The natural reaction to market breakdown is to add layers of protection and regulation.  But trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crisis rather than extinguishing them because the safeguards add even more complexity which in turn feed more failure.  Trying harder means sinking deeper into quicksand.   Yet regulators and institutions can’t stand idly by in the face of potential crisis and they certainly cannot know where or how the next crisis will arise, but they learn from their mistakes and develop new or revised regulations and safeguards.  And in a world of increasing complexity, those safeguards add yet more complexity. And so on.

In the face of progress and technological advances that have resulted in stability on many fronts, financial markets, designed to provide a mechanism for managing and addressing economic risk, have developed a structure that has made them inherently more risky.  The irony is that this structure has features that at face value are desirable, in some cases approaching the essential elements of the ideal. As with many ideals, its origin is in academia, in this case a theoretical framework that underpins a half century of work in financial economics.

From a Demon of Our Own Design by Richard Bookstaber

HKO comment:  Bookstaber draws analogies from airline crashes, the Three Mile Island and Chernobyl nuclear disasters and the NASA Challenger and Columbia disasters to demonstrate how excessive safety procedures addressing complicated systems actually contributed to the ultimate disasters in those systems.

Beyond left and right, his analysis of the fault of the regulations to contain the financial meltdown does not stem from a blind ideological commitment to free markets but a carefully considered understanding of the problems of applying complex regulations to complex systems.  We end up fighting the last war and at the same time causing the next one.  The function of the regulation of the financial markets should not be to address the last problem but to reduce the complexity in the system.

There are many small business people who contend that they cannot get a loan. The press reports that banks are sitting on their money and not loaning any. They are just making a safe spread between very low bank rates and Treasury bonds.  By driving interests rates down even further this spread decreases and thus will force the banks to actually loan to customers.  This is supposedly the purpose of QE2.

But what if the problem is that there is a deficit of good loans to make?  The banks are in the business of lending money.  If I have a warehouse full of steel but I do not want to sell a customer with bad credit am I being stingy or prudent?

There may be demand for loans but the critical element is the quality of the loans. There is a big difference between loaning to someone who is losing money and wants money to stave off bankruptcy until the ‘ market turns’,  and a loan for a profitable company who wants to expand or buy new equipment. The first is trying to borrow his way to solvency and the latter is borrowing to grow.

Borrowing to remain solvent is just postponing the inevitable and the remaining banks are not, nor should they be, willing to make these loans.  Opportunities to grow require liquidity.  If the growth history and plans are sound then the loan makes sense.

Banks used to be more comfortable loaning against sound plans and forecasts than they are today. Today they want assets to secure and the most common assets, and real estate has become so illiquid that their value for collateral has been discounted.

QE2’s attempt to unfreeze bank lending is an example of using monetary policy to solve fiscal problems.  Business growth has been stilled because of reckless legislation with the ruinous combination of uncertainty and higher costs.  No one knows what the costs of the health care bill will be, what a new employee will cost, or what their taxes will be.  Few businesses are being created and many are closing or cutting back. There is already plenty of money in the system. It is foolish to believe that interest rates are the reason it is not being deployed.

Solutions to provide liquidity will not solve problems of solvency.

Monetary solutions will not solve fiscal problems.

In We’ll Always have Basel The Wall Street Journal reports on the work to raise capital standards to avert future bank meltdowns.  One of the more interesting concepts is a “bail in”:

The idea is to set very high capital standards but allow banks to count as capital certain debt financing that automatically converts to equity when the bank’s capital ratios or stock price falls below a certain level. Creditors, not taxpayers, take the hit when a bank is struggling, and there is no discretion allowed for regulators.

The article also notes how the Dodd-Frank bill still fails to address the too-big-to-fail problem and how legislation harmful to bank profits and a tax code that punishes equity over debt damages the ability to increase their equity without curtailing loans which is desperately needed to boost this economy.

There is much change needed but the effort to increase equity is a big step in the right direction.  After this last mess we as consumers may seek the safest banks in a global market.

It is not Obama’s fault that home sales are dropping, though it is his fault that they did not drop sooner.  Why is it bad that the sales of home and home prices are dropping?

Yes, it eats up bank collateral and destroys individual’s home equity values.  But that is exactly what happens when a bubble bursts and it is what should happen.  To move forward from a financial collapse we need to clear away the debris.

Instead of propping up inflated values we need adjust to the fact that home value appreciation near 10% is not normal.  What we got used to was an induced high.  What we are experiencing is financial sobriety.

We are seeing that even our huge national government cannot keep a fake market alive forever.

We should instead create a market where housing has to compete fairly with other investment alternatives without the subsidies, tax breaks, and political meddling.

Housing will not drop to zero. At some point they will reach a point where the industry will recover. For every dollar one person loses on a home another will gain.  For a president so keen on redistribution this should be welcomed.

“The bankers fervently believed their new structures and systems would better ensure the soundness of their loans than old- fashioned credit analysis and human judgment, fraught as ever with human error.  Having crafted a system that seemed to relieve them of responsibility for making good judgments, they naturally  proceeded to make an enormous amount of bad loans.  Similarly, the government did not know the bank’s financial condition not because the banks were hiding it but because the banks themselves did not know.  Believing that statistical systems could transcend the need for human judgment, the bankers created and the regulators encouraged financial institutions with balance sheets no one could judge.”

“Finally, when the fraud began to be revealed by its consequences, the government turned crisis into catastrophe.  It was the government that actually collapsed stressed credit markets, largely by treating fraud as misfortune.  Transfixed by the same ideology of irresponsibility, the government coddled those who perpetuated the fraud and concentrated its ire on those who exposed it, especially short sellers.  (Short sellers are to financial markets what free speech is to political markets.)”

from Panic – The Betrayal of Capitalism by Wall Street and Washington by Andrew Redleaf and Richard Vigilante