Causes and Remedies of Financial Market Meltdown

Will the financial markets stabilize after the U.S. Congress admits the unprecedented losses in the banking industry and creates a trillion dollars to bail out the failed banks? This loss was prognosticated in 2003.

The Congress is stunned. The U.S. capital is dazed with a feeling of wartime.

The U.S. faces a dilemma: (a) If the new money is not created, the banking system will collapse. (b) If the new money is created, the dollar will gradually sink in value. The new money is needed to avert a crisis, but perpetuate a government-sponsored moral hazard. With the new money, banks will continue to run away scot-free with massive sums through inflated salaries, perquisites and bonuses. Money and credit will continue to flow to people who are unable or unwilling to produce globally competitive goods and services. This process will continue to debilitate the American economy and weaken the dollar.

The best strategy is to take-over the failing banks and fix CEO salaries by an optimal compensation formula, while monitoring them closely and adopting a safe banking policy.

Sankarshan Acharya, September 19, 2008 

Two U.S. Senate Panels have just decided to investigate the taxpayer-backed Bear-Stearns bailout, as per NYT report published today.

It is not important whether or not the US Senate took note of my letter of March 17, 2008. It is important that the Senate will investigate the taxpayer bailout seriously.

The federal government has been following a policy to not let big banks fail, under its tacit too-big-to-fail policy.  The reason given is that big bank failures will cause systemic risk, panic and runs across all banks. 

The too-big-to-fail policy essentially permits big bank executives to gamble with government-taxpayer insured deposits to siphon off created book profits through fat pay checks, bonuses and perquisites until their banks are drained of all capital. 

At the end of a big bank's game, the government steps in to not let the big gambling bank fail by pumping taxpayers' money. 

In other words, the taxpayers support all those fat pay checks in the big banks.  Big banks do not really generate enough profits to pay those checks.  Taxpayers do. This is an insane policy.

A saner policy will be to bail out all the defaulting mortgages, which are the sources of the problems for banks, capital markets and neighborhoods succumbing to declining prices of homes on foreclosure.

Sankarshan Acharya, March 25, 2008 

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I had sent a market-based safe banking policy proposal to the U.S. Congress in 2003, prognosticating then about an impending home mortgage debt crisis brewing under the veneer of government-hooted economic growth.  The very basis of my prediction then of the current depression-like catastrophe gripping USA (maybe the rest of the world too) is the exact cause now known to the U.S. Congress (thanks to my writings to them) for the unprecedented meltdown in the banking and financial markets.  The following letter highlights the causes and remedies of the current financial market meltdown, in contrast with today's New York Times analysis of the financial monster.

Sankarshan Acharya, March 23, 2008 

March 17, 2008

President of USA
Senator John McCain
Senator Hillary Clinton
Senator Barack Obama
Senator Charles Schumer
Senator Chris Dodd
Secretary of the Treasury
Chairman of Federal Reserve Board

Sub: Taxpayer Bailout of Banks is an Ineffective National Strategy.

A taxpayer bailout of banks may seem to be an unavoidable strategy needed to thwart a rapidly deteriorating financial market meltdown.  But bank bailouts will only exacerbate the financial depression facing American households because the intrinsic problems causing such meltdowns remain unresolved. 

The U.S. Congress will unanimously agree that an ineffective national policy strategy is one which creates new money for those ventures or individuals who cannot produce globally competitive goods and services. Such a strategy weakens competitiveness by dampening net exports and foreign exchange reserves of a nation.

Bank managers have gambled through their firewalled hedge-funds, including conduits and trusts, to create short-term profits to take exorbitant pays, perquisites and privileges.  The hedge funds use their lopsided advantage of borrowing massively the taxpayer insured deposits in parent banks to upstage the financial markets to rob taxpayers’ pension plans.  The gamblers make billions through such unseemly means.  But they destroy institutions and savings of the vast majority of taxpayers who are effective in producing globally competitive goods and services.  The usurious profits of hedge funds are really insignificant as compared to the financial havoc wrought on the effective taxpayers: hundreds of billions of dollars wiped out of pension plans and enormous residual risks piled within insured banks. 

The hedge fund managers are truly ineffective for a nation.  Creating new money for such ineffective gamblers is an ineffective national strategy that the vast majority will never support in a democratic nation.[1]  Such money creation will irreparably erode any remaining trust in the dollar.  It will further undermine dollar holdings and incomes of the American households.  Sovereign nations may pull out their reserves held in Federal Reserve Bank of New York. 

The principal intrinsic cause of meltdown is regulatory facilitation of firewalled subsidiaries like conduits, trusts and master trusts to operate as hedge funds by borrowing heavily from the parent bank’s insured deposits and by subverting the minimum capital requirements on a consolidated basis. 

I had prognosticated the financial meltdown in my safe banking policy paper, sent to all U.S. Senators in 2003.  Had the safe banking policy proposal been enacted timely, the current crisis could have been preemptively avoided.  This policy should be enacted even now, and urgently, to avert continual banking crises.  The current government banking policy is an ineffective national policy strategy. 

