Crisis and Regulation, part two: Enter the Investment Banks

At the end of Crisis and Regulation Part One I said that mortgage lenders packaged mortgages they had made together into mortgage-backed securities, and then sold them to "someone else." This meant that because they quickly unloaded the mortgages, mortgage standards declined, which many loans given to the NINJAS. The "someone" who bought these mortgage securities were the investment banks- think Goldman Sachs, Bear Sterns, Lehman Brothers, Morgan Stanley ect.

Now a word about invesment banks: the process of investment banking is essentially the inverse of the process of commerical banking. Investment banks purchase securities from issuers and then sell them to the final investors. For example, investment banks are how firms sell stock when they wish to issue more: Goldman Sachs will purchase x number of shares from Apple and then sell those shares to the general public; the margin between the purchase price from the issuer and the price they get from the public is their profit. So investment banks act as an intermediary between those selling assets and those wishing to buy them, as opposed to commerical banks that act as an intermediary between people buying assets (depositors) and those selling them (borrowers). But the big difference between investment and commercial banks is that investment banks do not hold assets on their balance sheets for very long; its a quick-turnover business, at least if done profitably: they want to flip the securities they have underwritten to a buyer quickly to get the margin of profit, as opposed to commerical banks who hold their liabilities (deposits) and assets (loans and other securities) on their balance sheets for a longer period of time.

But what are the implications of this for the financial crisis? Well, the investment banks were the critical link in the securitization chain that spread the risk of mortgage default from the originators of the mortgage to the broader financial system; if the investment banks had not underwritten the mortgage securities from the originators and sold them to other investors (such as commerical banks, pension and mutual funds, sovereign wealth funds, ect) the financial contagion would not have happened...

but why was it all able to go so wrong?

Germany's Current Account: World's Biggest Surplus

I thought this was interesting: Germany now has the world's largest current account surplus, while we have the world's largest current account deficit. What's really fascinating is that Germany surpassed China; think about the implications of that on a per capita basis. Scott Sumner reports:

http://www.themoneyillusion.com/?p=13760&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Themoneyillusion+%28TheMoneyIllusion%29

Here's that interesting piece by the guy who left Goldman Sachs...

I thought this was an interesting bit of candor from someone who actually worked in the depths of the financial services industry. And seeing as how I'm in the mist of a series of posts on the subject of the financial crisis, quite appropriate. Follow the link and the NYT won't dock you one free article view of the month. Enjoy.

http://www.nytimes.com/2012/03/14/opinion/why-i-am-leaving-goldman-sachs.html?pagewanted=all

Crisis and Regulation, part one

I watched Inside Job for the first time this week, and it got me thinking about financial regulation and the crisis of 2008. What struck me most about the whole thing was how ill-designed the subsequent Frank-Dodd regulatory bill was.

To start with, lets investigate my diagnosis of what caused the financial crisis, and what did not. The crux of the problem was asymetric information, where one side in a transaction has more information than the other. With asymetric information, markets cannot funciton efficiently because supply and demand equilibrium rely on both parties maximizing their utility; with asymetric information, prices will either be too high or too low, depending on whether the buyer or seller has the information advantage.

This was exactly the situation that arose in the market for mortgage-backed securities. Mortgages of individual homeowners were combined into securities and sold by the original lending institution. The mortgage payments from the mortgages that comprised the security than went to the new owners of the security.

Many of these securities were backed by mortgages that were given to NINJAS- no, not those ninjas, but people with No Income, No Job, No Assets- obviously the type of person who is likley to default or at least be delinquent on their mortgage. But the originators of these loans did not care, because once the made the loan, they simply combined the bad mortgages into mortgage-backed securities and sold them to someone else.

Ben Bernankes Gets Historical

This is kind of cool, I guess Ben Bernanke is giving a series of speeches on the history of the Federal Reserve, starting with the history of the gold standard. This is an area I have studied before; the lessons of the gold standard have particular relevence to the eurozone crisis today because of the parallels between fixed-exchange rate systems. More on this later.

http://www.businessinsider.com/ben-bernanke-murders-the-gold-standard-2012-3

Eurozone inflation =low, Unemployment = high

I'm not making this stuff up. Check it out.

http://www.reuters.com/article/2012/03/01/eurozone-economy-idUSB5E7JV02K20120301

I just thought I ought to reiterate this, in case any eurozone policy makers have missed it. (They all frequent this blog, right?)

Scott Sumner explains "Market Monetarism"

Scott Sumner at themoneyillusion.com has a good explaination of "market monetarism," the approach outlined earlier that looks at the business cycle through changes in the real money supply and its income velocity. Check it out.

http://www.themoneyillusion.com/?p=13353

Draghi (unintentionally) Blunts his Own Lance

In the past week, I pointed out what I believed to be a high expansionary action on the part of the European Central Bank when I lauded their decision to "flood" the European banking system with up to a trillion in new open market operations. This kind of monetary expansion is just what Europe and especially the Periphery need in the face of sustained unemployment and low inflation, not to mention the collapsing confidence of the bond market.

But as if in an effort to stymie this achievement, Mario Draghi has gone and made it explicit that the ECB does not plan on taking any future action; the onus is once again the the debt-constrained and depressed economies of the Periphery. Awesome. Bondholders that may have taken the ECB's recent expansion as a signal that the ECB won't allow another recession and won't allow a debt-crisis are being told not to get too optimistic; the ECB might just back out yet. Check it out.

http://www.reuters.com/article/2012/03/05/us-ecb-rates-idUSTRE82418G20120305