What Has Happened to Gillian Tett?

A year ago, I found Gillian Tett, then the Financial Times' capital markets editor, to be the single most useful financial reporter by a considerable margin. She gave insights into areas that were important but badly neglected elsewhere, such as CDOs, credit default swaps, SIVs, all well before they entered the mainstream lexicon.

She was promoted. While she may add value behind the scenes, her stories this year are a shadow of her former work. And that's being polite.

Consider her offering du jour, "How talking can help cut the risk of a lemming fall." Here's the set-up:

Imagine for a moment that you are a banker, who stumbles across a juicy new instrument called the "lemming" product that your sales team could sell to retail clients - for a fat profit......even though it has been rubber-stamped by your compliance department....investors will suffer big losses if stock markets fall more than 30 per cent.

....over 70 per cent of the audience [in a Securities and Investments Institute conference] voted to block the lemming deal in an anonymous poll, taken after the participants had discussed the issue with neighbours.

But then the organisers presented a chart which highlighted a more sobering point: when the SII has done these tests before, it has typically found that the proportion of bankers who block risky trades falls dramatically when participants do not discuss the issue with their neighbour first - even if they vote anonymously.

Tett uses this example to conclude that what investment banks need isn't better incentives, but (to use that horrid American term) more dialoguing:

....bankers should be forced to talk about their business with a wide pool of colleagues, including those outside their immediate silo, rather than just their bosses alone.

Rubbish. A conference is such an artificial setting that to generalize its findings to the day-to-day operations of a company is fantasy. People want to look good before their peers, and in a weird bit of self-deception, once someone takes a position publicly, they typically find it difficult to recant privately. And here, the tradeoff has been framed in uncharacteristically black and white terms: big profits versus big downside to clients in relatively low-odds situations. Would the response had been different if the question has included: "the odds of the market falling 30% in the next X year is Y"? Yes. Survey results are HIGHLY influenced by the wording of the question. So just imagine how susceptible real world situations are to subtle and shifting pressures.

Take the lemming. The response of a manager/department head in the real world no doubt will also be shaped by:

How tough standard disclosure language would be

What leadership in the lemming might do for league table rankings

How close your team is to being on track for its targets for the year

Whether your boss is satisfied with you these days

Whether your firm has had a major compliance/litigation problem in the last two years

Whether you sell to retail clients directly (ie, you own them) or primarily via other firms' salesforces

Whether other firms are selling lemmings actively. This is probably the biggest single consideration. There is far less perceived risk if others are already in the pool

Tett also argues that Goldman, an example of better practice, engages in just this sort of debate:

Institutions such as Goldman Sachs, for example, try to ensure that different business silos have ways of watching what each other does. They also invest heavily in creating a holistic risk management culture: Goldman Sachs' risk systems, for example, are run by Gerry Corrigan, the former New York Federal Reserve president, who makes a virtue out of sticking his nose into as many dark corners as possible - and trying to encourage companywide debate.

Tett has the causality backwards. Goldman still carries the legacy (now weakened since it went public and is dominated by the trading side) of being extraordinarily risk averse and image conscious. The firm when it was a partnership went to unusual lengths to make sure that even very junior staff understood the finer points of legal and practical liability. This was pragmatism; the partners regarded it as a cheap form of insurance.

The firm in the 1980s was also cautious about delegating decision-making authority to client facing staff that other firms delegated routinely (such as not letting investment bankers quote indicative prices for financings) and about putting capital at risk (it was late to book interest rate swaps). When its practices became visibly uncompetitive, it generally came up with a solution, or at least a finesse. Goldman is an inwardly-focused firm that takes few mid-career hires, so its culture is reasonably intact. The structure is a product of the culture, not vice versa.

Something this misleading from a formerly keen observer is surprising and disheartening. She needs to get back out and mix it up with her source more often.

Some Informative Credit, Housing, and Mortgage Charts

Reader AK sent me a bit of Christmas in May: three hot-off-the presses reports, one from Morgan Stanley on the credit standing of US and European broker dealers, a Moody's report on RMBS, and a UBS report on the subprime crisis.

The Morgan Stanley report, although the shortest, was in some ways the most informative, since it provided a table that shows the marks that dealers are using for various types of securities. The paper argues that the gap between US (based on a universe of 7) and European (universe of 15) broker dealers has narrowed considerably, so the perception that European dealers were in worse shape than they appear to be is dated (note Knight Vinke disagrees vehemently as far as HSBC is concerned).

Morgan Stanley is suitably mysterious about its methodology, but claims it is +/-2% for those marks that have later been disclosed. Their approach no doubt includes sexual favors and the liberal use of alcohol.

