In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.
Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values… .The results have been a form of financial gridlock.”
To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”
With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e-Trade) are in no hurry to sell at prices low enough to attract borrowers.
This poses a temporary problem for mark-to-market accounting (and Basle’s bureaucratic capital standards), but this seems a failure of accounting rather than markets. Cowen asks “why seek ‘fire sale’ prices when you might lose your job for doing so?” I would ask, “Why seek ‘fire sale’ prices if (unlike Bear Stearns) you are in a position to wait for a better deal once the market calms down?” Cowen says, “Only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities.” But large holdings can often be sold in smaller batches. And we don’t know who might have bought Bear Stearns, warts and all, were it not for favoritism the Fed and Treasury showed to a single bidder (who was shamed into quintupling the offer).
Liquidity refers to the ease with which various assets can be converted to cash without dropping the value of the asset. Hedge fund managers bought gold on margin at $1000 may find it is less liquid than they expected. But what seems terrible to sellers of marked-down assets (e.g., of Las Vegas condos) can seem wonderful to buyers.
Most people think “liquidity drying up” means banks have cut back on lending, which is demonstrably false – bank loans are growing at a 10-11% annual rate since August, and much faster for C&I loans. Consumers and small businesses were never dependent on mortgage-backed IOUs.
There is no “financial gridlock” for most assets, even real estate (31% of household wealth). Auctions for foreclosed properties are drawing plenty of bids.
Mr. Cowen thinks “investors are instead flocking to the safest of assets, like Treasury bills.” Smart investors shun long-term Treasuries and are flocking to stocks, particularly U.S. stocks. The S&P 500 is down less than 10% this year – much better (in dollars) than most other markets, including Europe and China.
Tyler says, “Every step of the way, the pricing of [Bear Stearns] stock has surprised the market.” Really? It didn’t surprise the shorts, who owned a fourth of the shares. I own the SKF exchange fund (ultra-short financials) which, ironically, fell sharply a couple of days after Bear was sold out by omniscient and kindly government regulators.
Nobody ever said housing was a liquid asset, but even housing is far more liquid than the doomsday crowd imagines. The OFHEO index shows that home prices increased in all but 11 states between the fourth quarters of 2006 and 2007. Home prices fell 4% to 7% in California, Nevada, Florida and Michigan, but home prices rose 4% to 9% in 16 other states—most of which are not even counted in the widely-cited Case-Shiller index (which gives California a 27% weight).
The only problem with financial markets is that information is never free, and it sometimes takes time to discover market-clearing prices. The solution is not more regulations, but more patience.
Capital requirements, on the other hand, can cause very serious problems. The 1988 Basle Accord on capital requirements was a heavy-handed reaction to the 1982 LDC debt crisis. It was also one reason Japan’s monetary base shrunk by 2.8% a year in 1991-92 – the start of a period some U.S. journalists are now foolishly comparing to the restoration of sanity in coastal housing prices.
As I explained ten years ago, Basle “required that by the end of 1992 banks had to maintain capital equal to a minimum of 8 percent of risk-adjusted assets, where risk just happened to be defined in a way that favored government bonds over business loans… . Did relatively higher capital ratios in the United States and Great Britain mean they were less exposed than Japan to LDC default? On the contrary, even in the late eighties outstanding LDC loans still amounted to 93-199 percent of the capital of the largest U.S. banks, and as much as 82 percent for British banks, but only 55 percent for Japan. American banks seemed to have more capital. But unlike Japan, all of the capital of U.S. banks, and sometimes much more, was exposed to LDC default.”
Even if markets for a few risky, exotic U.S. securities appears “frozen” for a short while, that is far less problematic than imposing stern, politicized regulation over a wide array of assets and institutions.