Tuesday, September 30, 2008

The Peterson Institute's History Lesson

The Peterson Institute, in their new "blog" sketch out a brief history for how we got into this mess and then go on to discuss what is coming next.

Read it all here

This is much more than a housing crisis……….

Problems in the US housing market triggered a global crisis of confidence in global financial institutions, but the housing problems themselves were not big enough to generate the current financial collapse....

…and it is not about too much leverage

But, conventional wisdom continues, this fall in housing prices was magnified by leverage, causing financial institutions to collapse. But this is also not a compelling argument. First, what does it mean to be too leveraged? Economic theory provides no concrete answer, because it depends on the way you use leverage, and on the other tools available to mitigate risk...."

The authors then see the events leading to our imminent economic collapse unfolding in several stages:

1) Investors no longer believing that subprime mortgages were safe investment vehicles (that is, ways to make good money with little risk of losing money)

2) Bear Sterns' Fails: "As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. In other words, they became like emerging market economies in 1997.... However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole—a pattern they would follow with Fannie and Freddie. In effect, the government sent the message that creditors could safely keep their counterparty risk with large financial institutions—implicitly encouraging banks to continue lending to each other."

3) Policy Change: "The third stage, beginning two weeks ago with the failure of Lehman and the "rescue" of AIG, marked a dramatic and damaging reversal of policy—something which is underappreciated in Washington today....This decisive change in policy probably reflects a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions and the headlines that US taxpayers were now taking on $6 trillion of debt. In any case, though, the implications for creditors and bond investors are clear: RUN from all entities that might fail. Even organizations that are too big to fail, even if they appear solvent apart from the liquidity crisis, are no longer safe. As in the emerging markets crisis of a decade ago, anyone who needs access to the credit markets to survive might lose access at any time, and hence might fail....

There is no doubt the genie is now out of the bottle. There is general fear around the world that any leveraged institution might fail....There is a second ominous aspect of these collapses. When companies fall, the survivors benefit....While the conventional wisdom views this as healthy, in reality this is a cost of extreme lack of trust in credit markets. The acquirers have an incentive to wait, let a company fall, and then scoop up the assets. Treasury and the Fed are each time relieved that someone can "come to the rescue." America's financial system is quickly becoming dominated by a few players who will naturally strategize to get assets as cheaply as they can. This is standard market behavior, without any collusion or conspiracy, but quite far from generating efficient market pricing.

In this context, there are two critical questions. First, what happens next? And second, what can we do about it?"

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