An outsider’s perspective - Page 3
From Griffith REVIEW Edition 25: After the Crisis
© Copyright Griffith University & the author.
Written by Christopher Joye
The first-order cause of the global financial crisis was not the advent of sub-prime lending, the Basel II Accord, greedy investment banks, non-recourse lending, community reinvestment acts, or the GSEs per se (although all contributed as catalysts). The underlying driver was over a century of flawed political decision-making that created a deeply dysfunctional and structurally fragile system of housing finance under which bank balance sheets, and a nationally integrated deposit-taking infrastructure, had been displaced.
The government-created yet ostensibly private GSE duopoly, which acted as a surrogate for a national deposit-taking system, stunted the need for the geographically dispersed and intrinsically fragile US banking industry to consolidate and insulate itself from failure. These structural flaws were exacerbated when the highly leveraged GSEs entered the much riskier non-prime segments of the US mortgage market. The traditional private lending sector was pushed further down the credit curve with a consequent explosion in sub-prime loans.
The introduction of the Basel II Accord that encouraged off-balance-sheet securitisation activity only lent additional momentum to these dynamics. As default rates inevitably rose and the system of securitisation instantaneously transmitted these risks to investors around the world, the dark side of capital-market integration and globalisation emerged. Defective mark-to-market accounting standards, premised as they were on the belief that ‘efficient markets' always priced assets accurately (but rarely during times of crisis), entrenched a vicious negative-feedback loop as artificial declines in collateral values forced banks and investors all around the world to pull back on lending, triggering further reductions in asset values, and yet another contraction in lending, and so on.
Many of the so-called ‘toxic' assets were not toxic at all: the market failures triggered by the implosion in America's housing finance system precipitated illiquidity for all forms of credit internationally, which then embedded the deleveraging death-spiral that decimated asset values, parts of the international banking system and, recently, real economic growth.
Today, the private lending market in America has all but disappeared. The GSEs and FHA account for 95 per cent of housing finance. The remnants of private banking are being stealthily nationalised by a questionable process of private risk socialisation; the American government is now the largest individual shareholder in Citigroup and Bank of America.
IT IS WORRYING THAT American policymakers continue to apply prescriptions that do absolutely nothing to address these dysfunctions. Stakeholders from Paul Krugman to Timothy Geithner appear to be in a state of denial – Krugman had the temerity to blame the crisis on Asia and its ‘excess savings', while Geithner and the Obama administration appear desperate to bail out bankers, without any real reforms. As taxpayers are forced to internalise private risks and the role of the GSEs is repeatedly reaffirmed, the perverse moral-hazard incentives – we'll take the upside of billions of dollars worth of bonuses but only bear limited downside when we're caught short – are being re-infused into the institutional DNA.
If America is to have any hope of cauterising these problems, and preventing similar cataclysms, the administration and key thought-leaders must acknowledge the structural flaws that caused them. Applying bandages myopically in a desperate bid to avoid a cathartic recession without concomitant reforms is not the long-term answer. In fact, the administration's policies increase the likelihood of the same issues reoccurring – on another president's watch.
America's credit-creation system must be transformed to a hold-to-maturity, balance-sheet-based focus. At some point, the GSEs should be fully nationalised and, alongside other public housing-finance agencies, phased out of the day-to-day housing-finance infrastructure. Governments have a role to play supplying the public goods of liquidity and price discovery when markets fail – but only when markets fail.
In the medium to long term, the administration needs to create something that has been beyond governments since the Founding Fathers: a robust and nationally integrated private banking infrastructure, underwritten principally through retail deposits, to firmly reposition balance sheets as the main repository of credit. To achieve this, the administration must establish singular banking and insurance regulators, rather than a kaleidoscope of agencies, and remove all legal and regulatory obstacles to enable the private banking system to expand and eventually supplant the GSEs and the unnatural activities they spawned. ♦