By Mark Bhasin, Palisades Financial
As U.S. policymakers attempt to navigate through America’s greatest financial and banking crisis since the Great Depression, the amount of regulation in America’s financial markets is becoming a major topic of discussion.
The current systemic financial crisis is a vicious circle between a contracting real economy and massive credit and financial losses feeding off each other in a downward spiral. This financial crisis will likely imply total credit losses of somewhere between $1 and $2 trillion.
Recent governmental intervention in America’s financial markets includes the bailout of the Bear Stearns creditors, the bailout of Fannie Mae and Freddie Mac, the use of the Fed balance sheet — hundreds of billions of safe and liquid U.S. Treasuries swapped for toxic illiquid private securities, the use of the other government sponsored enterprises’ to provide hundreds of billions of dollars of liquidity to distressed, illiquid and insolvent mortgage lenders, the creation of a new set of bailout facilities to prop up and rescue banks. Not to mention bailing out non-bank financial institutions, the bailout of AIG and a $700 billion U.S. rescue package.
These actions come from the most ideologically zealot free-market, laissez-faire administration in American history. The current administration was a great proponent of free markets and reducing government in financial affairs over the past eight years. However, the administration was such a proponent of free markets that they did not realize that financial markets without proper supervision and regulation are like Thomas Hobbes’ “state of nature” where greed and self-interest, untempered by fear of loss or of retribution, leads to credit and asset bubbles, manias and eventual devastating bust and panics.
In recent months, the demise of the primary broker-dealers such as Bear Stearns and Lehman Brothers has garnered many headlines. However, it is currently estimated that hundreds of small banks with massive exposure to real estate (the average small bank has 67 percent of its assets in real estate) will go bankrupt. In addition, dozens of large regional and national banks, such as IndyMac, will also likely go bankrupt. The continued deterioration of the housing sector (home prices have already dropped 12.5 percent nationally and may drop an additional 15 percent), real economy and credit markets will continue to adversely impact commercial real estate fundamentals and valuations.
Financial institutions such as banks have always been known to be different from industrial corporations. If an industrial corporation goes bankrupt, people lose jobs, shareholders get wiped out and creditors compete with each other for the assets of the corporation. However, the effects are generally contained to that company. Conversely, if a financial institution goes bankrupt, there is the potential for systemic risk.
Systemic risk is defined as “financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries.” It is risk which is common to an entire market and not to any individual entity or component thereof. Because systemic risk is common to the entire market, it can not be diversified away. In fact, typical asset correlations generally break down during times of systemic crisis and begin to approach one as a flight to quality/liquidity occurs. In other words, risky assets start to move in the same direction as diversification benefits are diminshed.
Regulation in the banking industry is primarily designed to prevent systemic risk. Because of the broad-reaching, systematic effects of a systemic crisis, it is sound public policy to have a well-regulated banking sector. The most important requirement in banking regulation is minimum capital ratios. The capital requirement sets a framework on how banks must handle their capital in relation to their assets. Capital is held in relation to the riskiness of the bank’s assets. Internationally, the Bank for International Settlements’ Basel Committee on Banking Supervision influences each country's capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords. The latest capital adequacy framework is commonly known as Basel II. This updated framework is intended to be more risk sensitive than the original, but is also a lot more complex.
Despite the massive problems faced by American banks and broker-dealers, some players in the real estate industry are positioning themselves to take advantage of the current financial and economic environment. Undoubtedly, it will be these companies who rise in years to come.