A Simplified Explanation - And Novel Solution - to Preventing the Recurrence of the Credit Crisis

With all of the "Fixes" for the Credit Crisis still underway, most people still don't understood how the market failed to create safeguards for itself.  Fed Chairman Bernanke attributed the crisis to a market failure, but how can a market fail, unless there are undue influences?  The influence, ironically, was a flight to safety itself.  The mechanics of how unsafe investments were transformed into "safe investments" is now well understood, but it was the demand for safety, itself, that created the crisis.  The solution, it turns out, is the government guaranteeing as much cash as it can (by borrowing) regardless of whether it is willing to. 

Zoltan Pozsar, a visiting scholar at the IMF, shows that the shadow system was fueled by institutional investors looking for a safe place to park large amounts of cash. There weren't enough short-term Treasuries to fill demand, nor were there enough banks to store the money in amounts below the FDIC insurance limit. So the investors found their cash-storage facilities at one end of the shadow banking system's "risk-stripping" assembly line.

At the other end was the by now well-known process in which pools of questionable loans were repackaged into triple-A securities (what Pozsar calls "credit transformation"). Said securities were then placed into investment vehicles funded with short-term instruments like repos and asset-backed commercial paper ("maturity transformation"). And those instruments were then placed in money market funds one could write checks against ("liquidity transformation").

The resulting "privately guaranteed instruments" ended up being the government's problem when the crisis hit, Pozsar writes; the shadow banking system's short-term obligations "were guaranteed by insured banks and hence ultimately the sovereign (whether via central bank backstops or equity injections)." So why not just accommodate the demand for a safe haven by having the government write more of its own IOUs? Pozsar acknowledges the obvious objection - that this "would increase rollover risks and the variability of interest expenses for the US Treasury." But he submits that the "externality," or cost to society, would be less than risking another crisis.

Sourced by American Banker Newsletter