Saw an article in the Financial Times the other day (free registration required), and since this is the kind of stuff that people have a hard time understanding, and FDIC chair Sheila Bair and other pro-regulation types like to obfuscate, I thought I’d break it down piece by piece for y’all.  Numbers correspond to paragraphs in the FT article.

1.  Wrong, the most fundamental lesson isn’t that there was too much leverage.  The most fundamental lesson learned in the recent financial crisis is that government shouldn’t interfere with the allocation of capital, in particular, by pushing banks to become instruments of social policy and give home loans to people who can’t afford it.  Everyone would be better off if the government hadn’t done this, including banks who wouldn’t have imploded, people affected by the implosion, and even the people the government “helped” to get a loan.  If they were renting, they could have moved to a cheaper apartment instead of going bankrupt.  And government could do this because banks depend on government guarantees for their ability to compete.

2.  Its funny, the passive voice “banks … got into trouble”  avoids blaming anyone for the mess.  It just mysteriously happened.  The fact is, government policy and government bank guarantees, like the FDIC and off-balance sheet Fannie and Freddie paved the way for the collapse and the bailouts.

3.  The solution is, predictably, more regulation which fails to address the roots of the problem, which are that lenders have become servants of government policy and dependent on government bailouts.  Rather than ending the bailouts, Bair supports weeding out hybrid instruments, which are sophisticated new investment products which allow debt to automatically convert to equity under certain conditions.  There is nothing fundamentally wrong with these instruments, they represent a less risky way for creditors to lend to businesses and for businesses to take on leverage.  Its as though you got a student loan with terms that said that if you couldn’t make payments, you wouldn’t have to, and the bank would get a specified proportion of your future earnings in perpetuity instead.  Maybe not a great idea, but its a fair contract and everyone knows what they’re getting in to.  Her implication that these contracts “confuse debt and equity” is that financial professionals don’t know what these contracts mean when they enter into them.  That’s simply laughable, its their job to know about these things.  Its not that complicated.  Adding new capital buffers, I’ll get to that later.  Placing higher capital charges on riskier derivatives doesn’t make any sense- derivatives were invented so that risk would be explicit and known to the person taking on the risk.  For instance, most derivatives contracts are owned by non-financial institutions.  Fertilizer companies give fertilizer to farmers with the promise of being paid in the crops at harvest time.  Rather than risk the price of the crop changing, they buy a call option that sets the future price and pass that risk on to the traders who want to take it.  The problem with derivatives were that nobody knew what institutions bore which risks- a disclosure problem, not a derivatives problem, which is why people have recommended a clearinghouse for these instruments.  While clearinghouses are in the process of taking on many of these derivatives to make the risks transparent to third parties who may engage in other transactions with organizations who own derivatives, Congress was vague and banks have enormous clout over how these rules are ultimately implemented.  It is unclear whether effective rules will ever take effect, but the solution is not to discourage the use of derivatives, which is the effect of Bair’s proposal, but to write a better bill and bring price and ownership transparency, and stop kowtowing to the interests of the big trading banks.  Another problem is that these rules and the financial regulation bill discourage the use of derivatives by all companies, including non-financial companies.  These companies use derivatives to reduce risk and uncertainty, not boost profits by engaging in risky trades.  This failure to exercise common sense may have severe unintended effects on businesses who had nothing to do with the crisis, negatively impacting the economy and jobs .

10.  Bair cites academic studies against studies by actual banks to say that higher capital requirements will result in “only a .25 to .35” increase in borrowing rates, as if that wasn’t bad enough.  And is it surprising that the Basel Committee’s findings support the Basel Committee’s recommendations?  There is a difference in methodologies.  Essentially, payments on debts represent a business expense, unlike dividends and share buybacks, meaning its a tax-free form of capital financing.   Here’s the kicker, which goes back to the adding new capital buffers, which I skipped earlier.  Bair says this bias towards debt “narrows considerably in a properly regulated world where debt holders stand to lose in the event of a bank failure.”  Since government guarantees on bank debt, aka deposits at the bank and interbank lending, are not going away, her statement is nonsensical.  Debt holders don’t stand to lose in the event of a bank failure, the government will declare the failure a systemic risk and make the counter-parties whole.  What she means is that new regulations raising capital requirements simulate bank capital standards in a world where there were no government guarantees on debt held by banks.  Why not eliminate the guesswork and get rid of the FDIC and all other forms of government subsidies to banks?

You wouldn’t put your money in a bank with a 30-1 capital ratio without the FDIC, so banks wouldn’t have 30-1 lending to capital ratios without the government.  It is clear that the entire concept of eliminating all future financial crises which took hold during the Great Depression was impossible.  All that has happened is that risk has been transferred from private hands to public hands.  What is the balance to take between less risk and more growth?  Shouldn’t individuals and businesses be making that decision?  As it stands today, banks undo government regulations while keeping government guarantees, then go hog wild and serve up giant bonuses.  Then it all comes crashing down and the middle class taxpayer is left holding the bag.  Is it really any better than when people lost their deposits in the Depression?  The people who invested in the soundest banks, despite low interest rates, didn’t lose their money.  This time around, it is the prudent debtor, saver, and taxpayer who is getting screwed.  Its not just wrong, its damaging to the economy.  We are in this financial situation today because of over 70 years of increasing moral hazard.

And here is the really scary part:  the government had the money to bail them all out this time.  One day the crash will be bigger, and government resources smaller.  Then everyone from you to the banks to the government goes bankrupt.  There is no other solution besides withdrawing government guarantees and letting banks fail (though we had better let things recover before we do it).  Breaking up the big banks doesn’t really change anything- after all, there were more than 5 times as many banks in the US when the Great Depression struck as there are today.  Higher capital requirements and better regulation have drawbacks, and get undone over time.  Today, the government is tempted to run the banks, and the banks are tempted to take the government for everything its got.

We can’t change the way finance works.  Sometimes financial crises happen.  It’s better to have the people who take the risks bear the burdens.  We are like the forest manager who refused to have controlled fires on environmental grounds.  One day, all that underbrush goes up- and the whole forest burns down.