Monday, September 22, 2008

The government will have to take over the failed non-regulated investment banks

Compare Krugman's four step listing of what has happened in the financial markets in the previous post to Nouriel Roubini's similar list of how we got to the current stage of the crisis. Roubini states that what is happening is a run on banks generally, especially on the unregulated shadow banking system at the moment. This is a run which can only be stopped by government action.

The failed investment banks will have to be taken over, brought under regulation, and their assets sold off if taxpayer money is used to bail them out. According Io Nouriel Roubini's analysis, that is an inevitable action. The only decision left is how soon it can be done. Any delay will deepen the financial crisis and make the recovery cost more.
Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The run on banks has spread to almost all the unregulated banks, and is going to take down many of the regulated banks soon. When that happens then the government is going to take over those regulated banks as Krugman states it should.

But only the government can stop the run on the unregulated banks. That means giving the unregulated banks access to the federal reserve's money through the discount window or by exchanging loans the bank holds for government cash as Paulson proposes. The price for that has to be that the unregulated banks accept regulation.

If the problem of bailing out the current gamblers running the banks with taxpayer money is to be avoided, then the government is going to have to treat the failed banks in the shadow banking system just like the rest of the regulated banks. They will also have to be taken over by the government and sold off, just as was done during the S&L crisis by the Resolution Trust Corporation (RTC.)

By the looks of these two analyses, Paulson's proposal will be left in the dust. The solution is going to have to be for the government to take over the failed banks. The problem is going to be that every delay in actually taking over the banks will increase the level of the crisis and cause the recovery to cost more.

Politically this is going to be very hard for the bankers and their tame Republicans to accept.

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