How not to avoid the next panic

By J Saft
August 25, 2009

jamessaft1.jpg(James Saft is a Reuters columnist. The opinions expressed are his own)

A proposal to give banks, hedge funds and private equity firms “affordable” credit default swap-based insurance against market panics will be very effective: it will effectively encourage even more risk taking and turn the next crisis into one about government credit.

Global central bankers assembled at the Jackson Hole conference last week heard the proposal, by two Massachusetts Institute of Technology economists Ricardo Caballero and Pablo Kurlat. Their idea is that most of the damage in panics is due to a combination of investors overestimating the damage during a market seizure and policy-makers being too slow to pull the trigger on bailouts.

The solution, therefore, is to send the banks into the next panic ready armed with a Fed-backed get out of jail free card which the authorities can activate at a moment’s notice.

This is akin to looking at a bunch of toddlers riding motorcycles and deciding that what will really improve the situation is putting them all in crash helmets.

The proposal emphasizes “Knightian uncertainty,” which it says impairs markets during panics, as investors price in the worst about those risks which they cannot measure.  Remove this uncertainty, and hey Presto, you’ve cheapened the cost of the whole bubble business.

“The main antidote to fear is prime, government-backed insurance against what investors fear,” according to Caballero and Kurlat.

“The silver lining of this diagnosis is that providing such insurance is inexpensive for the government, as once the panic subsides the real losses are much smaller than those initially feared by investors.”

There are a few assumptions there, so let’s take them one by one.

First, we don’t know that markets were wrong to assume last year that bank losses would be catastrophic. Banks are performing better, but only within a context of having either an explicit or implicit government guarantee. We do not know how well their underlying assets will ultimately perform, or even if the assumptions made in the stress test will prove true. We only know that in making those assumptions and standing behind them, the government has removed risk for private investors.

Second, we do not know that the level of these losses will be affordable for governments to bear. Look at Iceland for a prime example of what can happen. The U.S. has taken on very real and very scary public liabilities in order to end the crisis. There is no guarantee that these are affordable or that U.S. creditors will keep faith.

THE FUTURE IS MORAL HAZARD

Caballero and Kurlat also say that the cause of panics is fundamentally unknowable, a surprise. While its hard to say now where the next one will come from, there are plenty of people out there who were patiently explaining where this one was going to be centered: real estate. People who ignored this advice did so for many reasons, but one thing in common many shared was that they were getting rich out of the bubble or hoped to.

This brings us to the main reason not to create these crisis swaps; they will only encourage people to take on more risk. If we effectively assume that all panics are essentially false alarms we will encourage an unwarranted confidence in risk managers and investors. Add in prospect of profits and bonuses and you have a prescription for ever expanding leverage, bubbles and crises.

The authors say that policy makers react too slowly, and compare their plan to placing defibrillators in publicplaces to save the lives of heart attack victims. But unlike human beings, all of whom we want to save, sometimes its better if banks are allowed to die, much less hedge funds. Shareholders and bondholders, unlike life, are not sacred.

The proposal also argues that leverage in the system was not excessive, at least when compared to the last recession in 2001. But of course by 2001 the amount of leverage had already began to expand, helped along the way by deregulation. Try running the numbers compared to 1985 or 1965 and you will reach a different conclusion.

None of this is to say that financial innovation is a bad thing, or that leverage is to be altogether eliminated. But there is in markets a growing hope that we are all awakening from a bad dream. That’s a delusion.

Financial panics are not nightmares to be ignored, but like chest pains, warnings to be heeded.

“In the end, the conventional common sense response to financial crisis – better regulation, rein in leverage, increase transparency, etc., is not such a bad one,” Harvard economist Ken Rogoff wrote in response to the proposal.

I couldn’t agree more. Let’s get the kiddies off the bikes, and the sooner the better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

691 comments

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