There seems to be some confusion over what threatened to cause
major banks to fail. Let me go over my list of the risks:
- Many relied on AIG (
) to insure their subprime and other structured lending risks.
Note: initially, when an insurer underprices a product
dramatically and attracts a lot of business, the sellers of risk
chortle, and say, "Sell away to the brain-dead." After it has
gone on for a long time, a sea change hits, where they think - oh
no, we're the patsies - the industry now relies on the solvency
of AIG! Alas for risk control, and the illusion of the strength
of companies merely because they are big.
- As an aside, though I have defended the rating agencies in
the past, please fault the rating agencies for one thing: the
idea that large companies are more creditworthy than small ones.
Big companies may have more liquidity options, but they also take
advantage of cheap financing to bloat in bull markets. When the
tide goes out - oh well, GE Capital might not have survived
without the TLGP program. Another reason why I sold all my GE
Capital debt when I was a bond manager. Big companies can make
big mistakes. Instead, I bought the debt of well-run smaller
companies with better balance sheets, lower ratings, and more
- Most of the real risks came from badly underwritten home
mortgage debt, whether conventional (bye Fannie and Freddie),
Alt-A and Jumbo, or subprime. Underwriting standards slipped
- Commercial mortgage lending hasn't yet left its marks - there
is a lot of hope that banks can extend maturing loans rather than
foreclose and take losses.
- In general, banks ran with leverage ratios that were too
high. Risk-based capital formulas did not properly account for
added risks from: securitized assets, home equity loans,
construction loans, overconcentration in a single area of
lending, the possibility that the GSEs could fail, etc. Beyond
that, there was a dearth of true equity, and a surfeit of
preferred stock, junior debt, trust preferreds, etc.
- The high leverage particularly applies to the investment
banks, which asked for a change from the SEC and got it in 2004.
The only bank to not lever up was Goldman (
); Morgan Stanley (
) did it only a little bit. Guess who survived?
- The Fed encouraged risk-taking by the banks by not allowing
recessions to damage them. They tightened too late, and loosened
too early, and that pushed us into a liquidity trap.
- Residential mortgage servicers priced their product in a way
that could only work if few borrowers were delinquent.
- Financial insurers took advantage of loose accounting rules,
and insured more than they could afford.
- State and local governments came to depend on increased taxes
off of inflated asset values.
What I don't see is problems from private equity or proprietary
trading. These were not big problems in the current crisis, but the
Obama Administration is focusing on these as if they are the
Look, my view is that banks should be able to invest in
equity-like investments up to the level of their surplus, and no
more. By this, I mean real common equity, not hybrid equity-debt
I believe that bank risk-based capital structures need to be
strengthened. I don't care if it means that lending diminishes for
a few years. Far better that we have a sound lending base than that
we head into a Japanese-style liquidity trap, which Dr. Bernanke is
sailing us into. (He criticized the Japanese, and he does not see
that he is doing the same thing.)
President Obama can demagogue all he wants, and make the banks
to be villains. In the long run, what makes economic sense will
prevail, not what scores political points.
Wall Street Hearts Fannie and Freddie