Note this research does not necessarily contradict what my buddy with high level sources said about European banks sitting on a lot of undisclosed losses. The bulk of the lousy 2006 RMBS and CDOs were sold abroad, often to smaller institutions. So their could be trouble brewing in the next-tier institutions.

The Morgan Stanley chart (click to enlarge):



Note that these marks are generally higher than the haircuts required by the Fed per its collateral table, with the notable exception of CDOs. Of course, these marks are averages, and one would have to assume adverse selection in whatever was fobbed off on the central bank.

The report argued that broker/dealers are two thirds of the way through their write-downs, but warned that there was still the potential for trouble via basis risk and counterparty risk in hedges (code for possible CDS woes). And its other main caveat:

But as our equity analysts in the US and Europe have highlighted repeatedly, the looming concern is that of more traditional loss provisioning by commercial banks. Rising provisions and further deleveraging will make the earnings environment challenging for years to come, although with tail risk also reduced, we be believe this will be a greater headwind to financial equities than to credit.

I thought I'd lift the charts I found most interesting from the two other presentations (150+ pages in total, so forgive the arbitrary selection). From UBS (click to enlarge):





From Moody's (click to enlarge):

How to Leash and Collar the Financiers? (Continued)

The fulminating over what to do about our miscreant socialized unrepentant and as yet unreconstituted financial services sector continues. Since massive subsidies have been extended in the form of help to the mortgage business and an alphabet soup of Federal Reserve facilities, with nary a demand made of the beneficiaries of this largess, it seems that the authorities have perilous little leverage over their wayward charges.

Of course, in reality that isn't so; a determined regulator can, if nothing else, harass a company into submission (the Japanese are masters of this technique) and they have more powerful tools at their disposal. But that presupposes the will to intervene, which despite the crisis, still appears to be sorely lacking.

The collective response resembles the storied boiled frog effect: the heat goes up, or in this case, the public outlays continue, yet legislators, regulators, and the public remain remarkably passive as the expenses continue to rise. Of course, it doesn't hurt that many of these costs are contingent liabilities, so the true damage will come to light only years later, when the perps have moved on to other roles.

But readers beware: the boiled frog is an urban legend. Real frogs have the good sense to hop out of hot water. But in a pot with high enough sides, even a frog that knows it is in trouble will be unable to escape.

The sightings today confirm the difficult of leashing and collaring a complex, sprawling, fast-moving industry. The Financial Times has a comment by Charles Dallara, the head of the Institute of International Finance, an international organization of financial institutions that verges on the sanctimonious. It confidently recites a list of four areas for action and asserts:

Thus, the debate is not about “self-regulation” versus “more regulation”. Instead, there is an emerging consensus on the benefits of reinforcing market-based corrections with improved regulatory incentives and structures.

A consensus among those who'd rather not be regulated, for sure.

Some regulators are getting mad enough to at least threaten action, but it isn't evident that they will be taken seriously. As the Telegraph reports in "EU to launch assault on bankers' bonuses":

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the "short-term" pay structure of modern capitalism has become deformed, causing firms to take on "excessive risk" without regard to the interests of stakeholders or society.

Note that these discussions do not include the UK.

Now one can correctly point out that this is silly; the main finance centers are not in Europe to begin with, and having the EU adopt even tougher rules will assure even less high powered finance take place there. But don't assume the EU is that naive. I suspect the credit crisis has at least another bad episode or two coming. The Fed has had to coordinate closely with the ECB on recent interventions. The EU may be trying to take intellectual leadership to force the US and the UK, which is also showing signs of financial distress, into taking more radical action. The EU may be taking a tough public posture while privately harboring more limited, realistic aims.

Ironically, the most sensible proposal comes from a US hedge fund manager. As reported by Ira Ross Sorkin in the New York Times:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation...

When you read that UBS did not even view parts of its mortgage portfolio as having market risk, it becomes very obvious that a number of firms were not dotting the i’s and crossing the t’s when it comes to risk management,” he said while on the panel [at the Milken Institute Global Conference] to a packed room.

How did it come to this?

A problem, he says, is youth and inexperience — and that’s coming from a former child prodigy.

“Walk across any of the trading floors — they are full of 29-year-old kids,” he said. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.”

On top of that, many chief executives of big universal banks, the ones that combine all sorts of financial services under one roof, “only understand a small part of the business,” Mr. Griffin said, suggesting too many of them come from sales backgrounds. Put those two things together, the traders and the chiefs, and you have the making of an outright debacle.

