Tuesday, April 17, 2012

Too Big To Fail Still Too Big

It's not often that a reader sees clear, unambiguous prose in economic writing from the Federal Reserve System, but the Federal Reserve Bank of Dallas has some plain speakers, including President Richard W. Fisher and Director of Research Harvey Rosenblum.  Let's start with Rosenblum's essay in the 2011 Annual Report of the Dallas Fed.

The basic economic argument is that our regulatory framework didn't allow Schumpeter's "creative destruction," the capitalist mechanism of failure and renewal to operate in our financial institutions sector during the global meltdown.  This despite the fact that we have always had in place battle-tested means of managing failure and resource reallocation, such as Chapter 7 and Chapter 11 bankruptcies, as well as buyouts of troubled financial insitutions.  Instead, the system turned to bailouts, which they point out "is a failure, just with a different label."  Most importantly, though, a bailout fosters no renewal, but rather a reduction in competition.

In 1970, the top five banks held 17% of the industry's assets, and in 2010, the top five held 52% of industry assets.  In 2008, "commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance."  Between 2008-2011, more than 400 U.S. financial institutions failed, the most since the 1960's.  Among these were the absolutely extraordinary failures of IndyMac Bank (7/08) and Washington Mutual (9/08), which had been a darling stock recommendation of bank analysts for many years leading up to 2008.

"All booms end up busts.  Then comes the sad refrain of regret: How could we have been so foolish?"   Concentration of assets amplified the pressures in the system and the transmission to the real economy.  Within individual firms, such as IndyMac, the concentration of an "originate and distribute" model in one type of asset, namely the Alt-A mortgage--a pig with lipstick--should have set off alarms throughout the system.  In fact the regulatory failure at IndyMac was the final straw that saw the demise of the Office of Thrift Supervision. 

Concentration, complacency, and then complexity led to balance sheets that were fraught with risk, which even public company boards and managements could not understand.  Auditors certainly failed to flash caution.  "..accounting expedients (mark to market and use of proprietary corporate models for asset valuation) allowed them (banks) to claim they were healthy--until they weren't."  Subsequent write-downs were later revised by "several orders of magnitude."  Listening to recent first quarter conference calls of Citi, Wells Fargo and JP MorganChase, the balance sheets are still opaque and painted with assets of questionable value. 

In the end, what's important is the transmission of fundamental, systemic banking issues to the real economy.  December 2007 began an 18 month recession, the longest in the postwar period, in which real output dropped 5.1 percent, resulting in the loss of nearly 9 million jobs.  Over the past 22 months of expansion to December 2011, Rosemblum's research shows that only 3.2 million jobs have been recovered.

In fact, in the same presentation linked above, in the Dallas Fed's 2012 outlook, they have a "worst case" scenario of zero GDP growth or worse, in which as many as 20 TBTF global banks "require assistance (i.e.--failure)"  Even if the global economy does muddle through, the fact that this kind of TBTF risk is still present is a deplorable failure of our regulatory system.  One of Dodd-Frank's worst features is a mechanism for again sidestepping the orderly resolution process for bank failure.  "In the future, the ultimate decision won't rest with the Fed, but with the Treasury secretary and, therefore, the president."  Not comforting.

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