A Bulwark Against Another Financial Panic

Some six years later, we are reaching a consensus on the financial crisis of 2008.

As I have said more or less since the beginning, the most important thing to understand about the panic in 2008 was that it was, at its core, a crisis of confidence. All of a sudden, financial institutions were afraid to transact business with one another. It wasn’t that the assets they held were valueless; it was that, in the absence of a market, no one could tell what their value was.

To its lasting credit, and to the incessant complaints of its ill-advised critics, the Federal Reserve stepped in to backstop the money markets where big companies, financial and otherwise, borrow money from one another for very short periods. Some of those powers have since been restricted, due to misguided policy created against the eventuality of another so-called bailout – even though the Troubled Asset Relief Program (TARP) ultimately cost taxpayers nothing and its alternative, the collapse of the financial system, would have been disastrous.

Now a group of large Wall Street firms, with the government’s support, are nearing agreement on a plan to guarantee the most-liquid types of collateral used to borrow money in repurchase agreements, Bloomberg recently reported. The market for such agreements, sometimes known as the repo market, accelerated the fall of both Bear Stearns and Lehman Brothers, largely due to the perception among investors that the firms might not be able to post enough collateral for the loans due to their exposure to the crashing subprime mortgage market.

Whether or not that perception was true, the belief that it was led to a funding squeeze that forced both firms to unload assets at fire-sale prices.

In a statement issued this February, the Federal Reserve Bank of New York warned that the repo market remains vulnerable to such crises of confidence. To address the Fed’s concern, firms that participate in the repo market are developing a plan that would have the Fixed Income Clearing Corp. (FICC) guarantee some of the assets used as collateral on such loans, such as Treasuries and mortgage securities backed by the federal government. The organization, which processes repurchase agreements between dealers, would relieve investors of the need to rely solely on a dealer’s creditworthiness by providing a safety net with the support of the industry.

For riskier collateral, such as structured notes and mortgage securities not backed by the government, the industry is developing best practices that would allow investors to dispose of assets in an orderly way if a dealer defaults.

While some academic economists have suggested that the changes are not enough to completely mitigate the risk of a fire-sale situation, like the ones that undid Lehman and Bear Stearns, a guarantor system like the one under discussion would still be a large step toward steadying the ground under investors’ feet.

Regulators have not always done well with allowing markets to self-regulate. Money market funds, often a party to the repurchase agreements currently at issue, have served as a target for misguided efforts by the staffs of both the Fed and the Securities and Exchange Commission. But between the Fed’s warning to stabilize the repo market and the SEC’s decision to grant approval to let DTCC, which owns FICC, allow registered investment firms to become members of its government securities division, it seems that the financial watchdogs are willing to actually stand back and watch as firms work out their own solution.

In the long run, a more stable, less vulnerable repo market benefits everyone. But the public sometimes has a short memory, and scapegoat-seeking politicians are still fond of stirring up ire over events, such as the bailout, that may not merit it.

The creation of a new backstop means the crisis of confidence is less likely to repeat itself, regardless of which way the political winds happen to blow.

About Larry M. Elkin 551 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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