Crisis Strategy: Getting it Right the first time

(Cross-posted at The Confluence)

There are very little details out in the public concerning the supposedly ironed-out terms that will solve the current financial crisis.   Almost every one is worried that the terms of the rescue will involve taxpayers bailing out Wall Street High Rollers and their bonus-loving CEOs.  If you review Financial Economics literature, you will discover that there are several findings in the studies done by economists that can provide guidance to every one on the best way to approach the bail-out.  One of the most recent studies comes from the International Money Fund.  It is by Luc Laeven and Fabian Valencia and was posted this month at the IMF research website.

If you’re not familiar with regression analysis which is the analytical method of choice here, stay away from the last half of this paper.  However, you may find some interesting things in the first section because it includes a huge database that looks at all systematically important financial crises between 1970 and 2007.  This means the database has 42 crises in 37 countries. It looks at steps taken by government to solve these crises and the length and depth of the crisis.

Here’s the link:  http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf

Another good source of information for suggestions is the Brit Magazine The Economist.  Many of its articles are also available on line and are not technical in nature.

If you’re not up to looking at the details, let me try to explain some of the things that Financial Economists have learned since the Great Depression.  You should look for some of these dos and don’ts when we finally get to see the details of the plan. Sixty years of study and growing theories has shown us that the tactical approaches–which mostly involve containing the crisis–are very expensive and don’t work too well.  Usually, containment approaches happen while the crisis is unfolding.  As an example of this, I will point to the bail-outs of individual banks and financial institutions that have happened to date.  We’ve seen this containment tactic most of this year.

Governments can respond to these kinds of crises in many ways.  In a lot of cases, we see reallocation of wealth from taxpayers to Banks and other institutions that hold debt. When wealth transfers like this happen, many problems happen in the general economy.  The existing research done in this area shows that providing assistance to banks and their borrowers can actually increase loan losses to banks and in many cases lead to laxes in regulation that can be abused. Study-after-study shows that individual bank bail-out is usually not a good approach.  Other costly and not that efficient tactical steps can include accomodative policies like direct government guarantees of bank liabilities or injecting ‘liquidity’ into the bank itself by lending money to the bank.  The literature shows that none of these steps necessarily lead to a speedier recovery.

So what strategies can our country adopt to staunch the current crisis?  Proposals vary, but a good example of something that worked would be the comprehensive plan we had back under the first Bush administration during the S&L meltdown.  The RTC (Resolution Trust Corporation) was set up in 1989 to deal with the many, many S&L bankruptcies.  The purpose of the RTC was to dispose of failed S&L assets in a way that didn’t drive prices on the properties and assets down.  It put a bottom price on things like farm land or houses that were the underlying assets held by the thrifts.  In the case of situation now, a new ‘agency’ would buy troubled mortgage-backed securities from the market and hold them until there was a turn around in their value.

This new agency could also serve another purpose similar to a depression-era institution called the Home Owner’s Loan Corporation.  Hillary has suggested this type of agency whose purpose would be to buy and restructure existing mortgages.  This would basically keep many folks in their homes with mortgages they could handle.  For this to work, it has to be geared towards folks that can actually follow-through and make their payments.  It could not be a social largess program because that would only create more loan losses in the long run.  It’s purpose would be to keep folks in their homes as well as put faith back into house prices and the mortgage market.  It would also alleviate the downward pressure on home prices.  A new agency would be allowed to hold the loans and troubled securities until the market function agains and the assets once again become valuable.  Many of the assets in some of these securities are fine now and could just be repackaged.  The profits need to be returned to the taxpayer and used to pay down the debt.  We should ensure that the proceeds do not go to any politician’s pet project.

At the same time, we need to look for better oversight of derivatives markets.  The big issue that can be layed squarely at the feet of the Bush Administration and Greenspan is their inability to see the need for regulation of these markets.  The existance of this market (which serves a similiar function to insurance) injected more ‘moral hazard’ into the banking community.  This means if you think you’ve got something insured, you’re more likely to act haphazardly.  We already had banks being encouraged to loosen their underwriting standards for certain borrowers by Fannie and Freddie.  With the invention of these innovations, banks were covered, or so they thought, even if they did practice lax lending standards.  These derivatives were an attempt to manage credit risk.  However, as we have seen, actually placing accurate vales on this contracts just created more uncertainty.  The implied consent and guarantee of the government via Fannie and Freddie exacerbated the misvaluation in a market with no oversight.  We need to re-visit the regulatory responsibilities of the SEC and the FED and update them so that they reflect the existence of these extremely sophisticated and difficult to understand markets.  Also, something has to be done about Fannie and Freddie and how their role to feed loans to creditworthy middle class Americans warped into some social engineering plan that began the lax lending standards and provided opportunities for exploitation.

So, do we need a bail-out?  Yes.  Unfortunately, financial contagions do act as a disease and can create economic downturns that impact everyone.  All you have to do is crack a book on the Great Depression to see how problems in banks and stock markets eventually transfer over to Main Street.  What is needed is the least expensive and most prudent approach.  The literature tells us that it must be systematic and not just tactical.  You need to strengthen the market, not just select players.  I’ve outlined a few things that financial economists have learned about past crises.  I’d hope we get the details out pretty soon so you can look and see if the bailout is consistent with these principles.