The problem is compounded further by weak government oversight, he said. “The unwillingness of the Federal Reserve and the S.E.C. to require working capital” limits, he said, only exacerbates the risk-taking environment because the banks are playing the equivalent of no-limit poker. “The sad truth of the matter is it didn’t have to be this way,” he said.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.

It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.

“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.

Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)

But he also wants to warn against going too far. “It may be a moment in time where there is quite a bit of fervor to put in place significant regulatory regimes that in my opinion could set this nation way back on the playing field,” he said.

He’s particularly nervous that excessive regulation could send more jobs overseas. “I see thousands and thousands of jobs at Canary Wharf and in downtown London, jobs that should have been in America in financial services. Derivatives really were developed in America and because of regulatory uncertainty left America.”

Note that, as readers have pointed out, moving CDS to exchanges isn't quite that simple. New contracts with different and more standardized features could be exchange traded; the current types don't lend themselves well to that. So the worrisome and potentially wobbly overhang of outstanding CDS would have to run itself off over time. Still, any progress on that front is welcome.

And to Griffin's point about regulatory arbitrage; that's where the EU's foray might prove useful. The idea of an international regulation, or failing that, greater international harmonization, is getting traction. But it will take a push, which may come in the form of another leg down in the credit crisis, for that to happen.

"Seven habits finance regulators must acquire"

I get worried when the Financial Times' Martin Wolf starts adopting Stephen Covey-esque sloganeering, particularly when he goes so far as to call his financial services reform proposal "the seven Cs." Eeek.

Earth to UK: one of the big hidden advantages you have is that the lingua franca is your language. That cloying business jargon so popular in America that we have managed to export is not an innovation, it is a debasement. Anyone who can speak and write in an unvarnished manner can trounce those who traffic in gobbledegook.

To be frank, this isn't one of Wolf's best columns, but that may be in large measure due to the near impossibility of setting forth how to fix the global financial system in his word budget. And I have omitted the liveliest part, namely, the set-up, in which he review Paul Volcker's recent speech at the Economic Club of New York, simply because it has been covered elsewhere.

Nevertheless, US readers are likely to find his recommendations to be thin gruel, but remember, there's a valid reason. The UK is a principles based system, so general, high level statements are more meaningful in that system than in ours, where sadly, the devil is in the details. But even giving that allowance, Wolf at points ducks questions he could have addressed. For instance, he mentions the problem of rating agencies, yet fails to mention any solutions. Several are on offer; surely Wolf could have given a thumbs up to one he likes.

Similarly, he sees the main problem in the "originate-to-distribute" model as bad incentives which can be solved by having the originators hold some of the riskiest tranches. Um, don't underestimate their ability to jigger the structures so as to still leave other parties holding the bag. The real problem with the originate to distribute model may be that it is seeking to create a free lunch by reducing the equity that needs to be held against loans. What if that in the end is a false economy? My sources with good regulator contacts tell me they expect to see a good deal more old-fashioned, on-balance-sheet intermediation. Mind you, that it not a view that is convenient for them to have; it implies that banks need to raise not only enough capital to cover their recent losses, but even more to allow for bigger balance sheets. Their view may be pragmatic, in that they see the market for securitized assets as sufficiently burned that it will not come back to its former size for quite some time. That degree of investor repudiation in turn suggests greater changes may be required.

Nevertheless, the advantage of a simple catchy list is that it provides a useful frame of reference.

From the Financial Times:

So here are seven principles of regulation. I call them the seven “Cs”.

First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.

Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.

Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.

Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.

Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.

Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.

Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.

John Maynard Keynes wrote of an eighth “c”. He argued that “when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done”. He had a point. Features of a casino will always be present in a financial system that performs the essential functions of guarding people’s savings and allocating them where they can do most good.

Regulation will always be highly imperfect. But an effort must still be made to improve it.

"Credit crisis shows that banks need wise men not wide boys"

Although we have spoken from time to time about the managerial and cultural failings of the financial services industry, an article today in the Telegraph by Roger Bootle provides a nicely balanced, colorful, and deceptively insightful overview of the issue, while also giving a taste of how the British variant of the problem differs from its Yankee counterpart.

From the Telegraph:

Don't get me wrong. I haven't got it in for all senior executives and corporate board members. Some of my best friends are chief executives. Really. But I have come to wonder whether their colleagues are all quite what they are cracked up to be.

We all get things wrong. Even the most brilliant general or politician fails in some respect or other. Never mind economists. For us, getting it wrong is a way of life.

But for someone trying to analyse how good or bad a great leader was the key question to ask is why they failed. Was it bad luck, or bad judgment, or bad information - or what? Similarly when they succeeded, was this rooted in good decision-making or in good luck? The same is true for corporate leaders. But who makes such careful and critical assessments of them?

