Financial Crisis stems from lack of trust, disappearance of “true value”

Princeton economist and former Secretary of Labor Robert Reich agrees that Wall Street’s biggest problem right now is the collapse of trust:

The problem is, government bailouts, subsidies, and insurance aren’t really helping Wall Street. The Street’s fundamental problem isn’t lack of capital. It’s lack of trust. And without trust, Wall Street might as well fold up its fancy tents.

Reich also writes:

Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing.

Why? Because the underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.

Many of these fancy instruments became popular over recent years precisely because they circumvented financial regulations, especially rules on banks’ capital adequacy. Big banks created all these off-balance-sheet vehicles because they allowed the big banks to carry less capital.

(For more on credit default swaps, see this).

Robert Reich wrote this a year ago, but everything he said then still holds true. The more I study the financial markets and derivatives, the more I realize how much our economy is based on make-believe.

Even Warren Buffett’s company Berkshire Hathaway made almost half of its reported profits last quarter on derivatives bets rather than on true value creation from its company’s underlying businesses.

Many large corporations report huge profits or losses as a direct result of good or bad bets in their derivatives holdings.

It really is hard to know the true value of any security these days. And I’m not sure we can turn back the clock, because the “financial entrepreneurs” who create and market all these instruments have so much money and so much influence in Washington, that the chance of making derivatives-related gambling illegal or even controlling it on exchanges, is actually pretty slim.

Posted via web from Paul’s posterous

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