Markus K. Brunnermeier claims that the the extent of securitization, which led to an opaque web of interconnected obligations, and leverage, which magnified the losses, have bene characterisitc of the present financial market crisis. He identifies four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets, starting with increase in mortgage delinquencies due to a nationwide decline in housing prices.
First, as asset prices dropped, the massive bad loan write-downs on borrowers’ balance sheets caused two "liquidity spirals" - financial institutions' capital declined and had a harder time borrowing because of tightened lending standards. The two spirals forced a massive chain of deleveraging. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.
Second, lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. Third, runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.
Fourth, the mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties’ credit, liquidity gridlock can result.
Raghuram Rajan and Douglas Diamond find three proximate causes - the US financial sector mis-allocated resources to real estate, financed through the issuance of exotic new financial instruments; a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets(originate-to-securitize); and these investments were largely financed with short-term debt.
Recognizing the critical challenge as that of enabling the removal of all the illiquid assets from the balance sheets of both banks and non-banks, they offer three possible suggestions. First, "the authorities can offer to buy illiquid assets through auctions and house them in a federal entity, much as was envisaged in the original TARP". Second, "the recapitalization of entities that have a realistic possibility of survival, and the merger or closure of those that do not. This would mean moving illiquid assets, of those entities closed down, into a holding entity that will dispose them off slowly over time."
The "third approach is some mix of the first two, where the authorities buy illiquid assets, even while cleaning up the regulated financial sector, focusing particularly on resolving entities that are likely to become distressed".
The problem with the approaches adopted by the Obama administration is that they treat the issue in parts, thereby leaving other parts of the crisis-ridden market un-repaired. The fundamental issue is that till all the toxic assets are cleansed out of the system and the market apprehensions about counter-party risks cleared, there is little chance that banks will lend and investors will invest. In other words, any approach to come out of the credit crunch has to be a comprehensive solution, covering all financial instruments and all institutions/agents (including the "shadow banking" system), and which removes all traces of illiquid assets overhang.
Unfortunately none of the approaches, including the third suggested by Rajan and Diamond, may help achieve the desired objective of restoring confidence and normalcy back. The extent and depth of the crisis is such that the only solution appears to be to subject all balance sheets to some evaluatory "stress tests", declare those insolvent and seize them, clean out stockholders, remove or shuffle its top management, pay off some of the debt, inject some equity, and re-privatize the entity. Siphon off the worst assets into a so-called bad bank (like the RTC) — pooling them with toxic assets from other nationalized banks, and hope they have some value after the crisis blows over. Call it "bankruptcy-receivership" or "nationalization", the substance of the aforementioned may be unavoidable!
(HT: Freakonomics)
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