Are Banks' Problems a Mortgage Meltdown? Or a Derivatives Meltdown? Two, Two, Two Excuses in One!

One thing I have learned after nine years in the corporate world, a few years consulting and 18 years teaching business in college is that it is difficult to understand someone else's business. In the recent discussion about a number of banks' financial problems I have heard that this was a "sub-prime crisis". The banks lent exhuberantly and to low income borrowers to whom they were pressured to lend, and the result was widespread defaults.

Today, the Belmont Club writes that the Washington Post now blames the banks' problems on derivatives trading. Which is it? Mortgages? Derivatives trading? I guess the banks, like the old Certs candy commercials, have two, two, two crises in one.

The Washington Post's familiar solution is of course regulation. But would regulators do a competent job? For regulation to work, the regulator must be smarter than the profit-maximizing investment banker. The question is whether reasonable, ethical, and profit maximizing bankers would have lost the money they have lost. If the answer is yes, then I'm not sure that regulators would have done much better. If the answer is no, then the problem is not regulation. Criminal, enforcement rather than better regulation is needed. Moreover, bankers already have a legal fiduciary duty to ensure the ongoing viability of their banks and to maximize profits. They obviously violated that "regulation". Why would a more esoteric form of regulation fare better? And why would government, which cannot even manage an election competently, be good at overseeing the esoteric world of credit swaps?

The pathology of Progressivism is that even where they do not understand the implications of their proposals, Progressives aggressively argue for them. The proposals inevitably involve expanding the state's powers, and the state then becomes the source of more severe problems than it solves. It is likely that the banks' current problems (and they are the banks' problems, not America's problems) are due to pressure from government, e.g., a form of regulation, to extend loans to low income borrowers who could not afford to repay the loans. Alternatively, and probably even more true, the problems are due to bad ethics on the bankers' part.

The article states:

"Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system."

The authors note that AIG suffered a loss due to derivatives, but they do not seem to know how much of a loss, just that it was attributable to $440 billion in mortgage swaps. Was three percent in default? Twenty percent? If AIG does not know, then why was AIG in the business? And if the reporters don't know, why do they claim to know what the solution is to a problem that they do not understand? I would not trust a physician who does not know whether I had a stomach virus or a heart attack and prescribes me medication anyway.

Markets are capable of evaluating and punishing banks that engage in excessively risky behavior better than regulators are at assessing what risks banks ought to take. Markets are attempting to do that, but President Bush and Congress have decided not to let the markets work and to let AIG and other financial institutions fail. If banks fail, the government ought to protect depositors, but they ought not to support incompetent investment decisions and bad ethics.

The media is discussing this issue without providing facts, and then offering specific solutions that are not based on evidence. Perhaps the Washington Post should provide their reporters with packs of Certs, and leave it at that.