Can The Banking System Hold Water?

John Kuhlman (left), economist, teacher and humanitarian


Struggling to understand the depth and breadth of the liquidity crisis enveloping us, I thought back to a quote projected onto a giant screen behind Professor John Kuhlman in the 900-seat auditorium at the University of Missouri many years ago.

The society which scorns excellence in plumbing because plumbing is a humble activity, and tolerates shoddiness in philosophy because philosophy is an exalted activity, will have neither good plumbing nor good philosophy. Neither its pipes nor its theories will hold water. - John William Gardner

Henry Paulson, U.S. Treasury Secretary, has put forth an emergency plan by which taxpayers would buy up some $700 billion of "troubled" mortgage-related credit instruments in order to inject liquidity into the financial system.

• Would it solve the problem?
  
• What would we be buying?
• From whom?
• Why us?
• Why now?

It is easiest to answer the questions in reverse order. Most immediately, the Treasury Secretary needed to coordinate an international effort to avert a liquidity crisis. It is not just that the money market funds were losing value; they were at risk of default. Nervous investors were redeeming money market funds for cash at such a rapid rate that some funds were on the verge of stopping or postponing payments, unable to sell assets fast enough to keep pace. Fearing a disastrous run on the entire financial system, Paulson's team reached for the most powerful defensive weapon in the arsenal, promising to put the full faith and credit of the U.S. Government behind those instruments. Only U.S. taxpayers could float that kind of cash, and it would take an Act of Congress to get them to do it.

Both presidential candidates, currently Members of that Congress, have rightly asked what they are expected to buy and under what terms. After all, $700 billion is the kind of money usually reserved for major programs like tax cuts, health care system overhauls, global wars, or all three combined. As it happens, the most troubling financial instruments at issue, credit default swaps (CDS), are mind-numbingly complex instruments by which investment bankers, mortgage lenders, and others have been able to transform risky portfolios of assets into profitable streams of cash, at least in the short run. In an article last week in Investors Business Daily, Ken Hoover states that "the worldwide CDS market has been estimated at $58 trillion at the end of 2007, a hundredfold increase from seven years ago." According to Wikipedia:

A credit default swap is a contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default or "credit event" in respect of a third party or "reference entity"...A credit default swap resembles an insurance policy, as it can be used by a debt holder to insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

"In the long run," however, as economist John Maynard Keynes famously quipped, "we are all dead." Issuers of credit default swaps, like AIG, make money as long as the instruments they insure are safe. Holders of CDSs, like banks, are insured so long as the insurer stays solvent. However, when the underlying portfolios of insured assets began to fail, as did mortgage-backed securities, CDSs became unprofitable and more visible to investors. So many CDSs were becoming so unprofitable that the values of their issuers and some of their holders began to fall in spectacular fashion. Had AIG been allowed to fail, it might have taken hundreds of banks with it.

And so U.S. taxpayers are being told to cover the failed bets of financial institutions or suffer the consequences of an insolvent financial system that brings down speculators, investors and savers alike. The details of the plan are still being worked out and the price tag may change as well. As initially proposed the Government would buy mortgage-backed securities. Now Congress wants to include mortgages themselves.

The timing of the crisis does not bode well for devising a comprehensive solution, nor is it clear that Paulson has asked for one. The Federal Reserve and Treasury have already taken steps to provide liquidity to financial markets, extending federal loans to banks and equity to AIG, as well as supporting the transition of the two solvent investment banks, Morgan Stanley and Goldman Sacks, to more regulated bank holding company status with access to federal lending.

When Paulson asks for federal government help in cleaning up the balance sheets of private corporations, however, he raises profound issues about the role of government and the responsibility of private corporations to accept the consequences of the risk they freely take on. Demanding immediate and absolute authority to spend $700 billion to clean up private debt smacks of brinksmanship. A prudent Congress will take only the emergency measures required and leave the comprehensive solutions for its succeeding Congress in January.

Any comprehensive solution will require far greater measures of oversight, accountability and respect for federal debt than has been in evidence as of late. In a democratic republic such measures should be subject to careful deliberation and open debate.

There will be plenty of time in the coming weeks and years for the accountants and politicians to count the dead and bury the wounded. For thirty years politicians have found it useful to paint civil servants with the broad brush of "fraud, waste, and abuse" while promoting the virtues of Wall Street's "Masters of the Universe." Regulation and regulators, disparaged as unnecessary and incompetent, were ushered out of the financial markets with the passage of the Financial Services Modernization Act of 1999.

Had we paid more heed to John Gardner and John Kuhlman, would our financial plumbing flow more freely today?

Professor Kuhlman himself, now 85 and retired from a distinguished academic career, continues his career of service, teaching English to immigrants.

A collection of posts on the US Economy can be found here. See also Review of the Economic Stabilization Act of 2008 (3-Oct-2008)

See How AIG Fell Apart by Adam Davidson, in Slate.

See also Nearly Deaf Professor Teaches English Literacy, One Student at a Time, by Samuel G. Freedman, New York Times, May 21, 2008.

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