Financial Russian Roulette
By PAUL KRUGMAN
York Times' -- - Will the U.S. financial system
collapse today, or maybe over the next few days? I don’t think
so — but I’m nowhere near certain. You see, Lehman Brothers, a
major investment bank, is apparently about to go under. And
nobody knows what will happen next.
To understand the problem, you need to know that the old world
of banking, in which institutions housed in big marble buildings
accepted deposits and lent the money out to long-term clients,
has largely vanished, replaced by what is widely called the
“shadow banking system.” Depository banks, the guys in the
marble buildings, now play only a minor role in channeling funds
from savers to borrowers; most of the business of finance is
carried out through complex deals arranged by “nondepository”
institutions, institutions like the late lamented Bear Stearns —
The new system was supposed to do a better job of spreading and
reducing risk. But in the aftermath of the housing bust and the
resulting mortgage crisis, it seems apparent that risk wasn’t so
much reduced as hidden: all too many investors had no idea how
exposed they were.
And as the unknown unknowns have turned into known unknowns, the
system has been experiencing postmodern bank runs. These don’t
look like the old-fashioned version: with few exceptions, we’re
not talking about mobs of distraught depositors pounding on
closed bank doors. Instead, we’re talking about frantic phone
calls and mouse clicks, as financial players pull credit lines
and try to unwind counterparty risk. But the economic effects —
a freezing up of credit, a downward spiral in asset values — are
the same as those of the great bank runs of the 1930s.
And here’s the thing: The defenses set up to prevent a return of
those bank runs, mainly deposit insurance and access to credit
lines with the Federal Reserve, only protect the guys in the
marble buildings, who aren’t at the heart of the current crisis.
That creates the real possibility that 2008 could be 1931
Now, policy makers are aware of the risks — before he was given
responsibility for saving the world, Ben Bernanke was one of our
leading experts on the economics of the Great Depression. So
over the past year the Fed and the Treasury have orchestrated a
series of ad hoc rescue plans. Special credit lines with
unpronounceable acronyms were made available to nondepository
institutions. The Fed and the Treasury brokered a deal that
protected Bear’s counterparties — those on the other side of its
deals — though not its stockholders. And just last week the
Treasury seized control of Fannie Mae and Freddie Mac, the giant
government-sponsored mortgage lenders.
But the consequences of those rescues are making officials
nervous. For one thing, they’re taking big risks with taxpayer
money. For example, today much of the Fed’s portfolio is tied up
in loans backed by dubious collateral. Also, officials are
worried that their rescue efforts will encourage even more risky
behavior in the future. After all, it’s starting to look as if
the rule is heads you win, tails the taxpayers lose.
Which brings us to Lehman, which has suffered large
real-estate-related losses, and faces a crisis of confidence.
Like many financial institutions, Lehman has a huge balance
sheet — it owes vast sums, and is owed vast sums in return.
Trying to liquidate that balance sheet quickly could lead to
panic across the financial system. That’s why government
officials and private bankers have spent the weekend huddled at
the New York Fed, trying to put together a deal that would save
Lehman, or at least let it fail more slowly.
But Henry Paulson, the Treasury secretary, was adamant that he
wouldn’t sweeten the deal by putting more public funds on the
line. Many people thought he was bluffing. I was all ready to
start today’s column, “When life hands you Lehman, make Lehman
aid.” But there was no aid, and apparently no deal. Mr. Paulson
seems to be betting that the financial system — bolstered, it
must be said, by those special credit lines — can handle the
shock of a Lehman failure. We’ll find out soon whether he was
brave or foolish.
The real answer to the current problem would, of course, have
been to take preventive action before we reached this point.
Even leaving aside the obvious need to regulate the shadow
banking system — if institutions need to be rescued like banks,
they should be regulated like banks — why were we so unprepared
for this latest shock? When Bear went under, many people talked
about the need for a mechanism for “orderly liquidation” of
failing investment banks. Well, that was six months ago. Where’s
And so here we are, with Mr. Paulson apparently feeling that
playing Russian roulette with the U.S. financial system was his
best option. Yikes.
Copyright 2008 The New York Times Company
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