Peter Levin’s Rethinking Markets

September 15, 2008

Market meltdown, and there is blame to go around

Filed under: Markets — Peter @ 10:39 am

*update: I did not mean to include JPMorgan in my list of independent broker-dealers. They are already JPMorgan Chase.

With the imminent demise of Lehman and the purchase of Merrill Lynch by Bank of America this weekend, you might be asking yourself, “What in the world?” Well, let’s say a few things first about the current crisis, and then about some of those responsible.

Here is what I think is going on:
- This is not a market collapse, in the sense of a price drop in the stock market. It is an institutional collapse because of a price drop. In other words, as long as housing prices, avarice, and economic growth propped up the more esoteric derivatives based on mortgage payments, the value of those derivatives would stay high. When that collapsed last year, many of the investment banks were left holding on to hundreds of billions of dollars of financial crap. Lehman lost over half its assets’ value in the past year (from $32 billion to $14 billion). Merrill lost about the same percentage, though a much larger number (from $64 billion to $28 billion).

- This is an institutional collapse, in that we should expect to see a number of institutions falter and then either get bailed out by the federal government, “bailed in” by a consortium of other firms (who would guarantee credit, take on some assets, or both), or bought out. Some of these firms seem like they cannot fail. But they will. We’re talking about Goldman Sachs, Morgan Stanley. Effectively, all the independent broker-dealers are potentially on the block. More traditional banks with commercial deposits, less leverage, and less exposure to the financial markets as such are in better shape.

- Investor money in brokerage firms is probably, but not necessarily, safe. These assets are not guaranteed under FDIC, but there are other protections, and it has never happened that customer brokerage accounts have been lost because a bank went under. Though, that does not mean that it couldn’t happen. Just that it hasn’t. The value of your investments may go down dramatically with the stock market, but they will probably be around. Merrill’s customers will likely just become B of A customers, or whatever they call the new entity.

- The finance sector economy, especially for New York City, is likely about to be in for a battering.

- It is unclear how the financial crisis will be related to the ‘real’ economy. It will be harder to get a loan, both residential and commercial. Assets like treasury bills will skyrocket (because of a ‘flight to quality’, though who know how much quality our gov’t bills have currently), which means that rates will fall. But no one will want to give credit. So now is the time to protect your credit rating. Right Martha? This all may exacerbate an already shaky consumer-spending-driven economy.

There is more, but we should also allocate blame.

- Most directly to blame are the Wall Street firms themselves. Greedy, greedy, unable to look long-term, willing to put their bottom lines ahead of main street’s interests. The people who tout how much value they bring to the world to justify the salaries they earn won’t get hurt the worst, but probably deserve to.

- Homeowners and the ‘main street’ crowd who bought bigger houses than they could afford, because everyone else was doing it, and who squinted, fudged, or outright lied on their loan applications because no one asked. Entitlement is wonderful, it can happen to you. And you should be held responsible for your actions, net of the pushy, fraudulent loan brokers and investment bankers who convinced you that you could get a point or two more on Puerto Rican municipal bonds.

- Regulators in congress and the fed, including Chuck-frickin’-Schumer, who has been the most hypocritical Democrat in the senate. With his faux-caring about middle-class families (the Baileys!) while taking care to keep regulation off the backs of Wall Street, screw you man. But of course it’s more than this. Phil Gramm (bigger jerk than Schumer) helped pass the Graham-Leach-Bliley Act in 1999 to ‘reform’ banking regulation. Meaning, to give investment banks free reign to do whatever they want. I’m always amazed at people in government who hate government. Gramm’s wife presided over the CFTF (which regulates futures markets), and Republicans in general have nodded sagely at the travails faced by Wall Street in the face of draconian governmental regulation. And responded by loosening as many restrictions as possible.

- Robert C. Merton. Seriously. The academic backbone of the ‘functional’ persepective in financial regulation, meaning that a) markets are efficient; b) market functions are more important than market institutions; and c) market institutions will, magically-competitively, gravitate towards efficiency. His premises? There are two:

1) financial functions are more stable than financial institutions - that is, functions change less over time and vary less across geopolitical boundaries; and
2) competition will cause the changes in institutional structure to evolve toward greater efficiency in the performance of the financial system.”
- A Functional Perspective of Financial Intermediation. 1995, pp. 23.

He contends all sorts of things that help us to understand our current situation:
- the shift over the past three decades from normal banking to complex derivatives have contributed to ‘vastly reduced costs of financial transactions’; a shift away from ‘opaque’ institutions towards transparent institutions; that options markets on fixed-income instruments would lead to better and more transparent credit evaluations than more conventional credit ratings. True; false; false.

As he notes, “financial innovation is the engine driving the financial system towards its goal of greater economic efficiency. Innovation in financial intermediation improves efficiency by completing markets, lowering transaction costs, and reducing agency costs” (36). Or, exactly the opposite of what is happening. Thanks Robert!

4 Responses to “Market meltdown, and there is blame to go around”

1. Jay Livingston Says:
   September 15th, 2008 at 12:27 pm

   Merton may have been wrong. But blame? That implies that he had some significant influence on the traders, legislators, regulators, et. al. Did he?

2. Peter Says:
   September 15th, 2008 at 12:51 pm

   Yep. For instance, take a look at the testimony by Timothy Geithner, CEO of the NY Federal Reserve Bank. Then take a look at article by Merton (that’s a .pdf). They could be word-for-word. Truly.

   Well, except for the part of the testimony here:
   “In many respects, financial innovation over this period outpaced the system’s capacity to measure and limit risk, to manage the incentive problems in the securitization process and to provide for an appropriate degree of transparency through meaningful disclosure. Once the performance of the underlying assets began to deteriorate, these weaknesses in the system magnified the uncertainty about the scale of potential losses and added to the intensity of pressures that accompanied the crisis.”

   In other words, we thought Merton was right, that innovation would naturally drift towards self-limitations on risk, greater transparency, and to limit incentive problems. And so we assumed that we didn’t really need to tie the hands of these institutions, to treat them like other banks.

   And instead, exactly the opposite has happened. Why shouldn’t we include Merton in our list of culpable?

3. is it time to panic? « orgtheory.net Says:
   September 15th, 2008 at 4:03 pm

   [...] This is not a market collapse, in the sense of a price drop in the stock market. It is an institutional collapse because of a price drop….This is an institutional collapse, in that we should expect to see a number of institutions falter and then either get bailed out by the federal government, “bailed in” by a consortium of other firms (who would guarantee credit, take on some assets, or both), or bought out. Some of these firms seem like they cannot fail. But they will. We’re talking about JP Morgan, Goldman Sachs, Morgan Stanley. Effectively, all the independent broker-dealers are potentially on the block. - Peter Levin [...]

4. The credit crisis: the inside conversation in New York City « socializing finance Says:
   September 22nd, 2008 at 10:37 pm

   [...] valuing collateralized debt obligations have led some observers such as fellow blogger Peter Levin to lambast financial innovation. So will securitization disappear? To answer this question, one needs only ask whether tainted meat [...]

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