Monday, October 20, 2008

Anna Schwartz' Thoughts On The Current Financial Crisis

The weekend Wall Street Journal carried two interesting editorials regarding economics and banking.

The first was a thought-provoking interview with Anna Schwartz, co-author of "A Monetary History of the United States," with the late Milton Friedman.

In the half-page piece, Schwartz, now 92 years old, maintained that current Fed chairman Bernanke is 'fighting the last war,' against illiquidity, when today's problem is counterparty risk and market valuation uncertainty.

What's troubling to me is these passages,

"Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."
Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake.

Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on."

It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues.

"I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?'" But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn't know how to react. Instead of looking principled, the authorities looked erratic and inconstant."

Ms. Schwartz provides a clear counterpoint to the effective message given to investors and banking executives in the past year. That is, rather than consistent, understandable, principled action, Bernanke, Paulson & Bair have seemingly lurched from crisis to crisis.

Viewing the past 15 months in the financial markets from Schwartz's perspective, we should have seen, beginning with the failure of the two Bear Stearns highly-leveraged mutual funds, a concerted, consistent philosophy in action by the Fed, Treasury, FDIC and SEC.

If that philosophy were to let imprudent institutions fail, and this were clearly articulated in advance, maybe counterparty would have remained at levels of early last year. Or, maybe the explicit promise to let institutions fail would have sparked the recent credit freeze-up 15 months ago.

While I personally share Ms. Schwartz's belief that moral hazard has to remain a credible force in financial markets, our current, consolidated banking sector, with its 3-4 super-sized institutions, might not sustain a strict expression of her preferred philosophy.

I do believe, however, that, back in July of last year, the modification- and I stress that word, rather than 'suspension'- of 'mark-to-market' valuation rules would have avoided at least $150B of asset evaporation among securities which were not all non-performing.

But that wasn't done. And Ms. Schwartz's conjecture about Paulson not realizing that buying distressed CDOs at market values would destroy bank capital is truly frightening. Surely this was not a mystery. I even wrote about it in this post, nearly a month ago.

The interview ends with this passage,

"But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job." "

It leaves me thinking that Schwartz is right, even if we don't know precisely how her recommendations would have had an impact on the financial markets.

If mark-to-market were modified, but regulators warned of forced closures of insolvent institutions, would this not have provided for the avoidance of needless destruction of value in performing, but untradeable, securities, while also providing a less-capricious process for treating troubled institutions?

Perhaps there would have been a quicker consolidation of overly-leveraged investment banks with commercial banks, while weaker commercial banks would have merged before the regulators closed them.

As Schwartz theorizes, the remaining fewer, stronger institutions might have resulted in the avoidance of a credit freeze, as only healthy institutions remained, with performing assets so valued.

Further, her approach would have required no draconian actions last summer or fall, when the lack of drastic market behaviors would have failed to support a public understanding of a need for radical action.

On this basis, her judgment of the Fed's performance might, indeed, be correct.

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