Systemic Risk Reduction via Failure

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One year ago, Bear Stearns faced collapse when its short-term lenders stopped rolling over their loans to the investment bank. The federal government and the FED stepped in. They financed and brought about an acquisition by the JP Morgan Chase (JPM) bank.

The reason for this was systemic risk. The FED feared that a Bear Stearns failure would cause the financial system to melt down when one party after another could not pay off on contracts. JPM assured others that Bear would honor its contracts. The chairman and chief executive officer of JPM said "Bear Stearns’ clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns’ counterparty risk. We welcome their clients, counterparties, and employees to our firm, and we are glad to be their partner."

Systemic risk is also the reason why the federal government and FED bailed out the AIG company. That bailout is a debacle. The government began by paying off in full a number of major banks that were AIG counterparties. That was not enough. The government is now into its fourth "plan." The cash infusions have risen to $180 billion with no end in sight. Congress has finally got around to wondering publicly who got the money, although this has been known for months.

It is painfully clear that the federal government and the FED, who nurtured the financial catastrophe in the first place, have wasted and are still wasting trillions of dollars without solving the problem that they set out to solve, which is systemic risk. One would hope that they will eventually realize that solving this problem is beyond their financial means and beyond their operational capacities. It is no doubt too much to hope that they realize that their bailouts and programs are not only preventing the resolution of the systemic risk problem but also making it worse. And it is beyond hope that they ever understand that the federal government and the FED are themselves responsible for the high degree of systemic risk of the financial and monetary system. They built the system.

What is systemic risk anyway? See here and here for the conventional wisdom. Invariably the example of a run on a bank will come up. Bear Stearns was such a case. The case of Long-Term Capital Management (not aptly named) in 1998 is cited as a recent example. The idea is that when one bank (or important company) fails, it cannot pay those whom it owes. They may then fail to pay others whom they owe, so that they fail. The others whom they owe may also then fail. The systemic risk is a chain reaction of failures that disrupts the existing financial arrangements, known ominously as the system. God forbid that anything should happen to the system, which is rather like the hallowed Union. Systemic risk and bank failures will then be invoked to explain the Great Depression. The misdirected attention will be on the bank failures, not on the fact that the Federal Reserve System (System!) lay at the heart of the matter.

Let us look at this systemic risk just a trifle more deeply than our superficial rulers or superficial court lawyers, economists, and business moguls who can see no way out but to support the government and the FED.

Systemic risk is a function of the risks that an individual firm takes on. A firm that lends to a Bear Stearns is actually supposed to investigate the credit-worthiness of Bear. It is not supposed to put all of its eggs in one Bear basket. A firm that obtains a credit default guarantee from AIG is actually supposed to check up on AIG and find out if that guarantee means anything or whether it’s just an empty promise. But if there is a great big sugar daddy or two in the background who are known to bail out an LCTM or to supply bank reserves when a bank gets short or to bail out an entire economy in recession or to work with other countries to save currencies and entire weak banking systems that are going under, and if these sugar daddies insure bank deposits and have a too-big-to-fail policy and coddle a select group of government bond dealers and wink at large bank consolidations and encourage financial leverage and allow off-balance-sheet irregularities, then the lending guards and the contracting guards will come down. The precautions will be relaxed. The individual firms will take on more risk and the systemic risk will rise.

Even without federal government and central-banking sugar daddies, it is more than possible that booms will engender undue confidence. It is more than possible, it is factual, that banks will issue too many credits or too many questionable credits and create an unsustainable boom. It is very likely that firms will take on too much leverage. It is likely that too much debt will be issued against collateral values that are being maintained by bubble prices that are unsustainable. Systemic risk will not disappear even with the government and the FED removed as would-be guarantors against all ills. But firms who must operate in a private economy will be pulled up short very fast when they undertake excessive risks. If history does not teach and theory does not teach, then failure is the teacher. There cannot be a market system or a profit-and-loss system without losers. The winners will be those who learn how to navigate the uncertainties and who learn how to assess the risks of their counterparties in financial dealings.

Systemic risk is mitigated when individual firms mitigate their own risks. It is not mitigated when those risks are centralized in a few large firms with a government backup. That creates systemic risk. Decentralization and risk-avoidance mitigate systemic risk. Both of those are encouraged in money, capital, and banking markets not controlled and regulated by the federal government and the FED.

The systemic risk of counterparties and the systemic risk of unknown valuations of assets held by financial firms are no closer to resolution today than a year ago. See here. We now have new and enhanced systemic risks. They include the risk of the FED’s balance sheet, currency risk, and government bond default risk. There is actually an enhanced risk of wealth destruction due to the programs being broached by the Obama government that promise a stagnant, over-taxed, and inefficient economy. A drop of stock prices of 75—90 percent is not out of the question.

The way to have stemmed the follow-on value destruction engineered by the federal government and the FED and to have lanced the existing financial boil was to have let Bear Stearns and AIG fail. The same holds true today for all those fine firms that the federal government has decided to aid, like Fannie Mae and Freddie Mac. They are black holes one and all. Failure was the answer then and it is the answer now. Failure resolves the risks. The counterparties take their losses. If some go under, they go under. No one knows who has the losses and how far they go. No one actually knows if there will be a chain reaction. This includes the government. That is why failure is needed to clear up the situation. Government cannot identify the systemic elements much less know what to do about them. Those elements are buried on the balance sheets of firms all over the world. Failure is the only known method to clear up the uncertainties. The failed firms may then re-organize and re-capitalize. Warren Buffet observed “It’s only when the tide goes out that you learn who’s been swimming naked.” Failure allows investors to learn what the loans are actually worth that are now being held by banks. Failure allows investors to sift the good banks from the bad banks, or they start brand new banks. They, not the government, decide who should get funding and who should not. Failure chastens those who fail and those who do not fail. It reduces the element of moral hazard. It gives society a chance to learn and remember valuable lessons. The lesson today is that the appropriate remedy for a financial firm that has failed is to let it fail.

There have been chain reactions in the past in which a series of failures occurred. We survived. Business slowdowns occurred. They were inevitable as a consequence of the prior boom’s excesses. There is no viable theory and no evidence that government action has mitigated this sequence of events. There is good theory and evidence that government actions has made matters worse. In the 1930s, the NRA (found unconstitutional) created immense confusion. The Wagner Act raised wages and contributed to the 1937 drop in business as did various regulations of the newly-formed SEC.

We have a year of government and FED action behind us now, and we can see plainly that their costly actions have not only failed, but that they have raised the odds of new and greater failures. The same was true in the 1930s, but that truth was submerged so that government could justify its greater power and control. Failure is the only and correct remedy to bring down the systemic risk and to allow a healthy set of financial institutions to arise.

Social learning is not easy. If we do not learn from appropriate theory, then failure itself must teach us. But large-scale financial and economic catastrophes do not occur often. Every 60—80 years, as in 1873 and 1929 and 2007, we get one. During and afterwards, we debate what happened and why it happened. The media and airwaves are filled with confusing and often wrong answers. Congress enacts measures that make matters worse. The political system encourages wrong answers and it seeks out and supports those economists who parrot the false theories that justify the biases of the ruling politicians. The political system impedes social learning. That system claims to be saving the economic system, but it is only vastly increasing the systemic risk.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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