Category Archives: Financial Crisis

I want my RTC!

I want my, I want my, I want my RTC! (apologies to Dire Straits!). Yesterday, Nicholas Brady, Eugene Ludwig and Paul Volcker published an article in the Wall Street Journal entitled “Resurrect the Resolution Trust Corp.” This article makes the case for the establishment of a new, “temporary” credit crisis resolution mechanism. As Brady, Ludwig, and Volcker note, “There are precedents — such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.”

Well, it appears that Messrs. Brady, Ludwig and Volcker may have gotten their wish today. According to a Wall Street Journal article entitled “U.S. Plans to Clean Up Finance System As Part of Widening Effort to Stem Crisis”, the federal government, “…is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s. At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies, according to people familiar with the matter, a device that echoes similar moves taken in past financial crises. It’s size could reach hundreds of billions of dollars.”
The stock market reacted very positively this afternoon to this news (with gains in the major indices ranging from 3.9-4.8%), and as I write this, stock futures contracts are also pointing toward a substantial continuation of this rally tomorrow. The main effect of this plan seems to be that it has assured investors that there is a plan in place for an orderly resolution of credit crisis. Markets hate uncertainty, and the rather ad hoc nature to date of the various US federal government interventions (e.g., involving Bear Stearns, Fannie, Freddie, and AIG) would now appear to be a thing of the past. Having said this, the amount of skin that the US taxpayer now has in the game has increased substantially. Before this news came out, the feds had already put around $800 billion of taxpayer capital at risk since March 2008 (putting this into perspective, this amounts to per capita contingent capital of nearly $2,700 for every man, woman and child living in the United States). It now appears that the level of contingent U.S. taxpayer capital committed to resolving the credit crisis has increased substantially!
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Wharton Faculty Discuss Financial Crisis

I would like to call attention to four videos which I showed in my risk management course this morning at Baylor University (in the order in which they were presented):

1. Jeremy Siegel: On the Resilience of American Finance

2. Joseph Gyourko: Fannie, Freddie, and the Housing Bust

3. Franklin Allen: Lessons from the Subprime Crisis

4. Richard Herring: What’s Next for Investment Banks

All four of these lectures were delivered at Wharton on Tuesday afternoon, September 16 at a Wharton “Teach-In” (see http://www.wharton.upenn.edu/teach_in_09_16_08.cfm). I also recommend viewing a panel discussion from that same day featuring Wharton professors Franklin Allen, Richard Herring, and Susan Wachter entitled “Wall Street’s Day of Reckoning: Turmoil in the Global Market”.

After viewing these videos, I now feel like I have a rough idea of how this (the so-called credit crisis) all came about. It’s really all about (perverse) incentives. I hope we can figure out a way to sunset (that’s a politically correct way of saying “get rid of”) Fannie Mae and Freddie Mac. We also need to think seriously about reforming public policy toward real estate; e.g., by abolishing the tax deductibility of mortgage interest. During the bubble we were encouraging consumers to make highly levered bets on a risky asset class (i.e., residential real estate), and it was funded by the likes of investment banks like Bear Stearns who had only had $1 of their own money and $32 of other people’s (creditors’) money at risk.

Also, according to the Wharton professor Joseph Gyourko, it now appears (after the fact) that the rating agencies probably relied too much upon historical US real estate market price data which showed that prior to the crisis, the national average price for residential real estate had never declined during the course of the postwar (WWII) period. The rating agencies incorrectly inferred from these data that real estate isn’t all that risky, and this helped to feed unrealistic expectations concerning real estate as an asset class (specifically that unlike all other asset classes, real estate “always” goes “up”!).

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Some thoughts about AIG being "too big to fail"

Today, I learned an interesting fact about the AIG CDS situation. Apparently AIG has in excess of $400 billion in exposure to credit derivatives, much of which were sold to foreign as well as U.S. banks. The reason why banks like to purchase CDS’s is that this enables them to satisfy risk-based capital requirements associated with holding risky bonds (e.g., instruments like mortgage backed securities (MBS’s) and collateralized debt obligations (CDO’s)) in their asset portfolios. Therefore, AIG may in fact be big to fail because if it does, then this would likely unleash a financial contagion throughout the banking system which would substantially limit the availability of credit throughout the US economy.

Here’s a simple explanation of how financial contagion could occur if AIG were to fail. If AIG failed, then banks who relied up AIG’s contingent capital (in the form of CDS’s) would be required to raise cash in order to comply with risk-based regulatory capital requirements. Probably quite a few banks would not be successful in doing this on a timely basis, and would be forced to file for bankruptcy. In this scenario, surviving banks who managed to comply with regulatory capital requirements would naturally become quite reticent about lending. The net result would be a substantial credit shock for the overall real economy.

One final point; apparently the U.S. penchant for bailing out “too big to fail” financial institutions is going global. For example, lately the Bank of England is beginning to act much more “Fed-like” in terms of establishing contingent credit facilities for troubled financial institutions in the UK. Anyway, the real world is providing us with lots of risk management data and it will be interesting to see how this all plays out.

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