“In the past ten years, the field of money, banking, and financial markets has become one of the most exciting in all of economics. Financial markets are changing rapidly, with new financial instruments appearing almost every day; the once staid banking industry is now highly dynamic, with the distinction between commercial banks and other financial institutions becoming increasingly blurred.”
Frederic Mishkin, Professor of Economics, Columbia University, The Economics of Money, Banking & Financial Markets, 2nd Edition, 1989
MIshkin was a former Member of the Federal Reserve Board of Governors from 2006 to 2008.
In 1990, I was a sophomore at a small liberal arts college in Salem, Oregon. Money and Banking was a second level course for students majoring in economics. The topic that dominated economic lectures during my time in college was the Savings & Loan Bailout. Thousands of small banks were seized and subsequently liquidated by the federal government. At the same time, one of the largest bank in the United States, was teetering near insolvency due to soured loans in emerging markets and commercial real estate. (Financial crises are like movie sequels -- the same characters and a slightly modified plot line.)
Roughly two pages of Professor Mishkin’s 500-page textbook published in 1989 are devoted to the subject of securitization. Securitization is the very much the root of the troubles facing today’s financial system. Professor Mishkin described securitization as the process of transforming otherwise illiquid financial assets into marketable capital market instruments.
Securitization was born in the 1970s, but in the 1980’s it gained momentum. Little did Professor Mishkin know that securitization would eventually bring the global financial system to a standstill. Ironically, 20 years later, these illiquid assets have been transformed, but into instruments that are still illiquid. These assets are more commonly know as toxic assets that sit on balance sheets of our biggest banks.
The problem facing Timothy Geitner, our new Treasury Secretary, and it is the same problem that faced former Treasury Secretary, Hank Paulson, is that banks believe these securitized instruments are worth far more than the market is currently willing to pay. Since no one will pay the banks what they are asking, these instruments cannot be converted to cash to loan out to borrowers, or pay out depositors if there was a run on these banks.
If we are to get the financial system working again, this problem must be resolved and it seems likely that the Federal Government will have to put taxpayer money at risk to create liquidity. If the government does nothing, the economy may spiral into a deflationary depression. And if government does something, we still have a very nasty recession and the taxpayers may be stuck with a substantial loss. But addressing the problem in a timely manner may pave the way to a stronger and more stable financial system in the future.
Written by Jason McMillen, Chief Investment Strategist, PPWM
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