Emailing About Whether We’ve Learned Anything From the Financial Crisis

An email exchange played out on my desktop that I thought readers might find interesting.  It started with Kristina Melomed (a former student of mine and a JD and MTax Candidate here at the University of Akron) passing on the following:

"Please find attached a chart showing the top 5 banks holding the largest percentage of credit default swaps, measured in outstanding notional amounts, as reported by the Office of the Comptroller of the Currency.  I was pretty excited to learn that the OCC releases reports on credit default swaps."

The chart can be found here: http://www.thesunshinereport.net/marksunshine/wp-content/uploads/2009/10/100609-0226-whoownsthed12.png

Another recipient of the email responded: "Staggering numbers.  If I'm understanding them, the banks, in the aggregate, have some 20 – 30 times as much derivatives as they do assets.  After what happened last year, it's hard to just trust that that's not a problem b/c they know what they're doing."

This prompted Professor Cohen to opine:

They don’t and it is.  FASB changed the accounting rules so we could ignore this problem for some time, but the toxic assets are still there (at least for now).  The banks will not be able to earn their way out of this mess (even with “free money”) and they still have defaults in CRE, credit cards, Alt-A mortgages, etc. to account for.  And the icing on the cake is that they are currently under-reserved, by most accounts.

I remain amazed that the American public is not completely outraged by the bank bailouts and all the policy measures and accommodations for Wall Street and the big banks.  This is not a political statement.  I don’t care who did it – in my view, it’s morally wrong and filled with moral hazard.  The worst part is that all these bailouts and accommodations will inhibit a recovery, not encourage one (as the Fed & others believe).  Politically, we are incapable of accepting short-term pain for longer-term concerns.  When a recession starts, we immediately work at overcoming it.  Recessions are a normal part of the business cycle – they are cleansing mechanisms.  The financial crisis involved systemic imbalances and misallocation of capital (as do our policies to deal with the crisis).  Instead of allowing the system to correct the imbalances (to be sure, a painful process), we work to overcome the crisis and interfere with the corrective process.  In fact, we have effectively maintained the imbalances (no doubt, as an unintended consequence – I hope – of our policies).

Interestingly, the New York Times DealBook Blog just posted a piece by Daniel Alpert of Westwood Capital entitled "Banking Lessons We Should Have Learned," wherein he noted that:

Some observers may (not incorrectly) point out that, despite some degree of recovery, certain, arguably systemically critical institutions simply cannot currently raise sufficient private capital to eliminate the true risks they pose to the financial system. After all, even today, the magnitude of potential losses to many institutional balance sheets is still too great — and, to an extent, unknowable.

Asset sales to raise capital may not be an option, given that many bank assets, held in excess of market value, are still on the books. . . .

Requiring banks to increase capital substantially will — assuming investors of equity capital are rational and wish to avoid future dilution — require banks to make greater provisions for troubled assets. . . .

We would argue that we are past the point of panic and that it is now time to take the necessary steps to recapitalize the most sickly of institutions on the backs of any of their stakeholders (owners and/or creditors), where this needs to occur.

Apparently, serious questions remain about whether we have really learned our lesson.