Sunday, January 11, 2015

The failure of the financial institutions are not by accident

They're by regulation:
I will oversimplify here, but basically it categorized some assets as "safe" and some as "risky".  Those that were risky had their value cut in half for purposes of capital calculations, while those that were "safe" had their value counted at 100%.  So if a bank invested a million dollars in safe assets, that would count as a million dollar towards its capital requirements, but would count only $500,000 towards those requirements if it were invested in risky assets.  As a result, a bank that needed a billion dollars in capital would need a billion of safe assets or two billion of risky assets.


Anyway, what assets did the regulators choose as "safe"?  Again, we will simplify, but basically sovereign debt and mortgages (including the least risky tranches of mortgage-backed debt).  ...

And for most banks, this was mortgage-backed securities.  So, using the word Brad DeLong applied to deregulation, there was an "orgy" of buying of mortgage-backed securities.  There was simply enormous demand.  You hear stories about fraud and people cooking up all kinds of crazy mortgage products and trying to shove as many people as possible into mortgages, and here is one reason -- banks needed these things.

So with this experience in hand, banks moved out of mortage-backed securities and into the last "safe" asset, sovereign debt.  And again, bank presidents told their folks to get the best possible yield in "safe" assets.  So banks loaded up on sovereign debt, in particular increasing the demand for higher-yield debt from places like, say, Greece.  Which helps to explain why the market still keeps buying up PIIGS debt when any rational person would consider these countries close to default.  So these countries continue their deficit spending without any market check, because financial institutions keep buying this stuff because it is all they can buy.
When Greece (and Portugal, and Spain, and Italy) leaves the Euro and defaults - as it certainly will, sooner or later - it will be the sub-prime mortgage crisis all over again but ten times bigger.

Good thing we have such smart regulators working on this.  Top Men.


libertyman said...

Okay, so I have no knowledge of economics, but is the USA to China a little like Greece to Germany? At least in terms of sovereign debt ownership?

JMD said...

Currently I am reading Griftopia which reviews in depth the breathe and depth of fraud and corruption of the financial sector, businesses and politicians. Most interesting.

Overload in Colorado said...

This reminds me why the stock market is doing well: interest rates are very low. If they were higher some of the money in the market would go into bonds and such.