Fault Lines – Part Three – They’re At It Again!

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan (Princeton University Press, 2010)

 
Authors’ Note: Recently several people have told me this series is depressing. That certainly wasn’t my intention. We are in a time of rising hopes in this country. That is great. But rising hopes don’t always come to fruition.

Raj’s chapters point out specific dangers that may impede our progress in this century.

We prepare for natural disasters, especially out here in California. So why not for man-made disasters? It’s just common sense.

Chapter Six “When Money is the Measure of All Worth”

Those of us who worry about derivatives will find this chapter useful.

We live in turbulent times, and the upcoming U.S. Presidential election is overshadowing financial changes that are going on here and abroad.

We’re in a time of high financial volatility that keeps dropping and then creeping upward. Our economy is good—for now. But we know that danger could lurk ahead in our future. Past history teaches us that.

Raj notes that Securitization goes back centuries – in the 1800s to the French monarchy sold annuities to wealthy men. Swiss bankers purchased these French government annuities and took out life insurance on “suitable girls” in Geneva.

Those annuities were then bundled and and resold at a higher price to investors. What happenened next ? The bubble burst. Sound familiar?

Just recently on May 3, 2019 a Financial Times article warned, that led by the big banks, Citigroup, BNP Paribas, Barclays, and SocGen, “Investors flock back to credit product blamed in financial crisis.”

The kind of derivative being sold is the toxic “synthetic CDO (Collateralized Debt Obligation) market.”

Another series of seven articles from the Financial Times starting on January 20th of this year with this article “Debt machine: are risks piling up in leveraged loans?”

This FT article notes that the levereged loans market “where credit is typically extended to lowly rated, more indebted companies…has overshadowed the better known high-yield bond market as a source of financing”.

It goes on to say too that regulators are very worried the “deterioration in underwriting standards” in this market might precipitate a downturn in the U.S. and European economies. The next crisis may not come from the housing sector.

In Chapter Six of Fault Lines, Raj dissects the Enron scandal, along with off-balance sheet accounting, and short-selling as being the only antidotes available for outing a company that there “was no way of analyzing”.

Enron was “a trust me” corporation which turned out to be not worthy of trust.

Subprime mortgage loans are featured in this chapter too. In particular, a company I don’t recall hearing about, called Century Link, is criticized for causing pressure on our government to provide people with low income low-cost “subprime” mortgage loans that led to defaults.

Chapter Seven “Betting the Bank”

This chapter tackles the question of why bankers literally bet the lives of their banks before the Financial Crisis. The discussion centers around rewards versus risks bankers base their actions on. And as you’d expect AIG, the insurance company seller of derivatives and Lehman are also discussed in depth.

At a time with 60% of subprime loans were rated AAA while only 1% of corporate bonds earned that high rating, bankers depended on correlation in time rather than paying attention to causes of risk.

That is, bankers assumed that there would be trouble only if all of the underlying securities for a particular type of derivative failed at the same time.

For example, they thought that there was risk only if all mortgages within a mortgage backed-security (an MBS) failed, only then would that derivative fail. As a result MBSs were rated AAA.

In other words, bankers severely underestimated the immense costs that “tail risk”  might cause in the way derivatives were rated.

[Author’s note: “tail risk” is based upon the statistical “law of probability” and “normal curve” that on Huffington Post and Brucenomics, I’ve objected to using to make predictions about activities related to living beings, i.e., (“pari-mutuel betting”),—as opposed to predictions related to inanimate objects (i.e., “casino-type betting”. Living beings are less predictable than objects.)

Raj also points out that bankers were incentivized by financial rewards for selling products that would make money for their banks. Traders were not incentivized for selling their customers products that were less risky than others. Raj suggests that risk management in the financial industry been rewarded and excessive risk-taking be penalized.

A big chunk of this chapter covers “tail risk”. This is a the kind of risk that bankers ignored when selling securitized products to wealthy investors. Tail risk is what took place after extremely risky products that were considered safe because buyer and seller were independent from each other were sold.

Because bankers were earning bonuses for selling tranched (cut -up)  derivatives, credit ratings and algorithms obscured the results of those transactions, no one considered the “big picture”.

In this chapter we also revisit the debates over “too big to fail,” and government intervention with the markets. It also challenges the long-held belief of economics in the “rational man” theory of human choices and the role that credit and credit cards now play in creating debt crises.

 Chapter Nine “Improving Access to Opportunity in America”

Those who are disillusioned with the ideal of The American Dream” may want to look at this chapter to see how the problems caused by huge income inequality and other kinds of opportunity needed in the U.S. can be tackled.

This is where I found myself amazed that an economist who taught at the University of Chicago School of Economics could sound so much like one educated at the more dominant universities that teach Keynesian Economics.

For example, Raj’s encouraging of the U.S. adopting European practices of two or even three years unemployment benefits for American workers seems something no conservative in the U.S. would every suggest. But his arguments do make sense, especially when combined with more and better education of out-of-work Americans (“human capital”) whose jobs have disappeared due to technical skills needed.

And in the next and last chapter, there are the sections on Universal Health Care, and Social Security that again, no conservative today would endorse.

But in fact, I discovered Rajan was an Eric J. Gleacher Distinguished Service Professor of Finance at the Chicago Booth School of Business. He also worked at the IMF.

Thus Raj also foresees possibilities of portability of worker benefits, state licensing portability, pension independence, longer unemployment insurance, and encouragement of worker savings. He also suggested a government Value Added Tax (VAT) for combatting our government’ rising deficit.

Chapter Ten ” The Fable of the Bees Replayed”

This chapter is for those who worry about the withdrawal of the U.S. from global relationships with our former allies, or who want to know about multi-lateral organizations and their roles in financial crises.

This chapter delves deep into the global actors who deal with crises like the Financial Crisis. Multilateral  organizations, such as the G-20, the IMF, The European Union and the World Bank. He has numerous suggestions how these institutions might become more effective in the future.

There is a long section about China as well, where among many other observations, Raj alleges China’s monetary policy is forcing U.S. interest rates to remain low, thus creating more risk-taking in both the U.S. and China. The Chinese too might create financial bubbles from mirroring U.S. low rates.

Further Reading

I highly recommend Wolf Richter of Wolf Street.com’s video “Can Australia’s housing Bust Morph into a Financial Crisis? This short video distinguishes between business cycles and financial crises. Wolf explains the difference between global and local financial crises and gives recent examples of each kind of crisis. Like Rajan, Wolf locates the origin of financial crises in banks. And in other posts he evaluates additional countries’ as well a specific cities’ housing situations.