Friday, January 22, 2010

Volcker Created The Foundation For The Current Crisis And Had His Own Financial Crisis As Fed Chairman

Paul Volcker's policies to cure 1970s stagflation, as Fed Chairman during the 1980s, were responsible for the savings and loan crisis of the 1980s and for setting into motion many of the economic forces that led to the current financial crisis. He also created the worst post WWII recession up to that time, 1980-1 recession.

During the early 1980s, Volcker's tight monetary policy and his shift to targeting the money supply instead of interest rates forced the prime rate up to 21 percent. The increase in short-term interest rates precipitated the S&L crisis. S&Ls at that time primarily made fixed rate mortgages funded by low rate deposits and other short maturity low interest rate instruments.

Volcker's high interest rates caused S&Ls to fund existing long-term, low rate mortgages with high interest rate, high cost money. The S&Ls suffered huge financial losses as a result and caused the S&L crisis, which cost the taxpayer, billion of dollars.

High interest rates also caused disintermediation in consumer banking as depositors shifted their funds to higher paying money market mutual funds. The high rates and lost deposits forced banks to finance their lending with higher cost funding.

Bankers' experiences under Volcker led banks to push variable, adjustable rate mortgages. Volcker's policies also led banks to expand across state lines to increase their consumer deposit sources, to seek merger partners and to consolidate into bigger financial institutions. It also made banks want to sell the loans off their books instead of holding them and taking the interest rate risk, which led to increased securitization of consumer loans and mortgages.

Banks also looked for ways to earn money from sources other than lending to consumers, such as consumer banking fees, investment banking and proprietary trading.

So in summary, while Volcker successfully stopped stagflation of the 1970s, his policies led to the S&L crisis, bank consolidation into TBTF, securitization of mortgages, increased fees on consumer banking products and pushed banks into non-lending revenue streams such as investment banking and proprietary trading.

What reason do we have to believe that any of the policies he has persuaded President Obama to adopt about bank risk will not cause as much future harm to the banking system as the previous Volcker policies as Fed Chairman.

The stock market understands the potential economic harm from Volcker's policy suggestions to Obama and the VIX (CBOE S&P Volatility Index) increased on Thursday by 19 percent.

No comments:

Post a Comment