The latest financial fuss has brought out the usual range of confused economic thinking (October 2008).

Market Queues

Commentators are suggesting that there is a shortage of credit. This is really an economic fallacy.

A shortage can only occur in a market, if the authorities get involved in price setting and keep the price too low. This happened frequently in Communist Russia. The government kept the price of bread low to assist the poor, but this produced frequent shortages and people would queue all day to get a loaf of bread, because the shops could be empty for days on end. If the price of any good is set too low, consumers demand more and producers produce less and shortages follow. When governments stay out of markets, prices rise and fall until the market clears and shortages and surpluses disappear.

This is what is happening in the financial markets. The Fed is keeping interest rates low, at a time when a new perception about financial risk has emerged.

Financial experts are saying that banks are unwilling to lend to each other. This is misleading. Banks are unwilling to lend to banks that might be bad credit risk. That is not a problem, but just good credit management.

The real problem is not a shortage of credit, but that investment banks with shonky assets on their books are unable to obtain credit at the cheap rates they paid in the past. They can still obtain credit, but they were unwilling to pay an interest rate that included sufficient risk premium to cover their likelihood of default. Some of the worst banks might have to pay "loan shark rates", but that it what happens to those on the bottom of the heap. I presume that is why they are screaming about credit crunch. They really mean that they cannot obtain credit at the price they are willing to pay.

Credit Squeeze

There is now less credit available. Americans have been poor savers for a long time and have relied on people in other nations to make up the short fall. I suspect that foreigners are now not so keen on that role. Worse still, some of the money that used to be available for lending has been wiped out by "write downs" and losses by various banks. The collapse of leverage has also reduced the amount of credit available. In a normal world, declining availability of credit would not be a problem. Interest rates would rise to ration the available credit to the most efficient users. However, the Fed is holding interest rates down at a level where demand exceeds supply. This makes it seem like there is a shortage.

When supply declines, some of those who would previously have received credit miss out. Marginal businesses will find credit more difficult to obtain. Homebuyers with only a small deposit will find mortgages more difficult to obtain. This happens as banks become more careful about allocating credit. However, credit is still available for good businesses. Statistics show that commercial and industrial loans by commercial banks are still at very high levels (independent.org).

Less Debt is Inevitable

The volume of credit available has declined. This should not surprise anyone given that we have just experienced a decade of easy credit. That flush of credit produced the housing bubble, the commodity boom, and previously the dot-com bubble, so it is a good thing that it has come to an end. However, the end of easy credit will change many things for many people and businesses.

Banks will be more cautious about the way they issue credit. Home owners will no longer be able to obtain ninety or one hundred percent loan-to-value mortgages. They will no longer issue "no documentation" mortgages. Thirty or forty percent deposits will become the norm for home buyers. This is not a problem, but sensible banking practice. A Return to sound banking practice will be good for households and businesses.

The American economy and American people have too much debt. A decline in the availability of credit is good for both. People will have to start saving for their future and saving to buy the things they need. Businesses will have to start investing their surpluses, rather than paying out big dividends and relying on credit to fund their expansion. Everyone will become more responsible.

Normal Banking Practice

The normal process by which a bank decides whether or not to make a loan is relatively straightforward. Two questions are asked.

  1. Will the borrower be able to pay the interest and repay the loan when it comes due?

  2. What assets is the borrower offering as collateral for the loan?

These questions have been forgotten over the last decade. Banks have lent to people who had no possibility of paying back the loan. They have lent to investment banks and hedge funds offering security with immeasurable value. Those days are over and not to soon.

Banks will go Back to asking the old questions. Businesses and households that demonstrate an ability to make the repayments will be able to get finance. Interest rates will be higher, but those who get over the higher hurdle will get funding. Borrowers with good security will be able to get finance. A ninety percent mortgage on a house will not be considered good security. In many areas, a twenty percent deposit will not be enough. A collateralised debt obligation that has had the risk sliced and diced a thousand ways according to a mathematical model will not be adequate security.

Applying these rules will dramatically change the finance sector.

Regulation will Fail

Many commentators are claiming that the American financial system needs stronger regulation. They are totally unrealistic.

Government regulators will never be able to keep ahead of clever bankers. The current crop of regulators did not foresee the current problems. Only a few weeks ago, they were saying that the financial system was fine. If they were not clever enough to predict the credit crunch, how would they be able to come up with regulations that would have prevented it?

Most government regulations are designed to solve the last problem that occurred. They are usually incapable of dealing with the next problem, because they regulators do not know what it will be. You cannot regulate something that you cannot predict.

Foolish or Bad Judgment

The current problems are the result of bad judgement and foolishness. This foolishness has been widespread through the economic and political system. I have described the full cast of fools in Credit Crunch Characters.

American households paid ridiculous prices for houses, because they assumed that house prices would keep up going forever. Some took on huge mortgages, assuming rising prices would eliminate the risk. Congress made banks lend to people who could not afford mortgages. Investment banks bought credit default swaps, assuming there was not risk of the counterparties defaulting. Banks relied on credit rating agencies, assuming that they would never get thing wrong. Hedge funds bought CDOs, assuming the clever mathematical models had eliminated all risk. Investment banks boosted their profits by being levered up to thirty to one, but never thought about the consequences of a decline in asset values.

