One thing that has me troubled about the financial mess is the degree to which the powers that be are wedded to a system that it clearly broken. In part, that results from financial capture of the government apparatus by the banking industry. But an equally sticky problem is the attachment to a rather recent vision of how the financial system works. And that in turn is oddly reminiscent of destructive patterns in the Great Depression.
If you go back to 1980, the world of finance was very different, The Federal Reserve was considerably larger than any single bank. On balance sheet lending was the norm. Banking was most decidedly not sexy, unless you were Ciitbank, which loved to innovate and push regulatory limits, even though lots of banks then became free riders on its pioneering.
No one in 1980 (outside of MBA programs and certain parts of New York City) knew what an investment banker was. If you used that term with most middle or upper middle class Americans, they would assume it was some sort of glorified stockbroker.
To make a very long story short, securitization changed all that. Banks saw their lunch eaten by investment banks as they were increasingly disintermediated. By 2006, only 15% of the non farm, non-financial credit was via the banking system. What Timothy Geithner called “market based credit” became the norm.
The problem is, as we know, as the model didn’t develop as much as devolve. There have been massive information losses. Much of sound banking credit processes has been replaced by sophistry, such as score based credit models that have been demonstrated to perform badly, incomplete loan files (so no one has enough borrower G2 to do updates and triage for mods), a reliance on ratings and hedging in place of credit analysis, even a mortgage registry service that only reduces transparency. And the very worst element is that securiitzation vehicles make debt restructuring, a key element to resolving a financial crisis, well nigh impossible.
And securitization was and remains the epicenter of the crisis. Gillian Tett of the Financial Times tells us:
What is imploding though is the securitisation world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds were sold in markets, and this year market issuance is minimal.
Now as we have said, some shrinkage is necessary. Too many people borrowed too much.
Yet there has been absolutely nothing in the way of seeing whether the model can be fixed, or scrapped. John Dizard suggested last year that central bankers expected the world would revert to more on-balance sheet intermediation, but that would entail even more equity in the banking system than the amount needed to plug the loss holes. And the Treasury and Fed actions, of creating a myriad of guarantees and special facilities, instead says that they are trying to put in place a government backed securitization process (witness in particular how Fannie and Freddie pretty much are the mortgage market these days) in place of its formerly private version.
But the lack of any thought, much the less action, on the securitization front is troubling. And I suspect no real fix is possible.
It’s surprising nothing has been done on the rating agency front. That’s a contained element. many good proposals have been made, yet not a peep from anyone in authority. If small fry like them can’t be reformed, clearly nothing serious is in the offing.
But ex the rating agencies, it would seem at least two things would need to happen, and even then I am not sure either would be sufficient.
One line of thought is that more of the intermediaries need to have some skin in the game by retaining paper they originate, rate, or sell.
But the reason that securitization beat out lending was that it was cheaper. And the big cost of banks holding loans was equity and FDIC insurance. The more players along the food chain have to retain some of the deal, the less favorable the economics, since they will have to put up some equity to support the assets they keep. Some securitization deals might still work even with a higher level of expense, but the market would be smaller.
But of course, that assumes the players do bona fide keep a long position. What’s to prevent them from hedging their credit risk? And if they do that, we are back to square zero in terms of fixing incentives.
Problem two is unless I missed it, I have heard no serious suggestions as what restrictions to impose on securitization vehicles and servicers going forward to facilitate mods. One problem now is that deep enough mods aren’t being offered (principal reductions have a much higher success rate). Probably more important, mods, just like the lousy credit decisions that helped create this mess, are being done via decision rules using simple borrower metrics rather than case by case assessment. The US has suffered falls in housing values in individual markets in the past that were as severe as the national declines we are witnessing now. I keep hearing from old style bankers that mods were always viewed as the better solution if you has a borrower with some ability to make payments. But they also made those assessments individually and with a knowledge of the community (as in stability of various local employers).
But again, would the securitization model work if you incurred the extra costs to do things right, as in better borrower assessment at the outset, establishment of good loan files (I hear repeatedly that servicers seldom have any good borrower documentation), and required investors to pay the costs needed to do mods? Again, by increasing costs, it would mean fewer deals would “work” from an economic standpoint.
So I would surmise that even if securitization were reformed, the market would indeed be considerably smaller. Paul Volcker thought we needed to roll the clock back and go to more traditional bank lending. It is pretty clear that the rest of Team Obama is not on that page and wants to restore the brave new world of fancy finance ASAP. But I don’t see how we get there, save waiting ten years for memories of the problems of this period to fade and the bad practices to start all over again.
Which brings me to the Depression. There are many theories of why it spiraled downward, but the one I find most persuasive was that it was the result of the efforts to restore the gold standard in the mid 1920s (worsened by France pegging the franc too low and accumulating massive gold reserves). The key observation from works by scholars of that era like Peter Temin is that the banking and political leaders of that day felt restoring the gold standard was pro stability, and perhaps even more telling, they were virtually unable to imagine a world without it.
Our paradigm is quite different, but many of the key actors seem hopelessly anchored by it. And I worry that like the Depression, we will have to see it break down completely before we can start to rework it in significant ways.