Government Is the Systemic Risk

Government Is the Systemic Risk
by Sheldon Richman

The Obama administration and congressional leaders assure us that the government can protect us from the “systemic risk” posed by big banks, insurance companies, and hedge funds.

But who will protect us from the government?

In light of all we’ve learned about the national government’s conduct in both domestic and foreign affairs over recent years, there is clearly no greater risk to American society than the government itself. Yet people look to it for security. That, I submit, is the fruit of propaganda and popular complacency. When can we expect the “eternal vigilance” that was supposed to keep us free?

One could go on at length about how the government — which includes the Great Counterfeiter, the Federal Reserve — threw the economy into turmoil with the housing boom and subsequent bust. Blame, as the politicians will, “Wall Street,” the fact remains that none of the firms there could have engaged in such systemically risky behavior without the partnership of the government. When Congress and the White House push and facilitate the guarantee of bad mortgage loans on a wide scale, while the Fed provides at least some of the money and a safety net to banks that get into trouble, you have the makings of a disaster that could never have occurred in a free market. Those who blame greed and deregulation have willfully blinded themselves for ideological reasons. The facts are plain for all who are curious.

Of course, it is not only in domestic financial matters that the government endangers us. Foreign affairs also are a source of risk. Long-running and various brutal U.S. interventions in the Middle East have filled people with enough hate that some were willing to fly airplanes into buildings in New York. Since then America’s misrepresentatives have made things far worse through invasions, bombings, occupations, open-ended detentions, and torture. Through it all, government officials have lied to the American people about was happening. Lied: about (nonexistent) Iraqi weapons, about (nonexistent) ties between Iraq and al-Qaeda, about torture, about the need for the “enhanced interrogation” that they denied was torture. They lied about everything — to the people in whose name they acted.

The enormity of these crimes cannot be exaggerated. Not only did the perpetrators betray the people they claimed to “serve,” they endangered the people by creating more reasons for others to hate them. Obama’s disinclination to prosecute those who made and carried out the torture policy is a shameful demonstration that, when it really matters, genuine change is an illusion. And since there will be no consequences for official criminal conduct, we can be sure it will take place again. That’s what happens when our rulers and their henchmen are above the law.

Where is the change? Obama’s policy in Pakistan has spread U.S. murder to yet another country. Meanwhile, he beefs up the war in Afghanistan, where, among other outrageous things, the U.S. and Afghan governments destroy Afghan farmers’ poppy crop. The results of this abominable action are predictable. They create resentment in the farmers toward the United States, while creating sympathy for anyone who offers assistance. Meanwhile the Taliban finances its resistance to occupation through the drug trade.

By what right does an American president destroy a crop in a foreign nation? Because some Americans use the heroin that is made from those poppies? Because profits from the crop support the Taliban? Neither reason makes sense. No one uses heroin because Afghans grow poppies. People use it because they want it, and if they can’t get Afghan-based heroin, they’ll get some other kind. They should be free to use whatever substance they want in peace. There certainly is no justification for blaming the poor farmers of Afghanistan.

As for the profits financing the resistance, there wouldn’t be abnormal profits in drug-related activities if the U.S. government would drop its inhumane war on drug producers and consumers, which serves only to empower the state to invade our liberties and to create violent black-market gangs. And there wouldn't be an occupation to resist if the U.S. left Afghanistan.

In so many ways, we’d be much safer if the government stopped protecting us.

Sheldon Richman is senior fellow at The Future of Freedom Foundation, author of Tethered Citizens: Time to Repeal the Welfare State

Is Silicon Valley a Systemic Risk?

Treasury decides to treat venture capitalists like hedge funds.

JAMES FREEMAN

The Obama administration wants to regulate venture capital firms to prevent systemic risks. Silicon Valley residents are scratching their heads and asking: What risks? The rest of us should ask why Washington is targeting a jewel of the American economy that had nothing to do with the housing bubble.

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The confusion began when Treasury Secretary Timothy Geithner recently told Congress that large venture capital (VC) firms should be forced to register with the Securities and Exchange Commission (SEC), and submit regular reports on their investors and portfolios. Data collected by the SEC would then be shared with a new risk regulator to ensure that VCs aren't "a threat to financial stability."

Since then, venture investors have been trying to solve the mystery of how they could possibly threaten the financial system. Their work involves very little banking. Venture firms raise equity from wealthy investors to buy ownership stakes in small companies. The VCs and the companies in which they invest use little or no debt.

"I cannot imagine any venture fund being of a size to pose 'systemic risk,' so they either don't understand the nature of the business, or by including this provision they are sharing that their agenda is not the overt one disclosed," says Jack Biddle of Novak Biddle Venture Partners. What Washington needs to understand is that bank-style regulation could destroy the culture that created the microprocessor.

