It isn’t easy managing financial crises: or another one bites the dust

I gave a talk on Australia and the financial crisis today in Adelaide and, in preparation went over a speech Ric Simes and I gave to a conference that Ric organised for which Australians should be ever grateful to Ric. At a time when the now ex-Treasurer was basking in the joy of the end of (net) debt for the Australian government being in sight, he had in mind liquidating the bond markets. Working in the bond markets at the time, and being a smart and sensible sort of fellow in any event (two qualities that do not always come in the same person), Ric thought this was a dumb idea and organised the conference. I don’t know how much Ric orchestrated things behind the scenes, but I’ve never seen a conference as successful in confidently arriving at a conclusion despite the fact that there seemed little consensus at the outset of the conference.

I wasn’t as well acquainted with the bureaucratic players as Ric may have been but my impression was not just that the Treasurer liked the idea of closing down the bond markets, but that quite a few Treasury officials thought it might be a kind of smart thing to do and had a kind of Mandy Rice Davies attitude to those in the financial markets who argued that it would be a bad idea – “they would say that wouldn’t they?”

Anyway, I was looking at our speech and noted that it quoted a then relatively recent speech by the (then) maestro Alan Greenspan on financial innovation. With hindsight this might be regarded as a faux pas. Still in the spirit of unashamed contrarianism, I put it before you. Greenspan was opining about the success of Australia in weathering the financial storm in Asia in the late 1990s.

Developments of the past two years have provided abundant evidence that
where a domestic financial system is not sufficiently robust, the consequences
for a real economy of participating in this new, complex global system can be
most unwelcome.

A recent study . . . suggests that financial market development improves
economic performance, over and above benefits offered by banking sector
development alone. The results are consistent with the idea that financial
markets and banks provide useful, but different, bundles of financial services
and that utilising both will almost surely result in a more efficient process of
capital allocation. . .

The addition of capital market alternatives [to banks] is possible only if scarce
real resources are devoted to building a financial infrastructure a laborious
process whose payoff is often experienced only decades later. . .

Despite its close trade and financial ties to Asia, the Australian economy
exhibited few signs of contagion from contiguous economies, arguably because
Australia already had well-developed capital markets as well as a sturdy
banking system. But going further, it is plausible that the dividends of financial
diversity extend to more normal times as well. The existence of alternatives
may well insulate all aspects of a financial system from breakdown.

I expect Greenspan overstates his case – probably rather a lot. Australia would have weathered the Asian crisis with or without asset backed securities. But the micro-economic advantages of such markets seem self evident and in normal times they could be expected to add some macro-economic robustness as well. We all know what happened – that, with the aid of some AAA ratings from credit agencies with a vested interest and some mathematical models of risk which looked very flash but masked the practitioners’ ignorance of what they were doing (read Nassim Nicholas Taleb) these markets went crazy with exotic products that meant that the information necessary to asses their value got scrambled. But right now, simple residential mortgage backed securities are not like that – yet the market in RMBS has collapsed.  

It’s been the collapse of markets such as this (and some dodgier ones) that has led to the collapse of the investment banks in the US.  Firms like Lehman brothers had to mark their assets to market, and with the market collapsing, it was no wonder that they went under.  If banks were forced to do the same – and mark their own assets to market (ie report the market value of their mortgages on their balance sheets) they wouldnt look too flash either.  But not only don’t they have to do this, but their depositors – and now other  creditors of theirs – know that the government stands behind them (until recently implicitly – now explicitly).  

And policy has sat by and watched the carnage as one major securitisation funded lender after another has closed its doors. And today we see that GE is selling Wizard Home Loans and a huge ‘white labelling’ finance business to NAB.  

The Official Family have been preoccupied with their Official clients, the core banking sector, and the shadow finance sector has not just been largely ignored (with the exception of a few crumbs being thrown to the residential mortgage backed securities market by a couple of $4 billion RMBS purchases by the Australian Office of Financial Management – from the budget surplus). And now, in addition to being ignored as we are fast discovering, the shadow finance sector is copping the backwash from the guarantees handed out to the core banking sector.

I guess it’s not the most persuasive way to end this post to say that Alan Greenspan might not think the outcome we’re getting is all that flash.  I know it’s not easy working out what to do, but in a lot of cases I’d rather see the government dealing with the crisis by guaranteeing assets (at least where they’re pretty straightforward as is the case with a lot of parcels of RMBS) than by guaranteeing institutions. But perhaps I’m wrong – and so dear Troppodillians, you are invited to point out why.

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Fred Argy
Fred Argy(@fred-argy)
13 years ago

As far as your last couple of paragraphs is concerned, I would ask two questions:

– wouldn’t the impact on the “shadow finance sector” flow mainly from the events in global finance markets – irrespective of deposit insurance?

-“I’d rather see the Government dealing with the crisis by guaranteeing assets —rather than the institutions”. How would that help?

Sorry, I am very confused at present.

Fred Argy
Fred Argy(@fred-argy)
13 years ago

Thanks.

Abe
Abe
13 years ago

Nice piece.

To what extent should the AOFM use the capacity to subordinate its stake to “super-senior” tranches (for a lower than market premium) to attract investors to the super senior tranches (now that all the fundie bids have disappeared)? Would it just wean the investment community onto a higher level of subordination and so be detrimental in the long run?

Abe
Abe
13 years ago

Agree that there is nothing wrong with making money. I guess the issue is that there is an overhang in the secondary market (maybe $40bn-$50bn) and all the other investors are scared witless about redemptions at the moment as you noted, so the secondary market for this stuff trades at a level (+180bps or so?) that is well above the solvency threshold on a new deal (+140 bps?) for the small non-ADI players. This is why they have been losing market share – they can’t issue at a level that enables them to compete with the ADIs.

I sense that the exercise may fail for this reason – the investors won’t buy at a level that works for the originators and $8bn will only go so far at a level that represents a subsidy versus the secondary market. So why not multiply the effect by pouring the $8bn into “junior AAA” tranches so that other investors will be attracted by the subordination this affords to the “super senior” tranches? But my problem with this is that the other investors might get hooked on the 30% credit enhancement this drives out when they will ultimately need to get comfortable with 3% again for the market to truly work.

As they say “Success has many fathers, but failure is an orphan.” If it doesn’t work, will there be so many people claiming to have had a role in influencing the government to do this, or will they just blame the dud public servants executing it?