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Monday, June 15, 2009

Blog Posts that Don't Compute

Someone name Dr. Manhattan at The Atlantic's Business Blog, in a post entitled "Sentences that Don't Compute" says:

Today's entry comes from Mark Thoma, who writes in a guest-blog at the Washington Post:

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

Is Dr. Manhattan seriously arguing that the financial market troubles began in the traditional, regulated banking sector even though commercial banks with insured deposits are doing just fine, it's the other sectors that are in trouble? Yes he or she is:

...the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren't regulated by the Fed or FDIC cannot be called part of the "shadow banking system"), AIG (regulated by the state insurance commissioners...) ...

Here's why this is wrong. It defines sectors by institutions rather than by particular activities or products. Suppose there is a multi-product firm that produces products A and B, so it operates in two different sectors. Product A is heavily regulated, B is not regulated at all. If product B causes troubles, can we argue that ithis shows that the problems started in the regulated sector? That's what's being argued above.

For example, let's look at the AIG case a bit closer and see where they got into trouble, with the regulated or unregulated part of their business (I bet you can guess which it is):

Propping up a House of Cards, by Joe Nocera, NY Times: Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion ...

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities..., it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. ... When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. ... So when housing prices started falling, and losses started piling up, it had no way to pay them off. ...

So Dr. Manhattan's example proves my point, it was the unregulated component of AIG - the part operating within the shadow banking sector - that caused them problems. Thank you. The Dr. even cites Fannie and Freddie who, as has been well documented, followed the shadow sector down into the dumps when they began losing market share, in no sense did they lead the process. So the Fannie and Freddie example also proves the opposite case. Had the shadow sector been regulated in the same way that Fannie and Freddie were, that market share pressure would not have existed since the regulation would have taken away the advantage enjoyed by the unregulated banks, and Fannie and Freddie would have had no reason to follow the unregulated shadow banks downward.

Here's a simple rule to follow. If you are going to set yourself up as a critic, it's a good idea to have some idea what you're talking about.

Update: See also The Atlantic Monthly Crashes and Burns... by Brad DeLong for more on this.

    Posted by on Monday, June 15, 2009 at 05:48 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (20)


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