Monday, January 26, 2009

Alan Blinder lists six sins that landed the US (and the rest) in mess

Princeton Professor Alan Blinder argues that the ongoing crisis is the result of "a series of avoidable human errors... recognizing and understanding (which) will help us fix the system so that it doesn’t malfunction so badly again... and we can do so without ending capitalism as we know it". He has outlined six sinful choices that contributed to building up and exacerbating the obngoing crisis

1. Wild and unregulated derivatives trading magnified the losses several times over and deepend the shocks on the financial markets.
2. Sky-high leverage, thanks to the permission accorded to securities firms by the SEC in 2004 to raise their leverage sharply. "Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1... under 33-to-1 leverage, a mere 3% decline in asset values wipes out a company"!
3. The sub-prime mortgage lending surged spectacularly in the 2004-07 period, as the bank regulators slept and more dangerously, "many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator".
4. Failing to act on the early flood of home foreclosures on grounds of "free-market ideology, denial and an unwillingness to commit taxpayer funds".
5. Letting Lehman Brothers collpase, especially after Bear Stearns, half its size, was rescued, was a "collosal error". "After Lehman went over the cliff, no financial institution seemed safe... lending froze, and the economy sank like a stone."
6. The deviation of the TARP, from its original proposal to buy the troubled assets of banks, to recapitalize them by direct cash injections, was the last major sin. He draws parallels with the markets for mortgage backed securities and commercial paper, both of which revived, atleast partially, in response to the Fed's direct purchases of these and the relaxation of lending standards against these assets.

For an alternate economic history of the world, as Prof Blinder writes - "if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed"!

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