Thursday, May 15, 2008

Economic History, Institutions & Choice

I was watching this story on CNBC's Worldwide Exchange this morning and I was reminded how decisions are shaped by institutions and institutions are shaped by policy choices. What triggered the thought was a comment by Simon Nixon regarding the reluctance of banks to finance big deals unless they are convinced there are investors to buy the Collateralized Loan Obligations (CLOs) - the packaged loans that allow financial institutions to transfer default risk to other parties, who may themselves be financial institutions.

This interdependence is at least partially responsible for the global reach of the credit crunch here in the U.S. It explains how mortgage-based securities can contribute to significant losses at British, German and other banks. The history of this interdependence goes back, at least in part, to the last major financial institution crisis in the U.S., the Savings & Loan (S&L) crisis of the late 1970s and early 1980s. As that industry tottered toward failure, financial institutions (particularly S&Ls) were allowed to invest in non-traditional areas. S&Ls had always been more or less restricted to home mortgages, banks specialized business loans, etc. And the institutions would generally live on the spread between what they paid depositors and what they received from loans or investments.

The S&L industry ultimately collapsed with a lot of questionable activity on the books of many individual firms. Financial regulators, under pressure from legislators and the public at large, basically told financial institutions that they had to find a way to reduce risk in their loan portfolios. One option was to invest in strictly safe securities (Treasuries, etc.), but this meant businesses and individuals found it hard to borrow. The second option was to make the loans, repackage them and sell the new product to others who would basically bear the risk of default. Financial institutions could continue to service the loan for a fee, and the risk would not appear on their books.

The products and industry have evolved beyond that simple format. But the idea remains the same. Originate loans, package and transfer to other parties. The other parties may be hedge funds, financial institutions, or even wealthy individuals. This brings us to the present. Banks and other financial institutions see demand for loans, and with recent monetary policy actions, they should have access to reserves that will allow them to lend. But they will remain reluctant to lend if they can't find other parties to accept the new loans as repackaged obligations.

The evolution of credit markets and banking has been, in my opinion, generally a good thing. But this market depends on supply and demand on both ends. There may be demand for loans, and banks may have access to supply. But unless there is demand for the repackaged debt instruments, banks will remain reluctant to go through with the loan process.

I look forward to your comments.

You can find another great discussion on institutional change in our economic history in essay by Chicago Fed President Charles Evans from their most recent annual report. While it doesn't speak directly to the period I mentioned, it does a good job of explaining how financial market change or innovation affects the economy.

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