In justifying new SEC registration requirements, Mr. Geithner said that Bernie Madoff's Ponzi scheme demonstrated that investors need more protection. He didn't mention that Madoff's firm was registered with the SEC as an investment adviser and had also been regulated by the SEC for decades as a broker-dealer. Also, Madoff was not running a venture firm.

The entire venture capital industry is smaller than the Madoff fraud. VCs invest a total of $30 billion each year, far less than one-tenth of 1% of U.S. financial transactions. Venture investors -- affluent individuals and institutions -- are putting up equity and know that they can lose it all. SEC regulation could have the same negative impact on them that it had on Madoff's investors: creating an illusion of safety in what is an inherently risky endeavor. Or the regulation could become so severe that it actually does eliminate risk from venture investing, killing the innovative ideas that can only be funded by risk-takers.

The fact that VC money is small potatoes compared to Wall Street money doesn't mean we wouldn't notice if the industry were regulated out of existence. Venture investments helped build Intel, Apple, Google, Amazon and Cisco, to name just a few. Is Mr. Geithner sure that he has a better model?

Since the Treasury secretary lumped venture capital into a category with hedge funds, there's a question of whether something has been lost in translation between Washington and Silicon Valley. Mr. Geithner says that he needs to make sure that private investment firms are not overleveraged. But leverage is such a small factor in the venture world that the trade association for venture capital firms doesn't even collect data on it. Responding to the Treasury plan, the National Venture Capital Association is now seeking more information. Will they discover dangerous levels of debt piled on such shaky foundations? Don't bet on it.

Greg Becker is the president of Silicon Valley Bank, a leader in providing financing to venture-backed companies. He says a typical start-up client will raise perhaps $10 million in equity investments from VCs. His bank will lend perhaps $1 million or $2 million at high rates on a short-term basis only if the bank expects the young company to get another round of venture investment. Every dollar loaned is secured against all of the assets of the start-up. Most of these loans are paid back, and even when a start-up goes bust, he reports that the $10 million equity investment has usually created enough enterprise value for his bank to recover its principal.

At the next level of growth, when companies have perhaps $20 million of annual revenues but still negative cash flow, he'll loan perhaps $4 million or $5 million for working capital, equal to the company's quarterly accounts receivable, if he thinks the entrepreneurs will be able to use the funding to win a big client. Even when venture-backed firms become cash-flow positive, his bank is still only loaning limited amounts of money based on the firm's accounts receivable, and always secured by the firm's assets. Loans to venture-backed firms never account for more than 10%-11% of the bank's business.

For anyone concerned about systemic risk, the dot-com bust of 2000-2002 has already provided the ultimate stress test. Mr. Becker says his firm was never threatened, and neither were the other banks that provide such financing.

Many start-ups don't use debt at all. After all, how many people want to lend to a business without stable cash flows? For the ventures that do use debt, many of them use less than Mr. Becker's clients. Steve Harrick of Institutional Venture Partners says that even companies in his portfolio with $50 million in revenues will typically limit borrowing to $2 million or $3 million for working capital. And at the level of the venture firms, there's a reason they raise equity instead of debt. Who would lend large sums to somebody investing in firms without profits or even revenues?

The only people threatened when a start-up goes bust are its small group of employees and investors, and they wouldn't have it any other way. Says Mr. Harrick, "You've got people willing to take risks. In fact, they need to have a tolerance not just for risk, but for the potential of outright failure."

If our economic system is to thrive, venture capital is exactly the place where we have to encourage risk. In pursuit of innovations that will enrich themselves and the world, employees at start-ups accept low pay and reputational risk, while well-heeled investors accept the possibility of losing every nickel of their investment.

Attempts to limit risk pose a systemic threat to American technology. Venture capitalists, mainly veterans of the tech industry, are deeply involved in the companies they back, often helping to recruit each of the key employees at a start-up. This hands-on feature of venture investing means that innovative companies and their backers tend to cluster in areas like Silicon Valley. If the VCs move offshore, that's probably where the next generation of companies will be born.

Even if one wishes to be paranoid about systemic risks, it's hard to imagine how tiny tech companies could be ground zero in a future credit bubble. The politicians aren't driving capital into this business. Fannie Mae and Freddie Mac don't provide cheap financing to VCs. Major credit-ratings agencies don't grade start-ups, so there will be no government-distorted judgments of creditworthiness. Neither VCs nor the companies they fund issue bonds or CDOs or CLOs. There's no Technology Community Reinvestment Act. Moral hazard? Not in Silicon Valley. No tech-company founders or VCs could possibly believe they are too big to fail.

