St. Louis Fed Pres. James Bullard on Economy
Last Thursday evening I had the honor of witnessing an intriguing lecture by St. Louis Federal Reserve Bank President James Bullard who received his PhD is Economics from Indiana University.
Bullard spoke specifically on the topic of the recent financial crisis focusing on systemic risk, which he defined as “the possibility that the failure of one firm will lead to the failure of other firms.” However, Bullard said the difficulty lies in defining when there is adequate systemic risk to call for government intervention.
Three Pillars of Systemic Risk
- Interconnectedness – Recent examples of systemic risk has focused on investment banks interconnecting themselves with complex financial instruments. For example’s sake, suppose Bank A purchases an option from Bank B to hedge risk, if Bank B fails then Bank A’s option becomes worthless. If other bank’s are involved in Bank A, then you see where things go with a quickly deteriorating domino effect.
- Overuse of Leverage – Fannie Mae and Freddie Mac were excellent examples of institutions that were holding too little amounts of capital in reserves and become vulnerable to a downturn in the economy.
- Maturity Mismatch – This was prevalent in the investment banks where they would fund long term investments with short term funding from wealthy “investors.” However, when those same investors refused to renew the short term lines of credit the firm becomes involvement because they can’t make debt payments and it collapses into bankruptcy.
Helping AIG, but not Lehman?
The crux of the current problems came when financial institutions built up large portfolios of mortgage-backed securities that brought income in from the monthly payments; however, these institutions had not managed their risk and when the mortgage payments stopping coming the value of the securities began to drop.
Bullard also discussed the failure of institutions stating, “Failure should occur in an orderly way with the lowest level of financial disruption.” While there is no problem with this orderly process for commercial banks, Bullard emphasized that the fed is improvising when it comes to the non-bank institutions such as Bear Sterns, Lehman Brothers, and AIG.
Bullard also noted the fact that the Federal Government gave aid to AIG, but not to Lehman Brothers. The Federal Reserve believed that the financial market participants were less likely to be surprised about the failure of Lehman Brothers and therefore the disruption occurred on a much smaller scale than if AIG, whose operations are extremely interconnected, had been allowed to fail.
Where to go next with regulations?
Bullard believes the government can and should play a constructive role in rebuilding the economy and he sees several criteria for moving forward.
- Enhanced supervision of financial firms.
- Federal Reserve oversight of transactions between financial institutions, which will allow the Fed to gauge interconnectedness between institutions.
- Creation of a rigid system to liquidate non-bank firms instead of improvising.
Bullard also made a few final comments noting that “Bailouts are expense, not just because they spend taxpayers funds, but because they bring about an expectation of protection. Expectation of government intervention reduced discipline.”
Leaving room for one final note, the St. Louis leader highlighted the uncertainly of the markets by saying, “We do not know what will happen at this time, and we should be humble in our estimates.”
Tags: economy, fannie mae, fannie mae and freddie mac, federal reserve bank, financial, government intervention, interconnectedness, investment banks, james bullard, mortgage backed securities, president, systemic risk, tution
