What is to be Done?

 

            As is ever present in the news, the financial markets are in disarray. The excesses of the last couple of years have led us so far on the up-cycle, that a huge downward spiral is bringing is far below what should be rational asset pricing. One of the most interesting trends in financial markets is that instead of decreasing volatility and managing economic risk, markets have begun to experience extreme volatility. Its not that this was unforeseeable, but few thought that such a rapid and extreme movement downwards for the financial markets would be experienced. Inevitably, there will be a large amount of after the fact commentary. Many will call this socialist or communist steps to manage the economy and markets, but in reality the situation is much more complicated.

 

            One of the components to this crisis has been noted by a few sources – Monetary policy. In the US, the central bank has allowed frothy rising markets to move upwards regardless of their over valuing of assets and over leveraging of institutions. At the same time, in order to buttress the subsequent decline due to these excesses, the Fed has moved in to support these institutions as letting them become insolvent would cause extreme consequences for the markets. This protection from defaulting has created the infamous “moral hazard” problem—as the Fed moves into to save banks, it is implicitly saying that they will be there when the worst of situations occur. Ironically, in doing so the Fed protects the creditors to this institutions (in order to keep it solvent), but wipes out the equity owners. To me, that seems like a huge incentive for debt over equity.

 

            Regardless, something which is absolutely necessary is to begin to segregate institutions so that when failures occur in one segment, the others can still operate in order to preserve the markets. These institutions perform the function of “market-maker” as well as counterparty to many other trades. That is why they are termed “too big to fail” because their going out of business causing many problems for the markets that they make. These companies (like airlines, public transportation) have built in protection because their service is too fundamental to allow them to fail. It is almost funny that most people now discuss that investment banks cannot support themselves and must merge with a commercial bank. There are few synergies to combining those businesses and many restrictions mean that investment banks cannot be financed by the commercial side. Essentially all this does is lower their cost to borrow due to the characteristics of the larger commercial bank. This is one thing the fed has done right—there should not be extra incentive to become tied to a commercial bank in order to have access to the fed window or get lower borrowing rates. Creating super institutions will just mean that they will be ever more “too big to fail” and they will have even less incentive to make proper investing decisions with their finances thus creating even worse problems for the market.

 

            The problem now is that the government now has to make sweeping and substantial steps to make sure that the financial markets do not collapse. This type of reform will be the most substantial problem that America will face in the coming years. The Feds actions have been unpredictable and will cause even more uncertainty in the market. At the same time, in order to make sure that they do not suffer as large of a moral hazard problem, stringent and sometimes arbitrary demands will be made of the remaining institutions. Liquidity and leverage requirements will certainly be made, however, the problem is not just the capitalization of banks, but rather how our economy has moved with regards to debt.

 

            I have gone on in other posts to discuss the interesting facets of how debt is handled in the economy, but interestingly enough its often not discussed in the mainstream. This is not just about the cliché arguments that Americans have too much debt, but that debt has been a largely misunderstood form of funding for most people. We have moved towards believing that the more debt the better especially due to the tax deductibility of interest for housing and companies. Asset pricing continues to become skewed due to this move away from rational and fundamental valuation towards financial valuations where asset value is predicated largely on the buyers ability to pay. For instance housing saw a huge shoot up in value for two reasons, one was the availability of large amounts of cheap debt, the other was a circular raise in home prices as demand was high. This created a self reinforcing cycle where it was ok to pay substantially more for a house than what was reasonable because it was going to rise even more in value. The same occurred for PE shops performing LBOs and infrastructure funds buying land assets.

 

            It is this shift in our economy which created this downturn and it will remain to be seen how we handle it. Right now our solution is to move in fast, support the economy to reduce the downturn, and move us towards “economic growth” again. However, without a shift in the way the financial industry operates along with the way our government interacts with the financial industry, this problem will arise again in the next 1-2 years. Markets are incredibly short sighted and once debt is really cheap and there is large interest from buyers, they will be happy enough to create a new frothy market. Perhaps the next big trend will be infrastructure funds that haven’t been hit as hard as other PE funds and with the lowering of debt rates will find more and more attractive opportunities for levering up assets and doing what they can to purchase new ones.

 

It is hard to say “what is to be done” because this is an unprecedented situation. Right now the fed will have to move in to protect the economy from a the worst case scenario, a new Great Depression. Following this situation, it will be important to take a look at what were the prime causes and think through a way to make sure that the financial industry is set up in a way that will lessen the volatility of cycles, not magnify it.