Will We Have Another Financial Crisis? Are We Prepared For One?

April 22, 2017

These two questions appear in my mailbox with the greatest frequency. The answers are very straightforward: we will have another crisis, and we are not prepared for it.

Thumbnail Sketch of Three Crises, Their Triggers and Aftermaths

I have lived through three financial crises during my life. The worst occurred during the 1930s, triggered by a stock market crash followed by widespread runs on banks. The aftermath saw the creation of the FDIC, FHA, Fannie Mae, the Federal Home Loan Bank System (FHLBS), and the Homeowners Loan Corporation (HOLC). The first three are still with us.

The second crisis occurred during the early 80s, triggered by a rapid rise in interest rates that depleted the capital of the savings and loan industry. The aftermath saw the demise of both the industry and the FHLBS, which among other things had been the industry regulator.

The third crisis occurred during 2008-9, triggered by a sharp drop in house prices, which led to an explosion of mortgage defaults, to the insolvency of many firms that originated mortgages or invested in mortgages or mortgage securities, and to widespread market disruption following the failure of one major player, Lehman Brothers. The aftermath saw the Dodd/Frank legislation, which created the Financial Stability Oversight Council, Office of Financial Research, and the Consumer Financial Protection Bureau. Dodd/Frank also mandated significant changes in powers and responsibilities of most of the existing regulatory agencies, including the FDIC, Federal Reserve and SEC.

Dodd/Frank had two major objectives: one was to prevent a recurrence of the 2008-9 crisis. The second was to eliminate “bail-outs” of firms in trouble that were “too big to fail,” which were viewed as an unjustifiable use of taxpayer funds and provided an unjustifiable benefit to large firms. Recent proposals to amend Dodd/Frank prompted me to write this article.

Building a Maginot Line to Prevent the Next Crisis

The French built the Maginot line to prevent an invasion by the Germans through the same route the Germans had used in World War 1. But the Germans in World War 2 invaded through a different route and the Maginot line was useless – less than useless, because it had to be manned by troops that were needed elsewhere. Similarly, Dodd Frank aimed at preventing another crisis originating in the home mortgage market by imposing a large number of restrictions on that market. I have written several articles criticizing some of these restrictions, including documentation requirements that have made it extremely difficult for self-employed borrowers to qualify for a mortgage. Many creditworthy borrowers are now shut out of the market, and new house construction is much below what it should be. But this won’t prevent the next crisis because the next crisis will originate somewhere else.

Crisis Forecasting

Forecasting a financial crisis is much like forecasting a meteorite hitting the earth: we can be sure that it will happen but we don’t know where and we don’t know when. A plausible surmise is that, just as the three previous crises were all different, the next one will also be different. We can be especially confident that it will not resemble the most recent crisis, which stimulated Dodd/Frank.

While it makes sense to try to anticipate where it might happen, ideally in time to prevent its occurrence, the prospects for success are not great. The foundation for the last crisis was a housing bubble and associated deterioration of credit standards that lasted in plain view for several years, yet the only ones who anticipated the disaster were a few shrewd speculators looking to cash in on short sales of mortgage-backed securities. All the relevant Government agencies including the Federal Reserve were caught napping.

Preparing For a Crisis

If you can’t anticipate a crisis, the prudent policy is to be prepared to contain it whenever and wherever it occurs. The objective should be to minimize the damage by preventing contagion. A major difference between the most recent crisis and that of the 1930s is that the most recent crisis was largely contained and the earlier crisis was not. The importance of containment can’t be over-emphasized, it is the difference between a curtailment of GNP for about 2 years as in 2008-9, and curtailment for about 10 years as in 1930-40. In this respect, the recent crisis was a success story. But the Dodd/Frank legislation that emerged from the crisis weakened our capacity to deal with the next one.

Dodd/Frank Made Containment More Difficult

In its misguided attempt to eliminate “too big to fail”, Dodd/Frank removed or weakened the tools that were used to contain the last crisis.

·   The Treasury, which had prevented a run on money market funds by guaranteeing their accounts, next time must go to Congress for the authority.

·   The Federal Reserve, which prevented a calamitous failure by AIG, next time will be prevented from rescuing individual non-bank firms.

·   The FDIC, which prevented a ruinous run from uninsured depositors by extending deposit insurance to all deposits, next time must go to Congress for the authority.

Note: These are bottom-line conclusions I draw from my reading of Dodd/Frank. For example, my conclusion that the Federal Reserve will be unable to rescue a non-bank firm in trouble rests on the following Dodd/Frank provisions:

·   A new definition of emergency lending authority, from a loan to an “individual, or a partnership or corporation” to a “participant in any program or facility with broad-based eligibility.”

·   A new requirement that any emergency program cannot “aid a failing financial company”.

·   A new requirement that any emergency loans be secured by collateral “sufficient to protect taxpayers from losses”.  

A colleague who read this article said that notwithstanding these provisions, “if necessary the Fed would find a way.”  Maybe he is right, maybe not, but why would we take that chance?       

Executive Order of February 3, 2017

The “Core Principles For Regulating the United States Financial System” issued by President Trump says nothing about the need for tools to prevent contagion during the early stages of a financial crisis.

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