society. Regulators, legislators, and academics almost all assumed the managers of these banks knew what they were doing. In retrospect, of course, they didn't.
Stanley O'Neal, CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed securities market at its peak in 2005 and 2006; in October 2007, he was forced to say, "The bottom line is we…I…got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity…in that market. No one is more disappointed than I am in that result."2 (O'Neal earned a $14 million bonus in 2006; forced out in October 2007, he walked away with a severance package worth over $160 million, although it is presumably worth much less today.)
At the same time, AIG Financial Products earned over $2 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities.3 Often described as "picking up nickels in front of a steamroller," this strategy is highly profitable in ordinary years and disastrous in bad years. As of last fall, AIG had outstanding insurance on over $500 billion of securities. To date the US government has committed close to $200 billion in investments and loans in an effort to rescue AIG from losses largely caused by this one division, and which its sophisticated risk models said would not occur.4
"Securitization" of subprime mortgages and other high-risk loans created the illusion of diversification. While we should never underestimate the human capacity for self-delusion, what happened to all our oversight mechanisms? From top to bottom, executive, legislative, and judicial were effectively captured, not in the sense of being coerced or corrupted, but in the equally insidious sense of being utterly convinced by whatever the banks told them. Alan Greenspan's pronouncements in favor of unregulated financial markets have been echoed numerous times. But this is what the man who succeeded him said in 2006: "The management of market risk and credit risk has become increasingly sophisticated…banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks."5
And they were captured (or completely persuaded) by exactly the sort of elite that dominates an emerging market. When a country like Indonesia or Korea or Russia grows, some people become rich and more powerful. They engage in some activities that are sensible for the broader economy, but they also load up on risk. They are masters of their mini-universe and they reckon that there is a good chance their political connections will allow them to "put" back to the government any substantial problems that arise. In Thailand, Malaysia, and Indonesia prior to 1997, the business elite was closely interwoven with the government; and for many of the oligarchs, the calculation proved correct: In their time of need, public assistance was forthcoming.
This is a standard way to think about middle-income or low-income countries. And there are plenty of Americans who are also comfortable with this as a way of describing how some Western European countries operate. Unfortunately, this is also essentially how the United States operates today...."
More at:
www.rgemonitor.com/piie-monitor/256572/too_big_to_fail_or_too_big_to_save_examining_the_systemic_threats_of_large_financial_institutions
Too Big to Fail or Too Big to Save?
by Simon Johnson
Apr 30, 2009
"Testimony before the Joint Economic Committee of the US Congress hearing, "Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions" April 21, 2009
The depth and suddenness of the US economic and financial crisis today are strikingly and shockingly reminiscent of experiences we have seen recently only in emerging markets: Korea in 1997, Malaysia in 1998, and even Russia and Argentina, repeatedly.1
The common factor in those emerging-market crises was a moment when global investors suddenly became afraid that the country in question wouldn't be able to pay off its debts and stopped lending money overnight. In each case, the fear became self-fulfilling, as banks unable to roll over their debt did, in fact, become unable to pay off all their creditors.
This is precisely what drove Lehman Brothers into bankruptcy on September 15, and the result was that, overnight, all sources of funding to the US financial sector dried up. From that point on, the functioning of the banking sector has depended on the Federal Reserve to provide or guarantee the necessary funding. And, just like in emerging-markets crises, the weakness in the banking system has quickly rippled out into the real economy, causing a severe economic contraction and hardship for millions of people.
This testimony examines how the United States became more like an emerging market, the politics of a financial sector with banks that are now "too big to fail," and what this implies for policy, particularly the pressing need to apply existing antitrust laws to big finance.
How Could This Happen?
The United States has always been subject to booms and busts. The dot-com craze of the late 1990s is a perfect example of our usual cycle; many investors got overexcited and fortunes were lost. But at the end of the day we have the Internet, which, like it or not, profoundly changed the way we organize society and make money. The same thing happened in the 19th century with waves of investment in canals, railroad, oil, and any number of manufacturing industries.
