Financial Flows and Regulation
By Arnold Kling
Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You’re doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.
If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren’t traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.
And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I’m afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I’m afraid they proved to be exactly correct.
I would feel better if Bernanke were less focused on how to “provide liquidity” and more focused on how to get the system deleveraged and more transparent.
I am a big fan of organized futures markets, so I agree with a lot of this. But I doubt that Bear’s counterparties were confident that it was too big to fail. Instead, they thought that in almost any reasonable state of the world Bear would be both solvent and liquid.
I don’t think you can regulate your way out of liquidity booms and busts. Let me formulate Kling’s Law of financial markets; During a boom, as risks premiums are falling, financial activity tends to flow out of the regulated sector. Instead, risks accumulate either in mis-regulated firms (think of the S&L’s around 1978-1981) or in unregulated firms.
I think that Ben Bernanke is making a reasonable contrarian speculative play, betting that the assets that he is buying are illiquid rather than insolvent. It turns out that his balance sheet is not all that large relative to the market, and now he seems to be looking for ways to expand it. I am not sure I trust any one institution that much.
I know this financial “crisis” is the sexiest thing in economics these days. But I would like to see something worse than a 5 percent unemployment rate before I expand the Fed or demand new forms of regulation.