killer buffalo

When Americans learned last September that AIG had miscalculated the risk for—and therefore mispriced—$441 billion of credit-default swaps (CDSs), they fought the Federal Reserve’s plans to bail out the company.  Although Reserve Chairman Ben Bernanke went on to give AIG a $123 billion loan, he told then Treasury Secretary Hank Paulson that “we can’t keep doing this.”

Eight months later Harvard University’s Oliver Hart and University of Chicago’s Luigi Zingales want to use CDS prices—from AIG and companies like it—to dictate the total reserves banks are required to keep on hand.

Yet in their rush for the tenure that could follow a successful bid at controversy, the two professors seem to have avoided making a legitimate case for their brand of financial industry reform, instead vying for a geography lesson on the distance between Wall Street and the University of Chicago.  That distance, in miles 710, appears to be larger in economics.

Mr Hart and Mr Zingales suggest that government regulators use the price of CDSs on banks—a measure of banks’ perceived health—as trigger mechanism for intervention.  Their argument for doing so rests on the doctrine that private investors can better interpret risk and reflect it in CDS prices than the government can in looking at bank reserves and fundamentals.

But the Dow Jones reaching thirteen-thousand points, even after the subprime mortgage crisis started in 2007, and results from Federal Reserve’s “stress tests” only partially being released to the public suggest that private investors lack the expertise and the information to judge the risk of bank defaults on both macro- and micro-economic levels.

More importantly, CDSs probably won’t be around long enough to become a barometer of financial strength.

Like all credit derivatives, CDSs transfer risk.  Unlike funded credit derivatives, however, CDSs leave the buyer with the risk that the default insurer—the largest of which was AIG—will default on its credit protection payout.  In other words, they function like a form of unregulated insurance where the insurance company can fail.  Not only does that possibility defeat the purpose of insurance, but it also means that CDSs provide financial firms and investors with a false sense of security.

Because CDSs and their sense of security led America into the worst recession in seven decades, the Securities and Exchange Commission has begun a campaign to regulate credit derivatives.  And once CDSs are strictly regulated, their costs won’t purely reflect the market forces that Mr Hart and Mr Zingales praise.

Having investors regulate banks’ required reserve ratio—the proportion of their equity to their debts—through the fluctuating price of a regulated product is like having Former President George Bush treat cancer patients through a nineteenth-century telephone: one party is making decisions that it isn’t qualified to make through a channel that distorts its message for another party whose life is on the line.

There’s a better way.

If the Federal Reserve collaborates with President Obama to perform a more rigorous “stress test” on Wall Street banks and uses the findings to create a temporarily-mandated reserve ratio, it can use the findings to make realistic required reserve ratios for individual banks.  In the short-term, the Federal Reserve should allow banks to use more leveraging than it currently permits; keeping a tight hold on asset leveraging will only require more government loans and make the bailout more expensive.  But in the far-term—once banks have recovered enough money to lend conservatively without chocking domestic credit—the Federal Reserve needs to require a reserve ratio closer to 18%.

Mr Hart, Mr Zingales, and other like-minded free-market economists ought to acknowledge that market failure in addition to weak government oversight caused the financial crisis.  The free-market and government intervention will get America out.

Denying that government is part of the solution is saying that the marketplace knows how to price CDSs—a claim that the Dow Jones can dispute six-thousand times.  And if the free-market can calculate financial risk, then Mr Bush is a doctor.  Perhaps Mr Hart and Mr Zingales could volunteer to be his first patients.

-David Lamb

Mr Hart and Mr Zingales explain their argument for using CDS price to regulate banks here.

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