In practice, my concerns are most acute regarding financial businesses, and principally banks. I could be wrong, but I suspect that the degree of incompetence there is greater.

I do not mean to imply that the quality of people involved is necessarily lower, but rather that there is more chance that skills and practices do not match up to requirements. Financial businesses are inherently more complex and they can change that much faster. Accordingly, it is probably easier to make catastrophically bad decisions in finance than in any other business.

What has prompted these thoughts is the recent news of large-scale losses by banks. The shocking thing is that in the case of major corporate decisions we know so little. We don't really know whether individual senior bankers are culpable. Stock market analysts have, as so often, failed to ask the pertinent questions. Major shareholders, who have often been part of the problem by pushing managements to deliver short-term performance, could ask key questions. But their activities seem to be mainly confined to pushing for the occasional executive scalp, without really knowing whether that person was the root of the problem. On the whole, journalists have given corporate executives and their decision-making processes an easy ride too.

About the only powerful source of scrutiny is the Treasury Committee of the House of Commons (to which I act as an adviser on monetary policy). A grilling by those rottweilers can rattle the most confident of chief executives and raise a mighty stink. But the Committee does not have the time or resources to conduct major investigations into corporate decision-making.

Even though they have a clear self interest in understanding why they made a bad decision, I doubt whether even within the corporations themselves there is much self-analysis.

I have more than a suspicion that in most cases the answers would make your hair stand on end. There are several characteristics of senior bank executives which should make you worry.

First, they are not by nature very ruminative and not normally given to self doubt. This can, of course, be a good quality, but not when the world is so uncertain and the consequences of bad decisions so serious. Second, they do not lightly tolerate dissent and tend to attract sycophants among the ranks of other senior executives. Third, they normally have distinct blind spots in the two areas where a financial organisation can most easily be brought to fail, namely IT and complex financial instruments. Fourth, if an activity is making money they usually give it the benefit of the doubt.

In a properly functioning corporate world these failings of the executive would be both recognised and counter-balanced by the wisdom of the board. But many boards are best regarded as a form of club. The City is a peculiar mixture of geekish quants and rocket scientists, wide-boy traders who would otherwise be selling apples and oranges down the Commercial Road and time-serving apparatchiks. Typically a board consists of no one from the first two groups but quite a few from the third. In what position is Sir Thingummy Whatnot to question the real risk exposure of a bank? Does Dame Noditthrough really know her onions on complex derivatives?

And for presiding over all this, of course, senior bank executives get rewarded on a scale that ordinary mortals find fantastical. And when they fail, they get packed off into the sunset, often begonged, with a very comfy nest-egg indeed.

The inability of most normal human beings to understand what the quants are up to is devastating. Of course, the banks all have their risk assessment teams and procedures. But they are also highly quantitative and to normal people speak gobbledegook. More fundamentally, their model-based approach rests on the continuing relevance of recent experience - often over pathetically short runs of data - with scant regard paid to the "off-the-model risks" which in the real world are the usual sources of upset. Personally, I would sack at least half of the risk assessment boys and replace them with historians and people versed in English literature. Their brief would be to think the unthinkable - not to measure the easily quantifiable.

Not long ago, banks and other lenders were falling over themselves to lend on wafer-thin margins to people and propositions which their predecessors would not have touched with a bargepole: 125 per cent mortgages; huge multiples of earnings; self-certification. Now the lenders are shutting up shop and fancy mortgages have disappeared like melting snow. Both approaches cannot be right.

The silence about the corporate behaviour which led us to this pretty pass is scandalous. Come off it boys, you were sucked into a bubble of the classic sort. You were persuaded to believe that nothing could go wrong. Yet any study of financial history would have set the alarm bells ringing. But do you ever read any? To his great credit, the Governor of the Bank of England warned explicitly and publicly of the risks. But did you listen? Outside commentators and analysts, and even, in some cases, your own in-house experts, pointed out the over-valuation of property. But did you pay any attention?

We cannot go on like this. There are all sorts of ways in which banks must be restrained and regulated to be better behaved in future, including with regard to their remuneration packages. But the structure and behaviour of boards and banks' procedures for assessing risk should also be an important part of this reform.

Supposedly the justification for the gargantuan pay packages of recent years has been the supreme cleverness of bankers. Yet so much of modern banking is a form of gambling. Those clever bankers, nodded on by their gilded boards, have done the equivalent of put a few billion quid on the 3.30 at Newmarket - and lost. Clever or not, what they really need more of is not cleverness but wisdom. And what they need less of is money.

