Posner's A Failure of Capitalism -- III

In the second chapter of Failure, Judge Posner enlarges upon his discussion in chapter one about how the current depression particularly involved the financial industry. Throughout the book, he uses "banks" to refer to all financial-intermediary firms, because by the 2000s, the regulatory restrictions on what non-bank intermediaries could do had been so eroded that they were all involved in "banking."

He recounts the rise of securitization of mortgage obligations -- how interests in baskets of mortgages were sold far and wide -- although he believes that securitization may not have been integral to this depression. He also explains (i) credit default swaps, which banks entered into in a (not irrational) effort to insure against losses on their mortgage and mortgage-securities holdings, and (ii) that insurers and credit-rating agencies lacked the history of dealing with these products in order to realistically calculate their riskiness.

When the housing bubble burst and credit froze, the Fed initially believed that banks were afraid to lend because their mortgage-related assets were illiquid. They were illiquid (not readily salable) because, it was thought, no one was confident of their precise value. The Fed's initial plan was therefore to buy the illiquid assets. However, it soon became evident that the problem was not merely uncertainty about the assets' value, but an absolute lack of value in such assets. In other words, the value of the mortgage-related assets was in fact very low.

The Fed then changed its plan. Instead of buying the mortgage-related assets, it would invest directly in the banks in exchange for preferred stock. The hope was that the cash invested by the Fed would then be loaned out, unfreezing credit. However, banks were so overleveraged, that a lot of the invested cash had to be retained simply to get the banks solvent (in banking terms), before any thought could be given to loaning some of it out. The Fed tried to persuade banks to lend rather than "hoard" the invested cash, but banks' problems were simply too great at that point.

Along the way, Judge Posner explains the policy behind some of the older banking regulations. Put very simply, banks stay in business by loaning out a large portion of the funds deposited with them. Thus, if all of a bank's depositors simultaneously decided to withdraw their deposits, the bank would fail -- it could not meet all such demands at once. Federal deposit insurance (under the FDIC) was created by the federal government in order to assure depositors that their deposits, up to a certain amount, would be safe even if the bank failed. This removed the incentive of despositors to "run" on the bank in order to get first dibs on the limited funds whenever a bank was rumored to be in trouble.

Next, in order to keep the now-insured banks from taking excessive risks with depositors' money on the Fed's dime (a "moral hazard" problem), regulations were imposed on the banks. Such regulations required that banks not make as risky loans -- and so offer as high interest rates -- as non-bank intermediaries could. Therefore, non-bank intermediaries had to be kept from taking advantage of the limits on banks and thereby drawing deposits into uninsured accounts. Accordingly, additional regulations put in place to prevent non-bank intermediaries from encroaching on the functions of banks.