On September 28, I wrote an article on whether the financial meltdown and concluded that it was mainly a regulatory failure. I would like to further this cause by examining some the of events in the past that could have contributed to the melt down and whether there was possibility in averting this crisis by having the right party make the break glass warning soon enough. I am a free market proponent and have Milton Freeman and Alan Greenspan as gentlemen for which I admire much for their thoughts and actions in their professional space. However, the unfolding of the recent events has lead me to re-think on the sufficiency and adequacy of the free market system in all things sundry and how then do we decide what should or should not come under heavier scrutiny and control. I can still remember vividly that Milton Freeman said that the best thing that the government can help the economy is by staying out of it in his book Free to Choose.I am not proposing a communistic state of affairs but that our free market system near perfect but not perfect and might need some fundamental adjustment for it to be relevant in the coming centuries.
One thing that occupies my mind these couple of weeks is Lehman Brothers and whether the ensuing action and in action might have contributed to the crisis. The American government stand on not being held hostage because a bank is to big to fail is a good policy to hold onto as it can set the wrong precedent and cause a larger breakdown of our financial systems. The various financial melt downs in the past has indeed shown that some of these institutions are too big to fail with wide ranging ramifications on the public at large but we must never never yield to this as the equity of the entire rescue no matter how hard we try will be very very inequitable to the population at large.
The Lehman collapse have a few special ramifications that could have contributed to the credit crunch as follows:
1.AIG is on of the major originators of credit default swaps that is estimated to run into the trillions based on its par value but AIG actual exposure could be a fraction of it. In this case, it is anxiety of how big this fraction is that can kill the market system of trust.
2.These credit default swaps does not have an orderly clearing house to ensure that trades are properly settled and this brings to bear that most of these are bilateral contracts that are kept out of the purview of the public especially on exposure to such instruments. Therefore, we can get current situation of trust no one leading to a credit squeeze. Although the central banks have done a great job in bring down their respective discount rates and windows and through open market operations to re-purchased their own sovereign bonds to increase the money supply. However, both of these are not working as we witness the normal con-tango relationship between discount rates and inter bank rates going in almost opposite directions. The LIOBR overnight, and shorter term 1 -3 months rates has sky rocketed in-spite of lowering of the discount rates. My explanation for this gap is not a case of simple demand and supply but that the counter-party risks has increased tremendously and the differential to a large extend represent this risk premium. No banks are saying they are not exposed neither are they saying they are. So the free market makes a guess and this is reflected in the risk premium it tags on them.
3.It is bad enough that the credit default swaps does not have a clearing house, to add injury to the whole episode, neither does it have a formal exchange either so that the prices are open and there is a fairer valuation of the instruments. Price disclosure is also not as transparent in exchange traded instruments. Price opacity does not help in these times as well.
Given the situation above having the benefit of a rear view mirror that the policy makers largely did not have, would I have recommended a rescue of Lehman instead of letting nature takes its course into bankruptcy? The answer is a resounding no to the rescue as it would create too much of a precedent. We are now eating the bitter pill of its consequence but the market will heal in time as these instruments are de-leveraged in due course and we can then separate the wolves in sheep clothing from the sheep and get rid of them again with some more pain before the market reaches some equilibrium.
In 1993, the much respected Alan Greenspan went before the US Congress to testify that in his capacity as chairman of the Fed that the government should leave the credit derivative market to its own devices as serves to transfer risk from those who cannot afford to carry it to those are willing to take the risk for a price. I do not think that Greenspan was wrong in the second instance but I am not so sure about the first instance of leaving the credit derivates market to its own device. We should not throw away the baby away together with the bath water. Credit derivates does have a role to play in risk transference however as it grows to such proportions, we should perhaps consider having an exchange to improve transparency and also a clearing house whereby trades can be cleared in an orderly fashion and prevent a bubble effect.
Last but not least, we have to decide how the credit rating agencies which have tremendous market and pricing power in ensuring their fair and proper participation in the market. It cannot be like the stock analyst in the stock market as their pens are much much more powerful than that of the stock analyst.
I do not have all the answers or even part of it but write this with a view that encourages communal participation in shaping our children's future as ours might already be too late as these reform takes time to materialize.
Safe Harbor. Please note that information contained in these pages are of a personal nature and does not necessarily reflect that of any companies, organizations or individuals. In addition, some of these opinions are of a forward looking nature. Lastly the facts and opinions contained in these pages might not have been verified for correctness, so please use with caution. Happy Reading. Peter Lye