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Wednesday, August 29, 2007

Lawrence Summers on the Credit Crunch

I do not feel qualified to comment on this but at least Summers not only gives his analysis of the causes of the problems but also possible solutions.


This is where Fannie and Freddie step in
By Lawrence Summers
Financial Times
August 26 2007

Over the past 20 years major financial disruptions have taken place
roughly
every three years, starting with the 1987 stock market crash; the
Savings &
Loans collapse and credit crunch of the early 1990s; the 1994 Mexican
crisis; the Asian financial crises of 1997 with the Russian and
Long-Term
Capital Management events of 1998; the bursting of the technology
bubble in
2000; the potential disruptions of the payments system after the events
of
September 11 2001 and the deflationary scare in the credit markets in
2002
after the collapse of Enron.

This record suggests that by 2007 the world had been overdue a major
disruption. Sure enough the problems of subprime mortgages –
initially seen
as a confined issue – went systemic as the market began to doubt the
creditworthiness of even the strongest institutions and rushed to buy
US
Treasury debt. Financial crises differ in detail but, just as there are
plot
cycles common to literary tragedies, they follow a common arc.

First there is a period of overconfidence, rising asset values and
growing
leverage as investors increase their faith in strategies that have
enjoyed a
long run of success. Second, there is a surprise that leads investors
to
seek greater safety. In the current case it was the discovery of huge
problems in the subprime sector and the resulting loss of confidence in
the
ratings agencies. Third, as investors rush for the exits, the focus of
risk
analysis shifts from fundamentals to investor behaviour. As some
investors
liquidate their assets, prices fall; others are in turn forced to
liquidate,
further driving prices down. The anticipation of cascading liquidations
leads to more liquidations creating price movements that seemed
inconceivable only a few weeks before. The reduced availability of
credit
then has a negative effect on the real economy. Eventually –
sometimes in a
few months as in the US in 1987 and 1998; sometimes over a decade, as
in
Japan during the 1990s – there is enough price adjustment that
extraordinary
fear gives way to ordinary greed and the process of repair begins.

Only time will tell where we are in this cycle. There have been some
signs
of returning normalcy over the past week, but we cannot judge whether
they
represent a false spring or the end of a crisis phase. There may be
further
shoes to drop in the financial sector. The impact on consumer
confidence and
spending that has driven US expansion over the past several years
remains
unknown.

While it is too soon to draw policy lessons, we can highlight questions
the
crisis points up. Three stand out.

First, this crisis has been propelled by a loss of confidence in
ratings
agencies as large amounts of debt that had been very highly rated has
proven
very risky and headed towards default. There is room for debate over
whether
the errors of the ratings agencies stem from a weak analysis of complex
new
credit instruments, or from the conflicts induced when debt issuers pay
for
their ratings and can shop for the highest rating. But there is no room
for
doubt that – as in previous financial crises involving Mexico, Asia
and
Enron – the ratings agencies dropped the ball. In light of this,
should bank
capital standards or countless investment guidelines be based on
ratings?
What is the alternative? Sarbanes-Oxley was a possibly flawed response
to
the problems Enron highlighted in corporate accounting. What, if any,
legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial
institutions? A premise of the US financial system is that banks accept
much
closer supervision in return for access to the Federal Reserve’s
payments
system and discount window. The problem this time is not that banks
lack
capital or cannot fund themselves. It is that the solvency of a range
of
non-banks is in question, both because of concerns about their economic
fundamentals and because of cascading liquidations as investors who
lose
confidence in them seek to redeem their money and move into safer, more
liquid investments. Central banks that seek to instil confidence by
lending
to banks, or reducing their cost of borrowing, may, as the saying goes,
be
pushing on a string. Is it wise to push banks to become public
financial
utilities in times of crisis? Should there be more lending and/or
regulation
of the non-bank financial institutions?

Third, what is the role for public authorities in supporting the flow
of
credit to the housing sector? The lesson learnt during the S&L debacle
was
that it was catastrophic to finance home ownership through insured
banking
institutions that borrowed short term and then offered long-term
fixed-rate
home mortgages. Now a system reliant on securitisation, adjustable rate
mortgages and non-insured financial institutions has broken down.

I am among the many with serious doubts about the wisdom of the
government
quasi-guarantees that supported the government-sponsored entities,
Fannie
Mae, the Federal National Mortgage Association, and Freddie Mac, the
Federal
Home Loan Mortgage Corp , as they have operated in the mortgage market.
But
surely if there is ever a moment when they should expand their
activities it
is now, when mortgage liquidity is drying up. No doubt, credit
standards in
the subprime market were too low for too long. Now, as borrowers face
higher
costs as their adjustable rate mortgages are reset, is not the time for
the
authorities to get religion and discourage the provision of credit.

This crisis could have a silver lining if it leads to the careful
reflection
on these vital questions.

The writer is the Charles W. Eliot professor at Harvard University

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