(Dt. Monday, September 8, 2008)



Update 3: Fire-sales, Bazookas and Hospitals

I will start off by congratulating Professor Benjamin Bernanke, the Chairman of the US Federal Reserve, for an excellent speech during the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on August 22, 2008. It is very heartening to know that somebody is thinking carefully, with a great deal of humility and wisdom, through the slew of financial crises that have hit the American economy during these last few years. I am afraid that I do not have any further positive comments to say about the current situation concerning the American economy. Please recall that I had sent out my research proposal (for studying the duration of interaction between the buyer and the seller) and two further updates on it in the first half of 2008. I had not intended to write another update for this year, since I had figured that I needed some more time to develop the ideas in my research proposal further. However, recent developments in the financial markets and the overall economy in America have become so scary that I feel compelled to put out an interim update.

In trying to find solutions to the ongoing economic crises in America, it is EXTREMELY important to keep in mind that the need of the hour is definitely not fire-sales, bazookas, extra-constitutional decision-making and supra-legal authorities. What the taxpayers (and the voters) within the United States, along with investors all over the world, most need to see, at this moment, is that there is a functioning legal (and legitimate) framework within which the financial markets play the role of enabling the process of economic decision-making towards optimal allocations of scarce resources. After this, the second-most pressing concern is that the United States demonstrate an intellectual ability to take advantages of the economic opportunities provided by this post-Cold-War era. In particular, the current mortgage crisis must be seen within the context of a long-term global trend towards democratization in finance. Aligning the interests of the United States, as well as the global economy, with this massive trend of democratization in finance could mean the difference between failure and success in recent efforts to tide over the financial crises. This means that the government authorities must be careful to extract the full benefits of the significant contributions that the government sponsored enterprises (GSEs) have already made towards this trend of democratization in finance. Moreover, this extraction of benefits needs to happen within the smooth functioning of the markets.

In 'bailing out' Fannie Mae and Freddie Mac yesterday, many questions about the transparency of the government's activities in the financial markets continue to persist. In addition, there is a different side to this issue which has not been given any coverage in the media. That is, in view of my comments in the previous paragraph, it seems certain that, many years from now, economic historians are going to compare this bail out event with the privatization of state enterprises in the former communist countries that took place soon after the fall of the Berlin Wall, and the privatization of public sector companies in India which has been happening in fits-and-starts since the early 1990s. Of course, the bail out of Fannie Mae and Freddie Mac, is not nearly as bad as the privatization in Russia with its politician-mafia nexus. However, the comparison with the privatization in India seems reasonable, and one could expect to gain several insights by this comparison.

Instead of this arbitrary take-over of Fannie Mae and Freddie Mac, one should wonder, why couldn't the government have simply bought a significant portion (say 20%) of the heavily under-valued shares of these GSEs in the open market? In this way, the government would have acted as just another market participant, avoiding any questions about transparency. At the same time, it would have provided a mechanism for shoring up the share prices of these GSEs, providing a measure of confidence to the investors of their mortgage securities worldwide. Further, this procedure could have been used to inject additional capital to these GSEs as a reserve against increasing mortgage foreclosures. In this way, the government could have obtained a much better deal for ultimately foregoing its seven-decades-long sponsorship of Fannie Mae and its four-decades-long sponsorship of Freddie Mac.

There is, of course, the question whether the stock of these GSEs had been under-performing because of inefficiency. This question can take four different forms. The first form is that of 'creative accounting' which was prevalent in the late 90s and early 2000s -- recall the scandals at Enron and WorldCom. Have the GSEs hidden massive losses in their balance sheets that would only come to light in the future? The second form is whether appointments to key managerial positions in these GSEs had been unduly influenced by political connections. Moreover, did such political connections help to pad up the balance sheets of these GSEs, with phony accounting? The third form is that, even if the top management has not done anything illegal, is it guilty of professional incompetence? That is, did it forego opportunities for bringing better profits for its shareholders? Has the current management taken wrong decisions that would be detrimental to the long-term health of these GSEs? Would the current management be incapable of dealing with the large number of foreclosures estimated for the near future? The first form of questioning and a part of the second form of questioning could have been effectively addressed by carefully scrutinizing the account books of these GSEs. The viability of Fannie Mae and Freddie Mac was under question ever since the bail out of Bear Stearns in March 2008. There was certainly enough time for the government authorities to closely audit the GSEs and make public the relevant accounting information, which would have transparently reflected how these GSEs had been functioning. The third form of questioning could have been addressed through shareholder forums and shareholder-management meetings, which could have resulted in management change, if necessary.

