Sunday, July 13, 2008

American Banks: A House of Cards

Reputation and trust are the cornerstones of financial stability. Once public confidence is eroded, an institution loses the ability to fund illiquid long term assets as credit availability evaporates. In order to magnify the relatively small spreads earned between borrowed funds and earning assets, banks utilize a high degree of leverage, often operating at an 8 percent capital cushion and 12 times leverage. As short term funding becomes prohibitively expensive or vanishes altogether, the financial institution quickly becomes insolvent as in the cases of Bear Stearns and IndyMac. Commonly referred to as a “run on the bank”, this phenomenon can quickly become a contagion as growing uncertainty causes depositors and creditors to become concerned about return of capital as opposed to return on capital. The continuing erosion of credit quality in the mortgage market leads to growing unease among lenders and depositors in America’s financial institutions. The slightest hint of weakness, such as comments by New York Senator Charles Schumer about the prospects at IndyMac, quickly brings down the house of cards.

The U.S. financial system is trapped in a seemingly endless cycle of crises that elicit the typical policy response – a government bailout. Bank executives, politicians, and government officials generally try to support the financial system through public speeches and policy statements, but responses become limited once distrust and fear permeate throughout the public consciousness. As a crisis of confidence takes hold, the U.S. Treasury and Federal Reserve must respond by orchestrating bailouts and providing financial support such as the Term Auction Facility for banks and brokers and an expansion of credit lines and equity financing for government sponsored enterprises Freddie Mac and Fannie Mae. These bailouts encourage a misallocation of capital that perpetuates the mortgage crisis and ultimately effects substantially higher losses.

The notion of “too big to fail” has become popularized among investors that view the largest commercial and investment banks as certain candidates for a government bailout in the event of insolvency. A sense of security, reassured by previous Fed actions, permeates the investment decisions of institutional and individual investors alike. These investors allocate excessive capital to weak financial institutions, postponing or potentially averting another bailout. Given the perception of a government guarantee, investors accept lower risk premiums and devour new debt issues as though they will provide a risk free premium to treasuries. Until the government restores market discipline through effectively managed dissolution of failed institutions, it risks enabling new asset bubbles by replacing overvalued mortgage securities assets with mispriced bank debt.

The Treasury and Federal Reserve must regain control of the financial system and restore discipline in an orderly manner. Replacing the housing bubble with new excesses fails to address the issues and postpones necessary market corrections. In order to restore discipline, the government must resist the easy solution of taxpayer funded bailouts and instead facilitate the sale or dissolution of the failed institution. The coordinated sale of Bear Stearns, while painful for equity investors, generally bailed out creditors while transferring almost $30 billion of credit risk to the Federal Reserve. The regulatory environment for the investment banks and government sponsored enterprises must be reformed so the Federal Reserve can take receivership of failed institutions and orchestrate an acceptable disposition, much as the FDIC is now coordinating with IndyMac bank. The creditors of the failed institutions, as opposed to uninvolved taxpayers, should absorb any residual losses resulting from insufficient capital. Until market discipline is restored, asset bubbles will continue to pervade our economy and innocent taxpayers will subsidize the excesses of the wealthy and privileged.