07.08.2011 0

The Next Financial Crisis

By Bill Wilson – There is a con game being played on the American public. At the same time governments around the world are proposing increasing the amount of money banks must hold in reserve to 7 percent, they are rigging the definition of what constitutes risk.

Dubbed Basel III, these new international requirements will define government debt as risk-free, according to Jim Jubak of Jubak Global Equity Fund. As a result, Jubak writes, “a bank that holds sovereign debt won’t be required to adjust its core capital ratio higher to make up for any extra risk.”

Jubak predicts that banks, to keep as minimal an amount of capital on its books as possible, will simply pour more money into government debt securities. But should anyone believe that a bank holding billions of Greek or Portuguese debt is adequately capitalized? Many analysts foresee default in the eurozone as a necessary and inevitable outcome of the sovereign debt crisis there.

With the banks that lent the money to these troubled sovereigns begging for a bailout, clearly they understand the risks of default. So, why don’t the regulators?

The entire financial crisis of 2008 was caused by overleveraging, where firms like Bear Stearns did not have adequate capital reserves to pay their bills when things went south. They carried risk to capital ratios as high as 30 to 1.

If you think that’s bad, consider a recent forensic study by former Fannie Mae chief credit officer Edward Pinto on Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac. They “only needed $900 in capital behind a $200,000 mortgage they guaranteed,” writes Pinto, citing the “The Federal Housing Enterprises Financial Safety and Soundness Act of 1992”.

That’s more than 200 to 1 of overleveraging, and paved the way for Fannie and Freddie’s inevitable failure in 2008 when the nominal value of mortgage-backed securities fell.

Since Fannie and Freddie guaranteed more than half of the U.S. market, its overleveraging set the tempo for the entire housing market during the bubble years. Pinto notes, “In order for the private sector to compete with Fannie and Freddie, it needed to find ways to increase leverage.” And so they did, increasing the likelihood that when the market fell, there would be a meltdown.

Basel III, by categorizing sovereign debt as risk-free, is doing precisely the same thing. Except instead of the $10 trillion U.S. mortgage market, now we’re talking about the more-than $50 trillion of sovereign debt worldwide. That does not include the untold trillions of sovereign debt credit default swaps, insurance policies bondholders buy against default.

The next financial crisis will be worse than the last one. Europe is already beginning to experience the real risks associated with governments borrowing too much. In Greece, civil order is practically breaking down, and a collapse of the government is not out of the question.

Basel III was set up to prevent banks from becoming undercapitalized in the event of a financial crisis. But by categorizing sovereign debt as risk-free, it has guaranteed they will remain so. It also guarantees that legislative bodies will continue spending like drunken sailors.

If there are to be any capital requirements at all, then taking on risky assets, whether it be sovereign debt or mortgage debt, should require higher capital to be maintained.

An alternative and perhaps superior solution would be to eliminate capital requirements all together — with the proviso that in the event of a financial crisis, there would be no bailouts and that capital reserve compositions be posted publicly. Under a tough transparency-no bailout rule, good banks would automatically protect themselves against insolvency by boosting capital.

Logic, instead of lunacy, would be the guiding star behind a bank’s decision of how much capital it needed to keep on the books, or on what types of loans to make, for that matter.

Markets, and not the government, can prevent the next financial crisis. But the only way to accomplish that is to reinstate the real risk of failure into the equation.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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