Washington-created failure is what riles Cypress Semiconductor CEO T.J. Rodgers. In a recent email, he notes that this isn't the best moment in history to add another burden to America's tech industry. Very few start-ups have gone public in recent years, thanks in part to the multimillion-dollar compliance costs imposed by the Sarbanes-Oxley law in 2002, the last time Congress sought to re-regulate corporate finance.

Says Mr. Rodgers, "First, Sarbanes-Oxley mandated byzantine corporate bureaucracy to 'protect' investors. Then, the SEC damaged the Silicon Valley economy by forcing companies to count stock options twice, both as dilution and as expense. As a result, Silicon Valley, for decades the bright spot of the American economy, produced only one [initial public offering] in all of 2008. Now, Geithner wants to regulate venture capital firms to protect us some more. It's like watching children deface an economic work of art."

Mr. Freeman is assistant editor of the Journal's editorial page.

Congress Is the Real Systemic Risk

PETER J. WALLISON

After their experience with Fannie Mae and Freddie Mac, you'd think that Congress would no longer be interested in creating companies seen by the market as backed by the government. Yet that is exactly what the relevant congressional committees -- the Senate Banking Committee and the House Financial Services Committee -- are now considering.

In the wake of the financial crisis, the idea rapidly gaining strength in Washington is to create a systemic risk regulator. The principal sponsor of the plan is Barney Frank, the chair of the House Financial Services Committee. A recent report by the Group of Thirty (a private sector organization of financial regulation specialists), written by a subcommittee headed by Paul Volcker, also endorsed the idea, as has the U.S. Chamber of Commerce and the Securities Industry Financial Markets Association.

If implemented, this would give the government the authority to designate and supervise "systemically significant" companies. Presumably, systemically significant companies would be those that are so large, or involved in financial activities of such importance, that their failure would create systemic risk.

There are several serious problems with this plan, beginning with the fact that no one can define a systemic risk or its causes. The Congressional Oversight Panel, which was established to advise Congress on the use of the TARP funds, concluded -- with two Republicans dissenting -- that the current crisis is an example of a systemic risk evolving into a true systemic event. After all, virtually all the world's major financial institutions are seriously weakened, and many have either failed or been rescued. If this is not an example of a systemic risk, what is?

The current financial crisis is certainly systemic. But what caused it? The failure of Lehman Brothers occurred long after the market for mortgage-backed securities (MBS) had shut down, and six months after Bear Stearns had to be rescued because of its losses. In other words, the crisis did not arise from the failure of a particular systemically significant institution. The world's major financial institutions had already been weakened by the realization that losses on trillions of dollars in MBS were going to be much greater than anyone had imagined, and before the major asset write-downs had begun. So if this was a systemic event, it was not caused by the failure of one or more major institutions. In fact, it was the other way around: The weakness or failure of financial institutions was the result of an external event (losses on trillions of dollars of subprime mortgages embedded in MBS).

If this is true, what is the value of regulating systemically significant financial institutions? Financial failures, it seems, can be the result, rather than the cause, of systemic events like the one we are now experiencing. Even if we assume that regulating systemically significant companies will somehow prevent them from failing -- a doubtful proposition, given that the heavily regulated banks have been the most severely affected by the current crisis -- we will not have prevented the collapse of a major oil-supplying country, an earthquake or a pandemic from causing a similar problem in the future. All we will have done is given some government agency more power and imposed more costs on financial institutions and consumers.

But increased government power and higher costs are not the worst elements of the proposal to designate and supervise systemically significant companies. The worst result is that we will create an unlimited number of financial institutions that, like Fannie Mae and Freddie Mac, will be seen in the financial markets as backed by the government. This will be especially true if, as Mr. Frank has recommended, the Federal Reserve is given supervisory authority over these institutions. The Fed already has the power -- without a vote of Congress -- to provide financing under "exigent circumstances" to any company, and will no doubt be able to do so for the institutions it supervises.

A company that is designated as systemically significant will inevitably come to be viewed as having government backing. After all, the designation occurs because some government agency believes that the failure of a particular institution will have a highly adverse effect on the rest of the financial system. Accordingly, designation as a systemically significant company will in effect be a government declaration that that company is too big to fail. The market will understand -- as it did with Fannie and Freddie -- that loans to such a company will involve less risk than loans to its competitors. Counterparties and customers will believe that transactions with the company will generally be more secure than transactions with other firms that aren't similarly protected from failure.

As a consequence, the effect on competition will be profound. Financial institutions that are not large enough to be designated as systemically significant will gradually lose out in the marketplace to the larger companies that are perceived to have government backing, just as Fannie and Freddie were able to drive banks and others from the secondary market for prime middle-class mortgages. A small group of government-backed financial institutions will thus come to dominate all sectors of finance in the U.S. And when that happens they shall be called by a special name: winners.

Mr. Wallison is a fellow at the American Enterprise Institute.