Why Such Timid Financial Reform Proposals? (Alan Blinder Edition)

Here we are, in the midst of the worst financial crisis since the Great Depression, and what do we see? Central banks madly pumping water out of leaky, listing vessels, some discussion of how to patch the most visible holes, but perilous little consideration of how to correct the defects of construction, poor choice of shipping routes, or recklessness of the crews and their captains.

Moreover, one has to wonder if the last two weeks' outburst of "the credit crisis is just about over" chatter isn't merely to talk up the markets, but also to forestall regulation. After all, if the worst is behind us, we clearly don't need to do anything, now do we? Of course, that view conveniently ignores the massive subsidies to the banking sector by the Fed's, the Bank of England's and now the ECB's willingness to create new liquidity facilities, and in the case of the Fed, accept increasingly dodgy collateral (I gasped out loud when I heard that the list had been expanded to include securitized credit card and car loans). But the Street knows full well that now that they have the dough, they have the advantage. It's rather difficult to renegotiate a loan once the proceeds are in the debtor's hands. Yes, technically, the Fed could refuse to roll outstanding loans, since, for example, the TAF is a 28-day facility, but the whole point of this exercise has been to avoid upsetting the financiers, so tough disciplinary measures will not be forthcoming.

The problem is that the ugly truth discovered by William Gladstone when he became Chancellor of the Exchequer is now on full view:

The government itself was not to be a substantive power in matters of Finance, but was to leave the Money Power supreme and unquestioned.

The latest example is the half-heated proposal set forth by Alan Blinder in today's New York Times, "The Case for a Newer Deal." The reference to the New Deal is disingenuous, since it brought a slew of radical, large scale interventions, some of which did not survive the 1930s. However, the securities law reforms implemented in 1933 and 1934 have not only proven to be durable, but became the template for public securities markets around the world.

Yet what Blinder recommends bears perilous little resemblance to the sweeping 1933 and 1934 acts. In fact, he even stoops to apologize for even daring to suggest regulation:

A warning to laissez-faire-minded readers: The following is mostly about the dreaded “R” word — regulation. But I’m afraid that we need more of that, starting in the mortgage market.

His first suggestion is to have a federal mortgage regulator (the notion being that the many of the worst mortgages were originated by unregulated brokers). Fine, but that's already on the table. Indeed, there is robust debate as to whether the Feds or the states should act as the supervising adults (states are arguably more motivated, give that mortgage abuses affect their communities and thus their tax bases; mortgages are subject to state, not federal law. Real estate broker licensing is also a state matter. An understaffed or half-hearted federal regulator might be even worse than the status quo).

Blinder's next observation:

Next, we should resist calls to scrap the “originate to distribute” model, wherein banks originate mortgages, which are then packaged into mortgage pools and turned into mortgage-backed securities that are sold to investors around the world.

There is good reason for us to keep it. As the refreshingly honest Lew Ranieri pointed out at the Milken conference, the securitization model saved America's bacon by distributing dodgy deals all over the world. Ranieri said the US financial system could not have withstood the amount of losses had the paper remained at home (although in fairness, I recall reading that by 2006, mortgage debt was being sold primarily overseas because US buyers weren't keen to acquire more. So the sales might have dried up sooner in the absence of access to foreign buyers and kept domestic exposures to a level we could bear).

But what Blinder misses is that model depends on credit enhancement. That's why Fannie and Freddie are being asked to assume a larger role, since they have an implicit Federal guarantee that is likely to be tested soon. Two of the three sources of credit enhancement – monoline insurance and credit default swaps – aren't an option right now (CDS are costly because few are willing to write protection right now). The only method of credit enhancement readily available right now for non-agency deals is overcollateralization, and investors appear more leery than they were in the past.

Blinder argues for having everyone in the securitization pipeline retain a piece of the mortgage pool. Um, Merrill and Citi DID wind up holding very large pieces of "super senior" tranches that they convinced themselves were fine and went out and originated more with the amount they would up retaining growing even larger. The magnitude of the fees led them to underestimate the risk. To have "keeping a piece" constitute enough of a check on behavior, the players along the pipeline would have to retain a fairly large piece, which means undermines the purpose of the approach. And Blinder fails to address another big failing: the difficulties of doing mods.

Blinder seems curiously blind to what this model hath wrought:

This seemingly convoluted model has given the United States the world’s broadest, deepest, most liquid mortgage markets. And that, in turn, has meant lower mortgage interest rates and more homeownership. These are gains worth preserving.

