We have learned that the "risk management" emperor had no clothes. Hundreds of Ph.D.s in risk-management positions are now discredited. The protective pyrotechnic mechanisms such as Value At Risk, which were supposed to predict the risk in a portfolio of assets, are duds. The financial controls have proven to be inadequate.but alas his solution, like Marx's, is wrong:
So it's not shocking that there are cracks in the system. What is surprising is the sheer size and the high proportion of risky bets that were made. But the real magnification of that risk comes from the nature of the leveraged balance sheets of most financial institutions. The traditional regulatory quantifications of risk were not realistically tested. That's why firms can assert they have enough capital and yet have no liquidity.
The rating agencies are at the vortex of the storm. What were they thinking? In a housing crash situation, which had a reasonable chance of happening, how could the securities rated AAA be worthy of that rarified appellation? They couldn't and shouldn't have been. But it was that label that got institutions around the world to buy into the bubble. That demand generated the hunger for more product and therefore drove "innovations" such as the document-free loan. The losses and write-offs will continue.
There may be situations where federal funding is the financing of last resort or is necessary as a backstop or catalyst to constructive transactions. Rather than have the Federal Reserve do these investments on an ad hoc basis, a preferable structure would be for the Fed to fund the equity for a new institution with professional management, which I call the Liquidity Funding Bank. The analogy is partly to the World Bank and partly to the historic Bank of the United States, but hopefully without the politics.
Wasserstein does not address the moral hazard; he merely transfers it to yet-another-institution. Neither the Fed, nor Congress, nor the White House, nor Fannie Mae nor Freddie Mac helped mitigate the credit crisis early on, and each helped make it worse. So we add a new institution to the mix, that's the answer? Please, no. Especially one corrupt like the World Bank.
1) Fed: don't keep rates artificially low. Follow the Taylor rule until you demonstrate that you outperform itThe U.S. economy went binge drinking (and Greenspan was primary supplier), and now has a severe case of alcohol poisoning. More alcohol is not the solution, but neither is removing all the alcohol immediately, which means removing all the blood, too--more cells die, and we get closer to Great Depression Redux. Unfortunately, 1) the auction facility, 2) the repo facility, and 3) bailing out Bear Stearns could keep the alcoholic from recovering from his addiction, yet keeping the heart pumping and liver detoxifying is the right thing for the Fed to do. Death-avoidance is part of the price stability and job creation mandates of the Fed, after all.
2) Congress: stop with the stimulus package and other ridiculous legislation that is a psychological closing of the door after the capital has already left the building. Also, don't give Fannie Mae or Freddie Mac more discount advantage and less regulation. In fact, reverse that. The private sector has shown more success in self-regulation than the history of governments, so how about for every regulation for the private sector, do 3 times for the government. (And don't tax non-government workers to pay for government regulation, just the government employees).
3) White House: what happened to the promise of limited government upon which you campaigned? Stick with that. Don't sign ridiculous legislation (see above)! And keep your Treasury Secretary on a tighter leash regarding limited government and ridiculous laws.
None of this means we should plug the body into a respirator forever, and call that machine the Liquidity Funding Bank.