After receiving my safe banking paper in 2003, the U.S. Congress had asked the then Federal Reserve Chairman to testify on safety and soundness of the banking system and the Fed too had a system-wide conference on the issue.  The conclusion of banking economists then was that the system was safe and sound.  It was obvious to me that the conclusion of banking economics profession was flawed. The flaw was due to lack of analysis of the real-world banking. [2]  I am raising this issue humbly to not score any point, but to simply argue that no implicit or explicit taxpayer bailout of banks should be contemplated because analysis of the fundamentals show that they are ineffective national public policies. 

As someone with decades of research on moral hazard, adverse selection and regulatory policy formulation, I had come to an analytical conclusion in 2003 of a brewing financial meltdown, sans the safe banking policy.[3]   My conclusion in 2003 has unfolded accurately.  I have now extended the analysis in a new article, “Safe Banking to Avoid Moral Hazard,” which is forthcoming in the Journal of Risk Management in Financial Institutions.[4]

Many large bank holding companies have simply subverted the minimum regulatory capital standards by not meeting them on a consolidated basis.  They have thus increased their leverages enormously, as compared to more capital-conservative banks.

Furthermore, the hedge funds and their parent banks lost heavily due to an unexpected global financial tsunami unleashed by unsuccessful U.S. government policies:

·         The U.S. policymakers perhaps prepared for WW-III in the wake of 9-11.  They built up petroleum reserves and invaded Iraq to take control over global oilfields.

·         Crude oil price skyrocketed due to the new demand for oil for the war plan. 

·         Excessive money was inefficiently created to build weapons for the war.

·         The war has not been won so far, despite a cost of about $1 trillion.  At 5% rate of interest, the interest cost is a staggering $50 billion per year.  Even if every drop of oil produced by Iraq could be usurped by the U.S. Treasury, hypothetically, the income from it would be very little compared to the perpetual loss of $50 billion per year. 

·         The war strategy thus amounts to printing a debilitating currency to wage battles.  But this makes oil producing rival nations wealthier and American households bankrupt.  

·         Though Western oil barons and defense contractors benefited from war strategy, their counterparts in rival nations became super rich.  The export powerhouse of China could not be subdued either.  The oil producing rivals engaged the Western hedge funds, short-selling commodities, to push the crude oil prices even further.  Some long-side Western funds and oil barons profited enormously.  But many other hedge funds simply lost their capitals.

·         Rising commodity prices prompted the Federal Reserve to raise interest rates.  This made homes unaffordable and prices of homes fall.  Falling home prices adversely impacted banks and sub-prime mortgage based hedge funds.

·         The vast majority of American households lost tremendously because their jobs were outsourced overseas or cannibalized within USA.  The equity values of their homes eroded dramatically.    

The strategy to capture oilfields is optimal only if the U.S. remains steadfastly benevolent for humanity.  The war strategy has not succeeded because of a failure to buttress the three pillars of American national competitiveness:

·         Increasing production of globally competitive goods and services.

·         Raising foreign exchange reserves.

·         Cooling down the hubris of leaders, corporate CEOs, media and think-tanks.

My analysis leads to the following specific government policies to strengthen American national competitiveness:

·         Pull out military deployments from other countries, but create a global front against terrorism.  This is the only effective national strategy that a dispassionate thinker can envision in the best interest of USA with a goal to serve long-run interest of humanity.   

·         Drastically cut the size of federal, state and local governments.

·         Revise the tax structure to cut budget deficits.  The current tax cuts for the upper bracket constitute an ineffective national strategy, unless they have proven to raise the production of globally competitive goods and services.  Such tax cuts are simply new credits created for an ineffective fringe through extra obligations on the vast majority of the current and future generations.  The majority will never not support ineffective tax cuts in a democracy.

·         Make the maximum CEO pay a reasonable multiple, say ten times, of the average employee wage.  The U.S. President receives about ten times of the average household compensation.  The newly created money has been gravitating to the individuals who are ineffective in producing globally competitive goods and services and are eroding national competitiveness.  This is a main factor for decimation of home prices and for meltdown in financial and building sectors.  Jobs of many high earners, especially in California, were cannibalized or outsourced. These individuals may be the talented Asians, East Europeans or even Americans who chose to relocate overseas by selling off or surrendering their possessions in USA.  A limit on CEO compensation is in the best national interest, as argued in a recent paper.[5]

·         Allocate federal, state and local budgets to ventures that produce globally competitive goods and services.

·         Ban short-selling of financial securities.  The practice of short selling of financial securities is illegal under the current corporate law.  It is also sub-optimal.[6]

·         Enact market-based safe banking policy.  This will prevent taxpayer bailouts of banks, while offering safe banking service to panic-prone savers.

·         Repeal the law on protection of patent rights. This will facilitate the emergence of more efficient producers of globally competitive goods and services.

 

With profound regards,

Sankarshan Acharya