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy. And these vaunted lower interest rates were the result of deliberate distortion: the Fed pushing short rates to 1%, which was negative in real terms, combined with the industry pushing ARM structures for weak borrowers. This pattern, including the increase in homeownership, was a misallocation of capital, and anything but a virtuous outcome.

Reader Richard Kline gives a far more accurate picture of what happened:

How did the financial industry come to the pass we now face? This is the first question to ask in considering what structural or regulatory changes are desirable. The fundamental issue, to me, is the unwillingness of firms lending money to set aside appropriate reserves against losses, at any level. We have 300 years of modern banking history which has without exception indicated that unreserved lending is to a financial institution what the absence of an immune system is for an organism; a scratch can kill you (default cascade or credit cut off), while a real virus not only kills you but infects your neighbors. So we see again. This behavior, an unwillingness to reserve against losses, suggests its own trajectory of solutions but let’s do a brief review for context.

Loan retailers, including mortgage brokers, set aside very little for losses because they weren’t going to hold the debt; instead, they pushed it up the chain, typically for securitization. Banks skirted their reserve requirements by opening conduits with pitiful liquid reserves to park debt of various kinds while shopping it or bundling it to be shopped. Similarly, banks underwrote huge volumes of inherently risky and unstable LBO debt against which they compiled no adequate reserves because, again, they expected to sell the debt at a profit not retain it.

CDOs are the freak show exhibit for tortured ill-thinking about how to reserve against losses. The principle benefit, initially, from securitization was overcollateralization against losses. Yes, really. This had at least three legs, of unequal size. In many cases, default swaps were bundled into the CDO as a shock absorber to take first losses. The CDO was sold at a discount to the face of the underlying debt, so that a further cushion against loss was bundled in. Both of these provisions were unequally distributed to tranche buyers, but in principle offered significant reserves against loss risk. Finally, some CDOs had limited recourse provisions against the originators of the original debt in case of fraud, high failure rate or the like. These mitigation options were small and hardly universal, but again they in principal reserved against risk.

All of these ‘reserves’ have failed massively in the present circumstance, and for much the same reason: they weren’t real reserves---cash or near equivalents tied to the debt---but promises of payment. Issuers of default swaps as we see never expected to pay off more than a tiny fraction of their swaps, and to the extent that they themselves had any ‘reserves’ these proved to be not cash but debt which in a pinch they have been unable to sell to raise money. The swaps on any one CDO may pay out, but on the instruments as a whole _cannot_ pay out. Then the underlying debt bundled in CDOs has tended to be overconcentrated in single asset classes, and thus totally, even ridiculously, exposed to price declines in the same asset class. The ‘excess collateral’ has been wiped out and far more by overall price declines. And many loan originators have simply gone out of business, or are accidents awaiting liquidation, eliminating pittance mitigation from retail underwriters. There were no REAL reserves in these CDOs, only promises to pay. This is the biggest fallacy of passing risk around the financial system, that promises without substance will be honored, or even can be.

Banks lent a great deal of money against which they retained no reserves. This in fact was a principle accelerator of the bubble in asset prices, because these hot, fluid, expanding vaporbucks competed for the same assets and so inflated their prices. This had the appearance of inflating asset _values_ but this was not really the case. Hopes that actual gains in asset values would cover any potential (and putatively unlikely) losses proved utterly speculative in all the worst sense of the word. Thus, at the same time that banks contributed to a balloon of asset prices they underreserved against the risk of trafficking in and owning those same assets, in effect multiplying their exposure to loss.

The public authorities also failed to reserve against risk in this, even leaving aside their regulatory dementia in allowing banks to vastly expand their exposure without increasing their reserves. The authorities did this by their implied, and now explicit, guarantee to let no major institution fail. With that hope and belief, why would big institutions lending money hold _any_ reserves, let alone large ones? And while the Fed had 800 gigabucks to play around with here, and many regulatory fudges, that sum isn’t nearly large enough to backstop the entire financial economy of the US. So the Fed didn’t really have the money to put where their mouth has been, either.

The issue isn’t simply that the financial system, in whole and in part, took excessive risks. Far more, it is that they system and all its players convinced themselves they didn’t need to set aside money commensurate to the amounts they were moving around---because the ‘vaporbucks’ would always stay in motion until they ended up somewhere else. We need to return to the concept or requiring solid and sizable reserves against losses for parties that lend large amounts of money.

And those reserves at the Federal ‘Reserve’ System? Well, part of them need to come from increased fees levied on regulated players. However, we also need the option of nationalizing failed or failing institutions, wiping their equity holders and shaving their bondholders to the extent necessary. We need that option in part to keep the public authorities from being greenmailed by financial institutions or cartels of same ‘too large to fail.’ The public needs to be able to give failing marks to those that so merit and run them out of the game. And money set aside for the purpose in the hundred billion dollar range needs to be there so that the threat has substance.

