Still in the dark

This article by U Chicago professors is supposed to explain the current market turmoil. Unfortunately, it makes no sense to me, but your mileage may vary. First Fannie/Freddie:

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

Does this make any sense to you? Fannie and Freddie were always government sponsored entities. The US Government always guaranteed their debt. Which is why it traded as if it was a Treasury bill. Why do Diamond and Kashyap ignore the most salient point about these two entities? Also, if you have a financial institution that borrows short and lends long, won't it eventually experience a bank run? Wasn't it inevitable that eventually, the Government would have to make its implicit guarantee explicit? What part of the Government backing up Fannie and Freddie debt was not inevitable, given that the Government backs up Fannie and Freddie debt?

Now, Lehman

Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Isn't borrowing short to lend long a recipe for a bank run? Isn't that why we have FDIC insurance? If this structure is inevitable for investment banks, then aren't bank runs inevitable for investment banks? And why is it so critical for banks to maturity transform at any rate? Why can't we have a financial system with no maturity transformation, and hence, no liquidity risk?

Finally, AIG:

The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part.

So, AIGs liquidity insurance was worthless because when it needed to supply others with liquidity, it could not access liquidity itself.

Most nonsensically:

6) What does this mean for the markets going ahead?

Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome.

If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.

"In this current environment, relying almost exclusively on short-tern debt is hazardous?" What makes this current environment so special -- that it's on planet earth? A fractional reserve financial system is hazardous in *any* environment, because it can experience a run for *no reason*, at *any time*. That is an inescapable feature of fractional reserve banking. If you define liquidity as "the ability to make long-term loans against short-term deposits, secure in the knowledge that you can roll those short-term deposits over", then bank runs, and systematic, contagious bank runs, are an inevitable feature of the system. If you put a lender of last resort behind the whole system (who has a printing press) then you will end up nationalizing the financial system those years that it has a run. This is no way to run a railroad.

Nowhere in the article do Diamond and Kashyap explain that bank runs are inevitable in a fractional reserve banking system. And no where do they explain why we need to run on a fractional reserve system, and why we cannot have a system where for every borrower, there is a single lender, and their maturities are matched. In other words, a world of fully banked cash accounts, and CDs. "Banks cannot make much profit" is not an acceptable reason.

If the US Government simply nationalized all bad debt, they will "solve" this crises, and set us up for the next one in 5-10 years, which will be even worse. Regulation in the CDS and mortgage lending world is not helpful, as the shadow financial system will find new instruments to borrow short and lend long. The problem is the "borrowing short and lending long", not sub prime, or CDS, or SIVs, or CDOs. But I can bet that the God Given right for banks to maturity transform will emerge from this crises unscathed, and begin setting up the next, bigger, one.