Lawrence Hillibrand is a well-known, experienced, and highly intelligent financier. He sent me a very interesting email on May 22 commenting on my book A Failure of Capitalism. He makes several points, some critical, all insightful. I quote the message in full, and then respond briefly to his points. I number his paragraphs to make my response clearer:
"1. At its broadest level I [i.e., Hilibrand] agree with the thesis that the process of credit extension has pro-cyclical features which create inherent vulnerability to financial disruption. The key question left largely unconsidered is why severe regional disruptions in the "rust belt", "oil patch", and Boston areas in the 1980s and 1990s did not trigger similar adverse outcomes, even though they resulted in the insolvency of significant parts of the regional financial industry. My own view would be that the key distinction is that in this case most of our mega-institutions (and those elsewhere in the world) are under severe stress when in the earlier cases they were not. It would be interesting to know how the crisis would have played out had virtually all of our mega-institutions been very solid. If this is the key difference, perhaps the major response to the crisis should be the enactment of much stricter capital rules for the mega-institutions. I think the discussion about poor incentives inside financial institutions is taken too far. It is worth remembering that two of the major casualties of 2008, Bear Stearns and Lehman Brothers, were distinguished from much of the industry by their higher than normal internal ownership. I think the biggest shortcoming in the thinking of market players was a tremendous underestimate of the characteristics of extreme scenarios. I think this is a common finding of behavioral economics research and was made just that much more extreme by a sustained period of prosperity. I think you are right that taking excess risk has the externality of increasing the risk of widespread credit stress, but as suggested above maintaining stability in the mega-institutions may reduce these effects tremendously.
"2.The discussion of credit default swaps could be improved a little. I would describe credit insurance as an innovation which segregates the risk-bearing function from the liquidity providing function of a lender. As such it opens up tremendous competition in lending and is (properly managed) a pro-competitive innovation. If the standard credit terms for the product include a daily mark-to-market, the collateralization process for these contracts protects the buyer against everything but the movement from the time of the last collateral call. The decisive error in the cases of AIG and the bond insurers (MBIA, Ambac, etc) was market willingness to purchase insurance from these parties without any collateralization in light of their AAA rating. This led to immense uncollateralized exposure in the present scenario, but if mark-to-market had been maintained throughout, the collateral demands would have built over time. More likely the need to post collateral on a continuous basis would have led the insurers to reconsider their actions. I also believe that much of the credit default activity is not easily converted to exchange-traded form (which is best for situations with highly concentrated trading in select instruments).
"3. I think I would also take mild exception to the use of the term depression. The most common standard I have seen for this is a decline in per capita GDP of more than 10%. This is vaguely equivalent to a one decade setback in the advance of living standards. Current consensus has the US experiencing an ultimate decline of about half this magnitude (and major foreign economies also remaining below the threshold). It is true that recent events have provoked far more dramatic intervention and perhaps reoriented policy regimes much more than anything since the Great Depression, but this makes the events more of a political revolution than depression in my view.
"4. I think your discussion is too pessimistic in describing the status of the banking system. If we demand that banks auction their assets over the next year, I accept that a large fraction will be unable to repay all their liabilities, but this condition is probably common for the banking system at the trough of an economic cycle. I believe that most banks (and more importantly most large banks) have capital and expected earning power more than adequate to absorb the losses under some relatively adverse conditions. Similarly I believe the TARP funds are treated too much as an expenditure and not enough as a loan which will be paid back with interest over the next few years. Regrettably, TARP is migrating into a support for unstable institutions rather than a decisive vote of confidence in stable entities. This may have the effect of changing TARP into the massive expenditure and restraint on useful market forces that has enraged so many. I want to acknowledge that your book "went to bed" during the first quarter when the picture did not look as positive as I express.
"5. If I could offer one important theme that failed to get appropriate consideration in your book it is that markets are adaptive, as market players work hard to understand and integrate recent events into their business strategies, whereas governments have much more difficulty adjusting their approaches to changing conditions. As we weigh regulatory against market responses to recent events I believe this deserves some consideration."
Now for my (Posner's) response:
1. I agree that internal management issues (e.g., compensation) were a secondary factor in the financial crisis. The main factor was the bursting of the housing bubble and resulting dive in housing prices, mortgage financing being a huge industry in which the banking industry (including nonbank banks) was very heavily invested. It would have helped if the industry had had more capital; Lehman Brothers for example would have been well advised to raise additional equity capital in the spring of 2008, as it could have done. How much additional capital the industry would have needed in order to weather the storm, however, I do not know.
I am not sure how important underestimation of extreme scenarios was. An alternative theory that I lean to is that the risk of bankruptcy as a result of the extreme riskiness of banking practices in the 2000s was correctly thought by the banks' managements to be small, but of course small risks do sometimes materialize. It is rational for a firm to assume a small risk of bankruptcy, since limited liability truncates the downside.
2. I agree that credit default swaps are a good thing and not the villain. But I am not sure that greater collateral or (as in other insurance markets) reserves or reinsurance would have made a decisive difference. Insurance, including credit insurance, is intended to protect against uncorrelated risks. Correlated risks (such as a forest fire that consumed the entire state of California) will break pretty much any insurer. I would like to see an estimate of how much collateral or reserves AIG would have needed to avoid ruination.
3. Regarding the use of the word "depression" to describe our current economic situation: unemployment and even diminished output are only two conssequences of an economic downturn. Others include political consequences that can be of far-reaching economic significance--think of the New Deal. Also, in my book and subsequent writing I have emphasized the danger of an "aftershock"--deferred costs of combating the downturn, costs that may include future inflation, devaluation, heavy taxes, increased dependence on foreign lenders, and corrective recessions, like the Volcker recession that broke the 1970s inflation.
4. The banking industry has been saved from insolvency by the massive bailouts and the Federal Reserve's "easy money" (low interest rate) policies, but bank lending has actually declined since last fall. The banks are hoarding--their excess reserves (lendable cash that is sitting in the banks' accounts with the federal reserve banks) were $844 billion at last count. Demand for loans is down, and default risk is high. These may now be bigger reasons than undercapitalization for the banks' light lending. In addition, they may be facing additional hits this summer from credit card and mortgage defaults.
5. The point about the superior speed of business adaptation compared to governmental is very important. Another way to put the point, with particular reference to the present situation in financial regulation, is that regulation lags innovation. New financial instruments, practices, and structures emerge continuously, some in specific adaptation to (or circumvention of) regulatory policies. That is one reason I am pessimistic that there will be effective "re-regulation" of the financial industry in response to the current depression.