Back to Blinder. He won't even get rid of off balance sheet vehicles, even thought that was one of the aims of Sarbanes-Oxley (I'd like someone to explain to me how SIVs aren't a violation of Sarbox). No, he'd merely increase capital charges against them. That's a limp wristed form of disincentive. If you can socialize your losses, you shouldn't get to engage in fancy footwork to increase your profits. I fail to see why that idea is treated as controversial.

But Blinder does want to reduce gearing of the big financial players to that of a typical commercial bank, say 10-12 times, versus the 20+ (or 30+ in the case of Lehman and Bear) typical of investment banks. He notes dryly that that has profit implications. He runs through the list of reform ideas for rating agencies and concludes by noting that any changes will require a coordinated international effort.

Note that Blinder fails to even consider a big dead body in the room: credit default swaps, the likely reason that the Fed bailed out Bear.

Blinder's proposal is the equivalent of seeing Prozac as the right treatment for someone who has lost their job. Mere palliatives will not get someone who is unemployed back to work, nor will they remedy serious failures in our financial system.

Hubris, Denial, and the Financial Services Culture

I am still recovering from the Milken Conference, and unlike my fellow blog panelists Paul Kedrosky, Felix Salmon and Mark Thoma, have not written any posts on particular sessions. In part, that was because in my other life as a consultant, I am well aware of the dangers of relying on memory even though mine is pretty good, and I had decided to listen rather than take notes.

But the other reason was in almost all the sessions has a strong element of overt pressure on the speakers to maintain an upbeat tone, combined with repeated reinforcement of Republican/Chicago School of Economics ideology. Normally I would not deem that sort of thing worthy of mention if it were a minor and only occasional element of the program; indeed it would have been valuable if other views had been tolerated and some sparks flew. No, the private sector/deregulation cheerleading was pervasive and baldfaced, and made it hard for me to sort out signal from noise. There were enough cases where I knew the data and knew it to be misrepresented so as to call a lot of what I was hearing into question.

I did manage to see one session that was free of that, by theoretical physicist Lisa Randall talking about her work (needless to say, it was way beyond me, but she did a good job nevertheless), and putting in the lone plea I heard for government intervention. She said the US was losing its edge in her kind of science due to our inability to make commitments that we will adhere to for large scale experiments, like the one at CERN this summer. And she told us it will not make a black hole that will destroy our universe, since the energy involved will be insufficient to produce anything other than a black hole that would dissipate immediately, and the odds of even that were extremely low. But her session had at most 60 in the audience, while the big presentation later on, with Eric Schmidt of Google, Craig Venter (famed for decoding the human genome) and Muhammad Yunus of Grammen Bank, had frequent comments by Venter about how badly the government funded efforts to decode the genome has performed relative to his efforts (with Milken as moderator making supportive noises). Um, isn't it possible that different types and scales of science require different approaches? And no one seemed willing to acknowledge that our vaunted pharmaceutical industry depends heavily on Federal funding (I've seen estimates in the 40% to 55% range).

Mind you, there were some signs of dissent from the Panglossian posturing. Myron Scholes, both in the large lunch ("Four Nobel Prize Winning Economists") on Tuesday and in a panel discussion on innovation in financial services on Wednesday, attempted at several points to take issue with some of the ideas that might have been oversimplified, and met considerable resistance, as did Edmund Phelps, And I noted what care Scholes took to be precise and non-controversial in his presentation. For instance, in the lunch, Milken, who was the moderator, put up a quote from Joseph Stiglitz which said that we were in the worst financial crisis since the Great Depression. Note that Stiglitz isn't alone in making that sort of observation; Soros and various private analysts (and not just Nouriel Roubini). Even the IMF has been unusually outspoken about its concerns.

So what was the response? The economy is not in a recession, unemployment is low, ergo all this talk is off base. Scholes pointed out that we aren't through this yet and in hindsight things might look different, and was almost hooted down (the response was something like, "we are here to try to forecast the future. Looking back is easy."). Similarly, it was Scholes on the second panel who was the ONLY one I heard mention (and only obliquely) the massive facilities the Fed has implemented, and the efforts made by other central banks.

So this group was also a singularly ungrateful lot. Not only was there NO acknowledgment of the magnitude of the efforts made on behalf of the financial services industry, but every time the government was mentioned, it was with derision and elicited considerable applause.

