The Paulson Delimma

I recently viewed an excellent "Frontline" program which detailed the events of late '07, '08 and early '09 related to the financial crisis and the onset of recession. In that show, they highlighted the irony of Secretary Paulson, whose career at Goldman was a testament to the free market system, announcing one Government intervention after another. In the press conferences at which he announced the steps, he always expressed his discomfort with the steps and a concern about creating moral hazard, and yet he took the steps (so contrary to his economic philosophy) because he felt forced by events to protect the financial system from even greater collapse, i.e. he perceived "systemic risk".

This started me thinking. Are free market financial systems doomed to bring about their own destruction (i.e. Government takeover)? If a free marketeer like Paulson feels compelled to take drastic action, amounting to a partial nationalization of the entire banking (and investment banking) system, how will a free market system ever survive or re-emerge?

Let's start at the beginning. What created the circumstances which gave rise to the systemic risk? Was it Government action, regulation, or the free market system? I think the answer is all of the above. Certainly Government action, for example in the creation of Fannie and Freddie, and the subsequent political and legislative pressure to accept mortgages from people with lower incomes and weaker credit ratings, contributed enormously. But even without the contributing role of Government, the free market is capable of producing the circumstances that render the system vulnerable to a "systemic risk" cascade of failures triggered by a single negative event. This is proven by the history of numerous prior financial collapses (or, as they are more charmingly referred to in history, panics).

Why and how does the free market produce such events? I think there are two basic reasons.

Firstly, in the financial markets, in normal times, the taking of risk is rewarded, and the taking of greater risk is rewarded more. In a competitive system, the institutions that make a higher return on their capital tend to attract more capital, more talented staff and more of the market. Firms that have internal policies which, for reasons of risk management, prevent the firm from fully participating in the more risky business tend to lose out, over time. For this reason, the longer the good times roll, the riskier the aggregate portfolio of the market. In other words, the longer the good times roll, the more vulnerable each institution is to unusual negative conditions.

Let me digress on the subject of "risk management" for a moment. The most basic form of risk management is the retention of excess capital. However, idle capital is very expensive. Accordingly, managers are always seeking ways of managing their risk through less expensive means. Other means include:
1. internal standards for competence and honesty of employees,
2. diversification and
3. limits on the total exposure in various areas of activity, or to various types of risk, or to particular geographic areas or particular individual credits.

Number 1 is hard to execute and impossible to measure and constrains expansion (since the pool of available prospective employees is more elite and therefor smaller). Numbers 2 and 3 are based on the reasonable, but not infallible, assumption that when things go bad, they don't go bad everywhere all at once.

Secondly, free markets, like free trade, tends to reward specialization, which increases interdependence. In a competitive, profit-oriented system, individual members will concentrate on what they know produces the highest return, and to contract with others for their other needs. For example, most firms need insurance. They can satisfy that need through self-insurance (resulting in increased reserve capital). However, most firms reach the conclusion that it is more efficient to buy insurance from those who specialize in it and who offer the most competitive rates.

A fourth way to manage risk, which has emerged in the last business cycle, is to insure against the various risks sitting on the balance sheet. These insurance policies are called "credit default swaps". If those who measure your financial condition (regulators, credit rating agencies and the market place for your debt) accept that the insurance effectively eliminates the risk insured, they will accept that you can re-use the capital otherwise tied up in those risks and you can treat those risks as nonexistent, for purposes of your various risk limits. In reality, all the firm has done is exchange the risk of default of the underlying counterparty for the risk of default of the insurer.

Credit default swaps allow firms to become massively overexposed to certain risks (looking at their gross actual portfolio) by notionally removing risks from their balance sheet. These massive over exposures (vulnerabilities) suddenly pop back on to the the balance sheet if the insurance evaporates. The insurance evaporates if the insurer defaults (Lehman), and effectively evaporates if the market perceives the insurer as vulnerable to collapse (AIG).

So, to recap, it is the natural consequence of free financial marketns to create massive interdependence and to increase in vulnerability the longer the good times roll. Interdependence and vulnerability produce systemic risk.

From this it would seem inevitable that free financial markets will produce systemic collapse. If we further assume that no administration, whether it be conservative (the Paulson delimma) or liberal, can stand by and watch such a series of events unfold without intervening, we would seem to have demonstrated that free financial markets inevitably tend, over time, to be subjected to ever increasing government intervention.

Does this mean that free financial markets are doomed to disappear? I don't think so. I will attempt to demonstrate this in the next posting.