This time around, something was different. Behind the usual ups and downs during the past 25 or so years,*there was a long boom in financial services, something you can trace back to the deregulation of the Reagan years, but which got a big jolt from the Clinton administration's refusal to regulate derivatives market effectively and the failure of bank regulation under Alan Greenspan and the George W. Bush administration. Finance became big relative to the economy, largely because of these political decisions, and the great wealth that this sector created and concentrated in turn gave bankers enormous political weight.*
This political weight had not been seen in the United States since the age of J. P. Morgan (the man). In that period, the banking panic of 1907 could only be stopped by coordination among private-sector bankers, because there was no government entity able to offer an effective counterweight. But the first age of banking oligarchs came to an end with the passage of significant banking regulation during and in response to the Great Depression. But the emergence of a financial oligarchy during a long boom is typical of emerging markets.
There were, of course, some facilitating factors behind the crisis. Top investment bankers and government officials like to lay the blame on low US interest rates after the dot-com bust, or even better, for them, the flow of savings out of China. Some on the right of the spectrum like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader home ownership. And of course it is axiomatic to everyone that the regulators responsible for "safety and soundness" were fast asleep at the wheel.
But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common, even though some are traditionally associated with Democrats and some with Republicans: They all benefited the financial sector. The underlying problem was that policy changes that might have limited the ability of the financial sector to make money, such as Brooksley Born's attempts at the Commodity Futures Trading Commission to regulate over-the-counter derivatives such as credit default swaps, were ignored or swept aside.
Big banks enjoyed a level of prestige that allowed them to do what they liked, for example with regard to "risk management" systems that allowed them to book large profits (and pay large bonuses) while taking risks that would be borne in the future and by the rest of society. Regulators, legislators, and academics almost all assumed the managers of these banks knew what they were doing. In retrospect, of course, they didn't.
Stanley O'Neal, CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed securities market at its peak in 2005 and 2006; in October 2007, he was forced to say, "The bottom line is we…I…got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity…in that market. No one is more disappointed than I am in that result."2 (O'Neal earned a $14 million bonus in 2006; forced out in October 2007, he walked away with a severance package worth over $160 million, although it is presumably worth much less today.)
At the same time, AIG Financial Products earned over $2 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities.3 Often described as "picking up nickels in front of a steamroller," this strategy is highly profitable in ordinary years and disastrous in bad years. As of last fall, AIG had outstanding insurance on over $500 billion of securities. To date the US government has committed close to $200 billion in investments and loans in an effort to rescue AIG from losses largely caused by this one division, and which its sophisticated risk models said would not occur.4
"Securitization" of subprime mortgages and other high-risk loans created the illusion of diversification. While we should never underestimate the human capacity for self-delusion, what happened to all our oversight mechanisms? From top to bottom, executive, legislative, and judicial were effectively captured, not in the sense of being coerced or corrupted, but in the equally insidious sense of being utterly convinced by whatever the banks told them. Alan Greenspan's pronouncements in favor of unregulated financial markets have been echoed numerous times. But this is what the man who succeeded him said in 2006: "The management of market risk and credit risk has become increasingly sophisticated…banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks."5
And they were captured (or completely persuaded) by exactly the sort of elite that dominates an emerging market. When a country like Indonesia or Korea or Russia grows, some people become rich and more powerful. They engage in some activities that are sensible for the broader economy, but they also load up on risk. They are masters of their mini-universe and they reckon that there is a good chance their political connections will allow them to "put" back to the government any substantial problems that arise. In Thailand, Malaysia, and Indonesia prior to 1997, the business elite was closely interwoven with the government; and for many of the oligarchs, the calculation proved correct: In their time of need, public assistance was forthcoming.
This is a standard way to think about middle-income or low-income countries. And there are plenty of Americans who are also comfortable with this as a way of describing how some Western European countries operate. Unfortunately, this is also essentially how the United States operates today...."
More at:
www.rgemonitor.com/piie-monitor/256572/too_big_to_fail_or_too_big_to_save_examining_the_systemic_threats_of_large_financial_institutions