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No doubt my title is an exaggeration, but not as much of one as you may think. Large and important financial institutions are toppling, and it's often not very certain why. After failures, we usually find problems to blame the failure on that aren't really the trigger for the failure. They may just be questionable practices that might have caused a problem some day. Learning the wrong lessons is common.
My first financial crisis to witness up close and personal was the Maryland S&L crisis in 1985. Maryland had over a hundred state-chartered, privately-insured S&L's that started experiencing a silent run when thrifts with similar insurance arrangements in Ohio experienced difficulty. The run in Maryland grew and eventually broke into the open, and all of them (102 as I recall) were closed to be reopened one at a time as they passed financial exams that validated their soundness.
As head of the Baltimore Branch of the Richmond Fed at the time, I played host to over 300 examiners from multiple agencies that descended on Maryland to perform the examinations. The logistics were interesting.
The examiners found some irregularities in some of the larger thrifts that eventually led to a few (very few) prosecutions. This created the myth that these irregularities were what caused the crisis. They may have caused problems eventually, but what caused the crisis was simply the similarity of the Maryland insurance arrangements to those in Ohio.
The loss of confidence (or fear) was not well founded in most cases, perhaps all cases, but few financial institutions are liquid enough to withstand a run, no matter how solvent they may be. This is no doubt also true of some nonfinancial institutions. Fear can trigger a run without any underlying cause.
Federal Deposit Insurance changes that dynamic for insured institutions. If your deposits are insured, you have little reason to stand in line for your money. Access to the Fed's discount window also provided a useful source of back-up liquidity for solvent institutions. The availability of good unpledged collateral has generally been considered sufficient evidence that the problem is one of liquidity rather than solvency.
I don't know the details of the Bear Stearns situation, but I do find it believable that it was a sound institution just a few days before its demise. It may have been undercapitalized, it may have been overleveraged, and it may have been guilty of other financial sins; but I doubt that it was much more guilty of these sins the week of its demise than it was months or years earlier. All I know that changed was a sudden loss of confidence, whether it was rational or irrational. What did Bear in was simply fear.
Alan Greenspan and others have warned about Fannie Mae and Freddie Mac for years. Their view was that their debt was backed by the U.S. government gave them a competitive advantage in borrowing money. Their ability to grow was virtually unlimited given that advantage. Congress didn't heed the warnings, presumably because they approved of their contributions to growing the nation's housing stock and, perhaps, because of their lobbying clout.
People now say that Fannie and Freddy were undercapitalized, but, as I understand it, they met their legal capital requirements. The point is that, whatever their shortcomings with respect to capital and leverage, they were not new; they existed months or years ago. What was new was a sudden loss of confidence, perhaps, ironically, triggered by a report from an analyst from Lehman Brothers.
Freddie and Fannie were not bailed out; they were taken over by the government. Presumably, the rationale for their "conservatorship" was that their assets, after marking them to market, were insufficient to cover their liabilities. Marking to market assets that can be held to recovery or maturity is a rather arbitrary excuse to take over a private enterprise. "Prompt corrective action" may save the government some money by not waiting for an actual failure to occur; but it's almost literally a license for a government agency to confiscate private property. I call it shooting the sick and wounded.
I don't know the details of Fannie and Freddie's situation, but I haven't heard anything that suggests that it had deteriorated dramatically or that their managements were doing something wrong. Their losses had the same national origins as the losses of many other well run firms. What happened in the end was simply a loss of confidence. What happened was fear.
I hear much outrage expressed on financial TV about the deferred compensation owed to the former CEOs of Fannie and Freddie. I'm a little jealous too. I'm also jealous of all those athletes who make more in a week than I make in a year because they have a talent for hitting little round balls or throwing larger round balls through hoops. It just doesn't seem fair to me.
But, while I've heard much outrage over Fannie and Freddy's CEO compensation, I haven't heard a word about what the CEOs did wrong that makes the outrage so strong. What did they do to justify breaking their contracts? Yes, the GSE's lost money, but for the same reasons, essentially, that many other financial institutions have been losing money. They sank in the same quagmire as all the others; so why are we treating them as villains rather than victims? Why are we so mad at them?
(Disclosure: Richard Syron, the ousted CEO of Freddie, and I served together when he was president of the Boston Fed and I was president of the Dallas Fed. In fact, we sat next to each other at FOMC meetings. He was a good, ethical and competent guy then, and my guess is that he remained so in his subsequent ventures.)
I don't know what will happen to Lehman over this weekend, if anything. But why should anything happen? Aren't they essentially the same as they were a year ago? What's new? All I can figure is they may be in the on-deck circle to become the next victim of fear.
Corny as it sounds, it does seem that the main thing we have to fear is fear itself. What a shame. We need a time out.
3 Responses to “All We Have to Fear is Fear Itself”
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September 13th, 2008 at 1:20 pm
thanks for the blog entry. it provided some much needed balance to what has become a mass, national hysteria fueled by the media.
i cover non-bank financials for a large money manager. i have known all the principals in this drama for years. Dick is a good man, who was trying to do what he thought was best for home owners & the country. same with buddy piszel, dan mudd, tim howard, frank raines, leland brendsel, greg parseghian, etc. etc. i’d even include kerry killinger, herb sandler, maurice mcallister, curt culver and jay brown on that list. the common denominator among all these folks is that starting in 2005, they all became very nervous about the froth in the market and tried to pull their institutions back from the brink.
if you take a look at the data the companies provide, you can see that they did in fact cut originations and tighten standards in 06 and 07. but it wasn’t enough. basically, the entire 2007 book of business – across all market segments – is rife with adverse selection. the collapse of home prices since the non-agency market shut down in july of last year has only exacerbated the problem. add to that 14 months of terrifying headlines, and i suppose it it only natural that we should be seeing these large failures.
the irony is that when you analyze the financial positions of the afflicted companies and make an educated guess about the range of outcomes on credit, there appears to be enormous value across the financial landscape. that is true both for the common equity securities of distressed institutions, as well as the underlying structured securities that were the initial catalyst for the meltdown.
the fact that no bank, though, wants to step up to clean up this mess in the absence of government support is troubling. at some point, the greed phase of the cycle should kick in. the fact that it hasn’t yet – when base case, un-levered returns pencil out into the high teens / low 20’s on senior bonds backed by mortgage collateral – suggests to me that something is going on that none of us truly comprehend.
September 14th, 2008 at 11:48 am
“Congress didn’t heed the warnings, presumably because they approved of their contributions to growing the nation’s housing stock and, perhaps, because of their lobbying clout.”
That is the real issue — in effect, FNM and FRE bribed politicians (of both parties) for years.
September 15th, 2008 at 1:50 pm
You write:
Marking to market assets that can be held to recovery or maturity is a rather arbitrary excuse to take over a private enterprise.
While it may be arbitrary, it doesn’t seem unfair. Banks derive economic gain from a public entity, the Fed. In return they are held to a well known standard of capitalization. Fannie and Freddie benefited from public backing, in return they are also held to capitalization standards. Yes, conservatorship is harsh but these entities have footings in excess of a trillion dollars.
I’m not suggesting that mark to market is the best way to handle things. However, financial institutions lobbied strongly for this treatment when the weather was sunny and management profited handsomely. And if mark to market isn’t an appropriate treatment for capital requirements, why wasn’t the Fed and other bank regulators promoting alternatives at the time? Perhaps I missed it. But it strikes me that to move forward, regulators need to engage in some collective soul searching about their role in this dangerous and difficult time.