Foolishness and stupidity were rampant in the financial system, but good times make fools appear wise, so they gave no thought about what they would do if markets turned down.

Foolishness cannot be eliminated regulation. Regulations cannot stop foolish behaviour. The only cure for foolishness is to experience its consequences.

Fostered Foolishness

Many people are blaming greed, but this is not really the issue. The world will always have greedy people and many of them will find their way into banking.

The financial system has come under pressure, because over the last decade greed has not been tempered by fear of failure. The actions of the government and the Fed over the last three decades have minimised the risk of failure for most of the financial sector.

This goes back a long way. It probably started with the 1987 share market crash when the Fed minimised the damage by pumping their money machine. The message was reinforced during the Savings and Loans crises of the 1990s. These institutions had moved into new areas of business and made unwise and foolish loans. When things went wrong, the government came to their rescue.

The rescue of Long Term Capital Management is another example. This company had used clever mathematical modelling to enter what proved to be foolish trades. The Fed rescued LTCM, so the clever people learned nothing their failures, except the need to be more clever.

When the dot-com bubble collapsed in 2000, the Fed boosted the money supply to prevent the markets from falling to far. Although this led to the housing boom, the government is riding to the rescue again.

Some parents rescue their children again and again, even if they keep on making the same mistakes. However, rescue without repentance reinforces rebellion.

The current rescue of the American financial system is creating the conditions for the next crisis, which will lead to calls for an even bigger rescue.

Perfect Storm

The clever people are now saying that they were caught our by abnormal market conditions. They are not to blame, but deserve to be rescued, because they have been hit by the perfect storm. This is just a crazy excuse for their foolishness.

The fall in house prices is not an abnormal market condition. It is what normally happens at the end of the boom. The collapse of a bank that is leveraged to the point where its liabilities are thirty times greater than its capital is not abnormal. It was asking for trouble.

The credit crunch is not a perfect storm. It is the normal functioning financial markets after period of irrational exuberance. It is what normally happens when government agency stuff things up.

Options and Derivatives

Some people are suggesting that options and other derivatives should be banned. We need to be very clear about this issue. Provided there is no deception and no coercion, buying and selling options or derivatives is not sinful. Buying and selling options or derivatives is not contrary to God's law. In every trade, there is a willing buyer and a willing seller, so there is no coercion. The price is usually agreed freely between the seller and the buyer. They are intelligent people who understood what they are trading. There is no basis for suggesting that trading in options or derivatives is evil or morally wrong. We must not ban what God has not banned.

The problem in the current situation is that many banks and hedge funds took positions in the market without thinking through the implications of their decisions, or what they would do if they were on the wrong side of the trade. They assumed that house prices would go up forever, or that cheap short term credit would be available forever. When their assumptions proved to be wrong, they got into trouble. And if they were leveraged 30 to 1, their woes multiplied.

There is nothing wrong with selling risk. For a farmer or business that is a sensible thing to do. For other investors buying risk in exchange for a higher return also makes sense. There actions are sensible provided those involved no what they are doing. The problem in this situation is that many banks thought they had sold risk, but did not realise that all they had done was transfer it to a subsidiary. Likewise they forgot that insurance is not a total guarantee, because the risk that the insurance company might default always remains.

The problem is not with options, swaps or derivatives. The problem was with the foolishness of those who were trading them. Unfortunately, we cannot ban foolishness.

Limited Liability

The limited liability created by government law is an enormous issue. It allows banks and other businesses to run risks and reap all the profits without carrying the full risk of their actions. They can earn enormous dividends during the good years by taking very high risks, but limit their losses during the bad years that usually follow.

The reality is that liability cannot be limited, just as risk cannot be fully mitigated. Limited liability does not eliminate liability, it just allows the liability to be shifted to innocent parties. The shareholders of the investment banks and hedge funds who have taken enormous dividends would have put far greater constraints on their mangers, if they knew they were liable for all possible losses of their companies. The profits that they took in the good times would no longer be sheltered in the bad times.

People would have far more confidence in banks, if they knew that their owners were liable for all the liabilities of the bank, even in bankruptcy.

Leverage

Modern banks are highly leveraged. This has been normal practice since central banks became normal last century. Central banks are supposed to protect depositors, so most governments have allowed capital asset ratios to fall dramatically. Modern banks have capital asset ratios less than 8 percent. Some European banks have ratios as low as 2 percent. This was great for profits during the boom years, but the chickens are now coming home to roost.

Capital or shareholders equity provides a buffer if things go wrong. If borrowers default on loans, the hit is on capital. If a bank has defaults on loans that are greater than its capital, it becomes insolvent, with loans exceeding deposits. When loan defaults exceed bank capital, deposits are eroded and the bank collapses. Many modern banks simply do not have sufficient capital to absorb the losses that they currently face.

Banks prefer to be highly leveraged, because this boosts profits. High leverage amplifies profits, but it also amplifies the losses. Solid capital is the best protection for depositors, but that has been forgotten.

Banking System

The modern banking system is rotten from the inside. Banks function by borrowing short and lending long. This means that most of the time they are illiquid and only a small decline in the value of their assets makes them insolvent. Modern governments have foisted on their people a banking system that does not work. They have done this because they gain the benefits that come from being able to print money. Until the people demand something better, the financial system will remain unstable.