There is a fourth form of questioning. That is, whether the business model of Fannie Mae and Freddie Mac are fundamentally flawed, or outdated. This question is relevant from the perspective of the information-based economy. Steel companies have found their shares heavily undervalued in recent decades, significantly below their 1940-60s level, because of the perception that the underlying foundations of the economy had shifted from steel-making to automobiles. Then in the last decade, the automobile companies have found their shares heavily undervalued, and the justification seems to be that the economy has shifted to services and information. Thus there might be a re-assessment of the economic value of the GSEs going on at present. This fourth form of questioning the GSEs' performances would only become clear as time goes by. There is no way that the intervention of the government or lack of it would be able to settle this issue.

I need hardly mention that the huge budget deficits the government has been running up in recent years are finally beginning to directly affect the functioning of the American economy. It is very important for the government to understand its own contribution to the long-term trend of democratization in finance, through the GSEs. Fannie Mae and Freddie Mac have defined the parameters for a homeowner's credit-worthiness (the 'prime' borrower). Moreover they have been responsible for the major share of mortgage securities in the market since their inception. These GSEs have served as the anchor for enabling this process of democratization in finance. Thus carefully extracting the benefit of the contributions of these GSEs could have provided the way for finally overcoming the economic disasters that America has been going through in the last few years.

Next, I would like to make a comment about Professor Bernanke's Jackson Hole speech. Professor Bernanke proposes two broad sets of measures to promote stability in the financial system. The first set of measures aim to strengthen the financial infrastructure -- what he calls the hardware and the software. The second set of measures provide a 'system-wide approach to supervisory oversight', under a risk management framework. Both these sets of measures are sound, and demonstrate that Professor Bernanke has been thinking carefully and conscientiously through the crises that have been impacting the American economy. I would just add one comment to his proposals. That is, I would like to point out that, at present, there is no infrastructural facility for a financial institution to voluntarily check in for 'stress-relief and recuperation'. Please recall that in my research proposal, sent out in March 2008, I had pointed out that instantaneous exchanges of financial objects is a major cause of the current economic malaise. If a financial institution finds that it has been over-stressed because of the break-neck speed of its financial transactions and that it needs a breather space, there is simply no place it can go. Most importantly, the financial institution may find itself 'over-stressed', even though it has carried out all its fiduciary responsibilities properly. I quote from Professor Bernanke's August 22 speech:

"... The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured - that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default"

What I am proposing is a paradigm change in the way we think of financial institutions. As human beings, all of us would acknowledge that we function under fundamental limits to our physical and mental activities. If we have been stretching these limits, we feel stress or ill-health. There are hospitals where we can check in voluntarily. These hospitals provide the expertise to monitor our bodies and minds, to help us rest and recuperate, so that we can come back, as healthy individuals, to our usual duties. Such a perspective on financial institutions is, at present, impossible because they are seen as equipped with instantaneous reflex mechanisms. However, we need to take a different perspective. If a financial institution finds itself too 'stressed out' to function, then it should be able to 'check in' with a 'medical authority', and for a fee, get its system monitored and get itself recuperated. Initially, the Federal Reserve could provide this auditory and certificatory function, for a fee. But, over time, this function could be given to certified expert-institutions. The existing credit-rating agencies do not provide such a 'medical' facility because they have a ham-handed mandate. Moreover, the prevailing paradigm of finance does not question whether financial institutions can function at instantaneous speeds.

Moreover, the lack of such a 'medical facility' has resulted in the long delay in directly examining and certifying the account books of the financial institutions that might be caught up in a crisis. At present, the prevailing view is that such examinations are of little value. In the short term, examining the book value has far lower priority than political expediency. However continued neglect of direct examination of the account books in times of crises is what caused the need for bailing out Bear Stearns in March, and now Fannie Mae and Freddie Mac.

I believe that I am the first to propose this new 'biological' perspective on looking at financial institutions as organizations with fundamental limits to the speed of their activities, and the need for 'medical facilities' to nurse them back to health. This new perspective has been directly obtained from my research proposal that seeks to study the duration of interaction between the buyer and the seller in a market. If somebody else has come up with such a biological perspective on financial institutions, please kindly let me know.

Sincerely,
T V Selvakumaran