“Economies Evolve, and so, too, must economic policy”—Hyman Minsky

“Sometimes you have to shoot stray horses and their negligent keepers.” For the sake of G_D, we surely should not pay errant gate keepers hundreds of millions of dollars in golden parachutes.

Ernest Werlin

 

Introduction: Twenty-five years ago, a maverick economist Hyman Minsky (1919-1996) noted that financiers periodically set the entire economy ablaze. That is, Wall Street encouraged businesses and individuals to take on too much risk, generating ruinous boom-and-bust cycles. Minsky felt that only the government could break this painful cycle. That is, government regulation could halt the boom-and-bust cycle by stepping and regulating the moneyman. 

 

In 1933, Franklin Roosevelt who could not physically walk on his own during his first hundred days of office took bold New Deal initiatives to “save the capitalistic system.” Specifically, he restored the credibility of the commercial banking system by providing insurance to depositors. This step stopped “the run on the banks.”

 

Since August 2007, we have read countless revelations about Wall Street transgressions, specifically the encouragement of over leverage by mortgage banks, investment banks, commercial banks, insurance companies, bond insurance companies, and individuals. 

 

However, I would note that Minsky “missed the boat” when he emphasized the curative role of government regulators. In fact, I would argue that either through omission or commission, regulation has miserably failed to stop the speculative fervor. That is, government regulators either failed to implement regulatory controls within their prevue or failed to ask for the appropriate legislative bodies to enact laws that would curb excesses. A blind bat could have seen that reckless lending policies would lead to a housing bust.

 

Five Stages of Minsky Model of the Credit cycle

1. Displacement: Occurs when investors get excited about something—an invention (internet), war, “easy money” or abrupt change in economic policy

2. Boom: Occurs when over-all valuations exceed normalcy

3. Euphoria: Occurs when commercial lenders, banks, or others extend credit to more dubious borrowers. Junk bonds promoted leveraged buy-outs at unreasonable levels based on assets, cash flow, or earnings

4. Profit taking: Cynics recognizing that the boom is not sustainable start profit taking. Hedge funds short internet stocks, Sam Zell sells his commercial real estate empire at record levels, Blackstone goes public.

5. Panic: Dramatic event leads to a massive change in psychology. The failure of Long-Term Capital, the Bankruptcy of a Major Firm or the Near Death Experience of Financial Behemoths, the Failure to Consummate a leveraged buyout such as Sallie Mae, the meltdown of the sub-prime mortgage market, begging Asian Sovereign Funds for bailout money, the bankruptcy of major hedge funds, gold soaring to $980 per ounce, or $100 per barrel oil.

 

Curative Actions

The Federal Reserve and Foreign Central Banks have taken major remedial steps to stop the financial crises: (1)Lowering interest rates rapidly, (2) relaxing regulations on acceptable collateral by commercial banks in order to borrow from the central banks, (3) the nationalization of commercial banks, (4) the encouragement of Sovereign Funds to inject needed equity into major financial institutions, (5) the imposition of $160 Billion stimulative package, (6) altering regulations regarding mortgages such as raising the lending limits of FNMA and Freddie Mac, (7)the request for a moratorium on resets of floating rate mortgages, (8) the moratorium on foreclosures, (9) the liberalization of rules regarding commercial banks such as Bank of America acquiring Mortgage Banks such as Countrywide Financial (10) Changing the rules regarding borrowing at the discount rate; that is, “stating it is an honor to borrow from the Federal Reserve for thirty days rather than a privilege.”

 

Limitations on the Role of Government

 

Low interest rates cannot help home owners when their house value declines below the value of their mortgage or leverage buyouts when the cash flow from acquisitions fails to repay corporate loans assumed from overpriced acquisitions.

 

Declining home prices impede extension of home-equity loans and reverse mortgages. Economists project that for every $1 dollar decline in home equity value, purchasing power declines by $.07.

 

Failure of Government Regulation

 

Since 1980, Congress and the Executive Branch have conspired to weaken federal supervision of Wall Street. For example, the abolition of the Glass-Steagall Act of 1933 encouraged speculative binges by both commercial banks and investment banks. That is both types of institutions shamelessly used off balance sheet financing to make massive principal trading bets or loans. (As a former partner of Morgan Stanley who financially benefited when the company went public, I am shell shocked that Morgan Stanley stock is below its trading level of 1998.) 

 

The skyrocketing leverage of the balance sheets of the financial institutions make them very vulnerable when their net worth shrinks to reflect losses from sub-prime mortgage investments, collateralized loans, and principal trading losses. Stated differently, Wall Street like a dope addict depends daily on global borrowing to finance their bloated balance sheets. Thus, a loss of credibility means “Death in the Morning, Afternoon, or Evening.”

 

Remedy:

 

Minsky felt that policy makers should focus on reforming the financial system so that it serves the rest of economy, instead of feeding off it and destabilizing it.

 

For example, (1) the meager balance sheet of bond insurance companies remains insufficient against their $2. 4 trillion of guarantees. (2) The outsized portfolio of Level III inventory (inventory that cannot be evaluated by third parties) dwarfs the net worth of commercial and investment banks (3) the $45 trillion credit default market, an unregulated off-balance sheet market, is ten times the size of the government market, seven times the size of the mortgage market, eight times the size of the corporate bond market, and twice the size of the entire United States equity market. (4) The persistence of some $6 trillion of credit default swaps where no counter party has been unearthed after thirty days is alarming. ($ Six Trillion is NOT POCKET CHANGE.)  Stated differently, sloppy paperwork has led to an absurd amount of “broken trades” where accountability is undetermined. 

 

Federal regulators who permitted the credit default market to mushroom without regulation and outside the regulatory rules of bodies such as the Federal Reserve or the Comptroller of the Currency must be chastised. This is especially true since many of the current guarantors lack the financial wherewithal to “pay up.”

 

Think Tank

 

Clearly, the capitalistic system is dependent upon the judgment of many individuals. Thus, (1) harnessing Wall Street remuneration packages to discourage excessive risk-taking, (2) restricting irresponsible lending, (3) eliminating predatory practices, and (4) the holding of rating agencies accountable for woeful rating assessments are the first steps toward reigning in the excesses.