just watching newsnight- doesn't this spell the end to free-market captalism (or at least should it)?
Can the system that the UK/USA/IMF/World Bank have been espousing be re-created after this? will politicians be able to justify a future roll back to minimal regulation?
Especially when the banks are saying that the state should have got involved more quickly?
Digby Jones sounded delusional on monday when he was still spouting free market rhetoric (i felt).
vim- what's your overview of the situation?
So, here's what I see -- the problem is located in the financial sector and formed at the intersection of monetary policy and banking and finance. There are components that are caused by bad regulation and poor oversight (the GSEs, e.g. -- Freddie and Fannie are perhaps the most heavily regulated companies in the world), de-regulation (Gramm's Commodity Futures Modernization Act, 2000, legitimising Credit Default Swaps, e.g.) and regulatory arbitrage (which is the sine qua non of securitisation). No one comes out of this looking particularly well, but no one comes out of this looking as bad as the private sector. From the perspective of regulation vs de-regulation, the real issue is not de-regulation per se, but lack of regulation of the 'shadow banking system' more generally.
In order to prevent financial crises impacting on the real economy, the formation of credit, asset and equity bubbles has been supported and encouraged by the Fed since the '80s, when it collaborated with banks who had lost money on loans to the developing world and allowed them to suspend mark-to-market valuation of their assets in a bid to keep them above water. In 1990 it persuaded the Saudis to rescue Citibank. In 1998 it bailed out the financial sector again, after the collapse of the (unregulated, uninsured, but nevertheless systemically important) Long Term Capital Management hedge fund, and cut rates to cope with losses in Russia and Asia. It cut rates following the tech and dot-com crash, and it cut rates again following 9/11. Basically the Fed has repeatedly bailed out the financial sector (and the real economy) with cheap money every time it looked like the bubble might burst, suppressed competitive pressure in the financial sector and ensured moral hazard in these markets.
In the 70s, commissions paid to stockbrokers were deregulated, biting into the comfortable living investment banks were making booking trades. And in the '90s, the Glass-Steagall Act was repealed, removing restrictions on mixing commercial and investment banking. This competition encouraged investment banks to move into new areas to increase margins: the principal outcome being the adoption of the ‘originate and distribute’ securitisation model and the use of extreme leverage. Asset backed securities and other structured finance instruments (MBS, CDO, CDO^2, etc) were thought to be more liquid because they are arranged as a kind of mini-corporation, such that the AAA (or some such) rated tranche has pretty much no risk of default, thanks to diversification of risk within the pool of assets backing the security and the protection offered by the junior tranches (equivalent to the protection offered bond-holders by equity holders in a traditional corporate structure) AND thanks to the ability of ABS to circumvent normal bankruptcy proceedings. In a bankruptcy, the owner of the ABS has preference over other investors to the pool of assets backing the security. So an ABS is normally thought to be a 'risk free' or low risk revenue stream, which is why ABS were so liquid -- in effect structured finance became international currency, and the US financial system reaped the rewards.
At the same time, a 'global savings glut', thanks to a rapidly developing third world (especially China) that doesn't spend as much as it earns, which has the reversed the expected direction of capital flows
into the developed world (especially USA), added fuel to the cheap money fire. China is saving something like 50% of what it produces. Given the crises in Asia in the late ‘90s, it chose to invest in the US, lots of it in Freddie and Fannie. The Chinese have propped up the dollar to fund their development, but a side-effect has been to reduce the cost of borrowing and increase US household debt. As money and credit became so cheap, investors looked to increase their yields. Money poured into Alt-A and subprime lending, as lenders ceased to do due diligence on borrowers, as in any case, the loans would be securitised and sold off to someone else who would have to worry about it. Not only that, but it is self-evident that the banks and intermediaries who created these instruments didn’t properly understand them: if they did they would have sold all the tranches and would not now be in crisis. Bad loans were made, and large sections of the globe as well as advanced economies staked their futures on the bet that the house prices backing these securities would continue to rise…
As I see it now, the whole thing was and is Ponzi finance – irrational, fragile, consuming the economy in un-productive activity. Western states have lived beyond their means, restructuring their economies to take advantage of an irrational affect, and funded their trade deficits with over-priced financial instruments. (Not that securitisation is all bad, or that the rise of China is bad). And worst of all, it is leading now to extreme amounts of deleveraging, an asset deflationary spiral that may or may not be halted, massive increases in public debt, seizure in the corporate sector and an uncertain future in which credit underpinned by rising asset prices no longer drives economic growth.
