This is me thinking out loud.
Now you know I explained a few months ago why questioning Italy’s solvency leads inevitably to monetisation, subsequently adding why Investors will buy Italian bonds after ECB monetisation. So far, this view of the sovereign debt crisis is accurate. But what about so-called moral hazard?
In the second post on why investors might buy Italian sovereign bonds I wrote:
The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration.
Here I was referring to the quid pro quo that is present European economic policy whereby the ECB monetises and the peripheral governments cut. I have talked a lot about why this is an unsustainable policy. But I wanted to discuss a different moral hazard for a bit, the hazard of regulatory forbearance.
Here’s what I wrote just after Lehman failed about regulatory forbearance in America’s savings and loan crisis of the 1980s:
The FDIC has a chronology of the Savings and Loan crisis on its website. I think they do a pretty good job of highlighting all the key points without slanting things for political purposes. See the link at the end of the post for the chronology.
The S&L crisis bears keeping in mind as many comparisons to that period regarding deregulation, risk, and bailouts are now being made. One note about the S&L crisis that I should make is that relaxing accounting rules caused the crisis to mushroom in size. And this bears noting as the onerous FAS 157 is creating quite a stir right now. Basically, the accounting rule mandates marking-to-market of various securities.
I am sympathetic to calls to relax the rule as it is pro-cyclical, meaning it naturally swings along with the business cycle. Marking to market causes balance sheets to be inflated during booms like the one we just had and it may cause them to be artificially deflated during busts like the present one.However, experiences like the Savings and Loan crisis show that relaxing accounting rules in order to bail out financial institutions is probably a bad idea and leads to much greater losses. It is better to take the losses in the first place and move on.
So, it remains a dilemma as to how we can regulate FAS 157′s pro-cyclicality while safeguarding our financial system. I don’t have the answer. But, expect to hear much more about this rule going forward.
–S&L crisis chronology and accounting rules, 1 Oct 2008
So what happened in the S&L crisis is that in the early 1980s American banks got slammed by Volcker’s high interest rates. Lending long and borrowing short meant that they were losing money as short rates skyrocketed. What’s more is that the S&L model was busted by money market funds which competed with the S&L’s low cost deposit funding base. The fix was what is known as regulatory forbearance, which is a fancy way of saying regulators looked the other way as insolvent banks continued to operate as if they were solvent.
The thinking here was that giving the banks a bit of time to "earn" their way back into solvency would keep the 1980-1982 crisis from becoming another Great Depression. There was no Great Depression in 1982. But S&L executives ended up loading up on risky high yield assets, knowing that it was a heads-I-win tails-you-lose situation since their banks were already insolvent. Many like Charles Keating turned to fraud and looting, what criminologist and law professor Bill Black calls control fraud.
The aftermath of this episode was the conviction of more than one thousand senior bank executive insiders and a law mandating prompt corrective action for insolvent banks, a law being flagrantly flouted right now I might add. The thinking today is much the same as it was in 1982. The US was first in terms of regulatory forbearance. In the US, mark to market accounting did come under assault as I anticipated. And its relaxation spurred an enormous rally in bank shares and the markets more generally as I predicted in real time (see here and here).
Now it’s Europe’s turn. Regulators are giving continued life to clearly undercapitalised/insolvent financial institutions. These institutions are like the undead, doing the things that one normally does but with the potential that they and their zombie-ness will come back to haunt us all. Now, the ECB is offering its Long-Term Refinancing Operation for European financial institutions. This is essentially free money and these undead institutions also get to take part. If you are the CEO of Big Euro Bank, an insolvent European bank, what would you do at this juncture?
Here’s how I told the story in the US case, using fictional ‘Big Bank’ CEO Phil. It was a post called Asymmetric information and corporate governance in bank bailouts from June 2009:
the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital. In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.
There was one problem, however, and Phil knew it. You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit. The company had done a significant amount of work to get to grips with likely credit exposure. And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios. What should Phil do?
Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base. But, there is clearly no incentive for that. After all, hadn’t Phil been beaten over the head before Congress for ‘not’ lending money? Why did Phil have so many billions of dollars in excess reserves at the Fed? Why was he preventing the economy from regaining its footing? Was Phil hiding something? Perhaps Phil and his executive team need to be replaced? On second thought, Phil decides the over-capitalization route is suicidal.
As it turns out, Phil’s internal credit gurus told him there is a 60% chance that the company can lend and make shed loads of money as the economy recovers. There is a lesser but not insignificant 30% chance that the company is under-capitalized if the economy remains fragile and a 10% chance that the company is severely-undercapitalized in a real worst-case scenario. Big Banks lawyers and accountants have told Phil that he can legitimately claim to the public that Big Bank is well-capitalized and proceed lending.
Phil is optimistic that things will turn out well. The fact that his underwater options depend on it is no small incentive to feel that way. But, he has nagging doubts about the downside scenarios of which the public and the government are largely unaware. So Phil decides to ‘reach for yield’ by taking a slightly aggressive strategy which will ensure that the company can make a lot of money now while interest rate spreads are high. That way, if things turn down, he will have a huge cushion with which to work.
Of course, he could get burned again and be forced into an under-capitalized position. That would be embarrassing. But, a bailout is likely if worse comes to worst and no CEOs were replaced the last go around. Sure they made noises about replacing Vikram Pandit, but he is still in office. And, anyway, Phil is a member of the club – the exclusive cadre of well-experienced bank executives who run America’s banking system. Surely he would land on his feet after a time.
If you are the CEO of Big Euro Bank, the easiest thing to do would be to load up on Italian and Spanish government bonds expecting a bailout and knowing they are too big to fail. You don’t buy Greek or Portuguese bonds because they aren’t too big to fail. In the meantime, you make a tremendous yield pick up over German bunds for free since your company is probably already insolvent. You can pay out bonuses as usual and record profits as usual, all in the expectation that your yield pickup play will eventually hep you "earn" your way back into solvency during the period of regulatory forbearance. And anyway, if you’re wrong and need to take losses, you will have gained more in salary and bonus than you otherwise would have. Heads you win, tails the taxpayer loses.
Here’s the question in two parts? Isn’t this what’s happening right now? And if this really is what is happening, how does this story end?