J'A' Kregel Senior Scholar, Levy Economics Institute of Bard College, Distinguished Research Profess

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J.A. KregelSenior Scholar, Levy Economics
Institute of Bard College, Distinguished Research
Professor, Center for Full Employment and Price
Stability, University of Missouri, Kansas City
and Professor of the Finance and Development,
Tallinn University of Technology
The Natural Instability of Financial Markets

• Presentation prepared for the Tjalling C.
  Koopmans Institute Conference The Political
  Economy of Financial Markets - A methodological
  account of a multi-disciplinary approach
  Utrecht, November 16, 2007.

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What is Financial Instability?

• Two Alternative Economic Approaches
• Simultaneous exchange Catalactics
• Intertemportal exchange Spot-Forward Swaps

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Catalactics

• Study of market exchange
• Supply and demand by reference of a behavioural
  ideal rational economic man.
• Efficient markets hypothesis -- any and all
  information required for rational economic
  decisions is reflected in market prices.
• One important drawback.
• Ronald Coase there is no explanation of the
  creations of markets themselves.
• Individuals who work in financial markets do not
  believe in the operation of the efficient market
  hypothesis..

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Time Trades

• Exchange as time transactions -- a commitment to
  do something today against the promised future
  commitment
• Applies to both real and financial transactions.
• consumption
• production and Investment
• financial transactions -- exchange of money
  today based on the expectation of the receipt of
  money in the future.
• Expectation of future events determine present
  decisions.
• Only if expectations are correct in their
  forecast of future conditions will the future
  transactions take place.
• It is thus only natural that in the real economy
  expectations should be disappointed and future
  commitments should not be honoured.

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How to Ensure Completion

• Complete Markets for transactions in all future
  states and dates to allow hedging of completion
  failure
• Prudential Market Regulation
• Robbins and the Classics
• the pursuit of self-interest unrestrained by
  suitable institutions, carries no guarantee of
  anything except chaos.

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Instability is caused by

• Failure to Complete Future Transactions
• Explanations
• Absence of Sufficiently Complete Markets
• Regulation Failure

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Alternative View

• Hyman Minskys Financial Instability Hypothesis
• Increasing fragility is endogenous
• You cannot prevent it even by regulation
• Declining Cushions of Safety as perception of
  risk changes with positive experience of
  transaction completion
• Increasing complexity and layering of financial
  transactions
• Change in Expected Conditions makes it impossible
  to complete transactions
• To meet transactions commitment -- Sell Position
  to Make Position Debt Deflation
• In the 1960s and 1970s prevented by
• Big Government Countercyclical Fiscal Policy
• Big Bank Lender of Last Resort

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Can Minsky Explain the Current Financial Market
Crisis?

• Background
• Falling share of assets in Commercial Banks
• Shift from Credit Assessment Banking based on Net
  Interest Margin to proprietary trading, asset
  management for fees and commissions
• Section 20 exceptions allow affilliates
• 1999 Gramm-Leach-Bliley Removes Glass-Steagall
  Restriction on Commercial Banks
• Commercial Banks create affiliates to provide
  capital market services
• Basle Reinforces the move to fees and commission
• After Collapse of the .Com Bubble, investors move
  into real estate, banks provide the lending

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The Mortgage Mess

• Independent Originators
• Bank Originations and Securitisation of mortgage
  Assets
• Underwriting CMO, RMDS based on rating arbitrage
• Structured Investment Vehicles
• Maturity Mismatching
• Credit Rating Agencies (NRSROs)
• Conforming Loans (to GSEs (Freddy Mac, Fannie
  Mae)
• Non-Conforming Loans
• Prime, Alt-A, Sub-Prime
• Hedge Funds

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Collateralised Obligations underwritten by Banks

• Assets Pool of Non-Conforming Mortgages
• Liabilities
• Senior Securities
• Cushion of Safety from Over collaterlisation
  right to more that their proportion of income
  from mortgages
• Rated Investment Grade via statistical model
• Often held by bank originator
• -- Residual Securities
• Take what is left high risk sold to hedge
  funds
• Credit enhancement
• Credit Derivative
• Monoline Insurer Guarantee
• Implicit Guarantee from Originator

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Structured Investment Vehicles underwritten by
Banks

• Assets
• Collateralised Mortgages, other structured
  Product
• Credit Enhancement
• Bank Guarantee to Commercial Paper
• Monoline
• Credit Default Swaps
• Liabilities
• Asset Backed Commercial Paper
• Equity Notes
• Leverage

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The Corpus Assets

• Non-conforming Loans Alt-A, Sub Prime
• Non-Standard Documentation -- NINJA
• No Income documentation
• No Job
• No wealth
• ARM Adjustable Rate Terms
• 2-28 2-27, low interest only first x years, then
  reset
• IO Balloon Interest Only, Principal after X
  years
• Second Lien
• Investment- Speculation

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Payoff for Sub Prime

• Requires
• House prices continue to rise
• Interest rates continue to fall
• Economy Continues to Perform
• Sub Prime Loans are Ponzi Investments
• Senior Investment Grade Tranch of CDOs are just
  credit enhanced Sub-Prime Loans
• CRAs only rate the probability of default of a
  CDO or SIV, not its liquidity

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Minsky Mortgage Cocktail

• Declining Cushions of Safety in the CDOs
• Higher Leverage in SIVs
• Small Statistical Series to Rate payment
  performance of Sub-Primes
• Banks exposed through guarantees to
• CDOs
• SIVs
• Warehoused mortgages
• Prime Brokerage Loans to Hedge Funds holding
  Toxic Tranches of CDOs
• Falling House Prices
• Sub-Prime Resents
• Economic Slowdown
• Banks cant lend to support prices Capital
  Ratios
• Banks cant sell assets loss of rating and
  covenant to call collateral