As we approach two and a half years of financial crisis and recession, one has to at least begin to inquire why the dynamics continue and what the Administration plans to do about them. So far, the answer seems to be “subsidize the financial services industry” and stage a “reorganization.” But subsidies keep the same practices in place and reorganizations rarely change anything important. Nevertheless, “green shoots” appear in the form of FDIC bank resolutions and stricter SEC enforcements that are finally releasing assets from nonproductive firms and yielding information that investors can use to get back into markets. There is hope, just not in the articulated proposals for recovery.
1. This is an asymmetric information crisis, and we still don’t have any better information
In summer 2007, I appeared on CNBC in a one-on-one with Carl Quintanillaand explained the economic dynamics of asymmetric information financial crises. (I would give a link, but have been unable to find this as a defined “segment.” It was in studio so I have no DVD, either.) The economic explanation is that while there has been a shock to asset values, investors still do not know which firms are principally affected and therefore (1) are unable to cash out of markets and (2) remain wary of putting their funds into new investments, even if they could cash out. With investors held up like this, financial intermediation is at a standstill, and when firms can’t get funded economic growth is hard to come by.
2. Central bank credit and capital facilities are a temporary expedient to bolster bank profits
Consider, however, the nature of economic policies to date. There remains a firm commitment to “too-big-to-fail,” which is implemented on a foundation of capital and credit subsidies that bypass investors, ignoring their desire for more information and somehow expecting them to be attracted back to dysfunctional markets after experiencing significant losses. Investors, however, are not that gullible and not led by profits alone, but seek an understanding of the markets and firms in which they invest. Investors invest in risk, not uncertainty.
The Administration’s credit and capital programs have therefore provided a vacant subsidy to financial sector performance, a fact that is becoming apparent in recent earnings announcements. No investor really believes that recent financial results are built upon anything other than government subsidies and no investor believes that those government subsidies can persist indefinitely. Without any semblance of real growth, investors remain reluctant to take anything but niche plays, largely following the government money. Adverse press of financial services company earnings and bonuses as well as the bust-up over executive compensation all suggest that the strategy cannot continue much longer without significant socialization of the financial services sector, where everyone (including the economy) loses.
So while subsidizing what is broadly held to be an economically and socially important financial services sector is a fine short-run strategy, in the end even the government money is unstable. Every investor knows the losses from the bad debts that caused the crisis will have to go somewhere. But the merry-go-round of government subsidy programs – from TARP, to TALF, and increasing modification payments – keeps stirring the pot of information, maintaining uncertainty about the incidence of losses and keeping investors off-guard.
Hence, the operating economic belief seems to be that by forestalling failures we can engineer the crisis to minimize the recessionary trough. In operation, however, it seems that attempts to reduce the peak to trough decline tend to drag out recovery. Such a policy risks imposing a greater total recessionary effect (the area under the curve of steady-state growth) than would otherwise occur, especially when – as in Japan – recovery is dragged out into the next cyclical downturn. Furthermore, the approach risks breeding moral hazard, so that the next cyclical downturn has as its impulse mechanism the exact same financial crisis, arising from investors and firms embracing risk specifically because of government support programs.
3. Some regulatory agencies, acting independently of the Treasury and Fed “regulatory reform” efforts, are working to restore information and promote economic recovery by restoring financial intermediation.
Asymmetric information financial crises are solved with information. With information, investors invest, lenders lend, and borrowers borrow. In that respect, there are “green shoots” rising, just not in the places people usually tend to look.
The information investors, lenders, and borrowers need is being revealed piecemeal in FDIC resolutions, SEC investigations and Inspector General Material Loss Reviews, as well as state Attorneys General investigations and reports. Unfortunately, few understand the importance of information to recovery. So while Rep. Warner (VA) is sponsoring legislation to give FDIC bank holding company resolution authority (a good thing, in my view), others in the House are sponsoring legislation to restrict Inspector General Material Loss Review investigations to cases where DIF losses are above $200 million, up from $25 million (less information is not good).
The dynamics are illustrating the two-sided nature of regulatory capture in financial services: financial regulators need worry not only about industry capture, but also about political capture. Hence, political calls for a single regulator can be self-serving, in that a single regulator would make it easier for politicians to manipulate financial services regulators – and therefore financial services firms – for their own political ends. We are seeing regulatory competition at work: when one or more agencies is politically captured, others can still stick to time-tested and economically sound principals of recovery where the financial industry takes its losses, investors learn to avoid risky firms, and the economy moves forward without repeating the exact same mistakes over again. There is hope.
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: [email protected]; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.