[tt] [wta-talk] 1929 Redux: Heading for a Crash?

[Perry E. Metzger]

>    Your predecessors on the Senate Banking Committee, in the celebrated
>    Pecora Hearings of 1933 and 1934, laid the groundwork for the modern
>    edifice of financial regulation. I suspect that they would be appalled
>    at the parallels between the systemic risks of the 1920s and many of
>    the modern practices that have been permitted to seep back in to our
>    financial markets.

The great depression was not caused by people taking too much risk, it
was rather caused by very bad reactions to a market downturn taken by
the Federal Reserve and by the US Congress. The Fed responded by
removing liquidity from a crashing market, causing it to crash
faster. The Congress reacted by enacting protectionist trade barriers
that destroyed many businesses.

Subsequent financial downturns were not prevented by the Glass-Steagal
act or by the securities act of 1933 -- if anything, Glass-Steagal
made proper asset diversification harder, and the securities act
slowed economic growth by making it very difficult to enter the
capital markets without enormous cost.

Given this, I'm not sure what value additional regulation would have
right now.

At the moment, the market seems to be recovering nicely from the
comparatively small blip that the recent subprime mortgage situation
caused, though that could of course change given significant
additional market intervention by well meaning but misguided
regulators. If anything, the far larger strain on the US economy at
the moment is the continuing waste of resources represented by the
unneeded and unwise war the US is currently engaged in, and that will
not be fixed by increased regulation of the securities markets.

>    The most basic and alarming parallel is the creation of asset bubbles,
>    in which the purveyors of securities use very high leverage;

Asset bubbles are not alarming. They happen with considerable
regularity, and, provided that the government does not try to rescue
the fools involved, they deflate on their own. They certainly hurt
people when they deflate, but attempts to prevent people from being
hurt would cause moral hazards, and attempts to prevent people from
overpricing assets would cause a disease far worse than the putative
cure. Right now, I see no bread lines, but I agree that could
change -- but only if Robert Kuttner gets his way.

>    A second parallel is what today we would call securitization of
>    credit. Some people think this is a recent innovation, but in fact it
>    was the core technique that made possible the dangerous practices of
>    the 1920. Banks would originate and repackage highly speculative
>    loans, market them as securities through their retail networks, using
>    the prestigious brand name of the bank - e.g. Morgan or Chase - as a
>    proxy for the soundness of the security.

Modern securitization was created in the 1980s with the creation of
collaterlized mortgage obligations that separated prepayment and
default risk into multiple tranches. I am unaware of multi-tranch
securitized debt having existed before Solomon Brothers introduced the
first CMOs.

Overall, I'm unimpressed by Robert Kuttner's thesis on all this, and
quite unimpressed with his command of the facts.

Perry