Not that everyone there drank the Kool-Aid, mind you; in fact, the number of like minded might have been quite substantial (during the dinner the second night, the mention of Obama elicited more applause than the other candidates). I had some very good discussions with some others participants despite the impediment of a conference badge that read "Press." One was quite incensed ("Where's the humility?") and later said the fans were turned up high so no one could smell that they were shitting in their pants. Ouch!

But the example that bothered me the most was the panel on financial innovation. The panel consisted of Lewis Ranieri (who created the mortgage backed securities business), Richard Sandor (who invented financial futures), Myron Scholes, and Milken. Some of the lines of thinking were truly peculiar. What was bad about our financial crisis wasn't that is has and will continue for at least the next couple of years to do damage to people's lives and businesses. No, it was that other countries might become skeptical about financial innovation and thus deny themselves the opportunity to use financial innovation to solve problems like climate change and poverty

Ranieri was far and away the most downbeat on the panel, yet was repeatedly steered away from expressing his views fully. He felt that the problems we witnessed are not inherent to the products (ahem, are the bad incentives inherent or not? How do you separate that out?). He pointed out that the economic difference between doing a mod with a borrower who had some ability to pay was 30% (and in context, he seemed to mean 30% of the value of the original mortgage). He acknowledged that the modifications weren't being made, that the industry needed to cut the Gordian knot and might require legislative relief to do so. He also said that things could get very bad (he invoked the Great Depression) if this path wasn't taken. Mind you, that train of thought came out in snippets, with many attempts to steer him away from it. Milken, by contrast, claimed it was another example of highly regulated banks doing stupid things, just like in the sovereign debt crisis of the late 1970s (conveniently forgetting the role Wall Street played in structuring and selling the product, and in repeated and aggressively contacting mortgage orginators and telling them they wanted more product). Milken also maintained that the government should not get involved, the private sector could do a far better job of handling this, again conveniently ignoring the massive subsidies extended by the Fed via negative real interest rates on the short end of the yield curve and an alphabet soup of new facilities. I could go on, but you get the point.

An article earlier this week in the Financial Time by Abigail Hofman focused on the deeply-seated cultural issues that produced the crisis:

I worked for 18 years in investment banking and several aspects of the culture unnerved me. Investment banks are all about making money. At the extreme, this means making money for employees not shareholders. The big revenue producers are revered. It is not considered prudent to upset them by asking too many questions. The subprime meltdown is a perfect example of the "emperor has no clothes" phenomenon. These were complex products, yet obfuscation was considered acceptable. Bank chief executives should have asked more questions. I suspect they saw the juicy profits and hoped underlings understood the risks.

Moreover, investment banking culture has a cult aspect to it. If you work on Wall Street or in the City, you toe the party line. Despite lip-service to "diversity", diversity of thinking is not encouraged. This atmosphere of craven conformity breeds at first complacency and then mistakes.

The Milken conference provided vignettes of how to cultivate conformity: select the likeminded, or at least sympathetic, for high profile roles, and apply subtle and not so subtle pressure to make sure they stay within approved boundaries. But as Hofman's comments suggest, this isn't a Milken conference problem; rather, the conference illustrated certain behaviors found widely in the financial services industry (note also that, at least in my day, most firms were agnostic about their staff's political leanings).

A long time ago at McKinsey, one paradigm they mentioned was that people fell somewhere on the spectrum of internalizers and externalizers. Internalizers tend to blame themselves for what happens whether it was their fault or not. They are very conscientious and strive not to repeat their errors. Externalizers blame everyone else for their problems. They are very resilient and well suited to sales jobs. And they are incapable of learning from their mistakes, since they never make any.

"The inappropriateness of financial regulation"

Because I have yet to throw my stuff back in my bags to be on a morning plane back to NY, I must be brief.

I have not had the chance to think about Avinash Persaud regulatory proposals at VoxEU deeply, but at a first glance, they sound appealing. However, the devil will lie in the details, particularly since all his programs would be new. For instance, he suggests a new axis for distinguishing between lightly and more heavily regulated institutions. While I like the idea, any sharp line will encourage regulatory arbitrage; a gradient might work better. And these proposals are so far from the traditional approach that their novelty alone will provoke resistance.

From VoxEU:

Financial regulation never works the way it should. Here one of the world’s most experienced analysts of the global financial system presents some remarkably clear thinking on why we should not just do more of the same. An alternative model for policy action is proposed.

I have had the misfortune or fortune of being up close and personal with seven major financial crises in my banking career, from the US Savings and Loans crisis of the late 1980s to today’s credit crunch. In each crisis I have observed a “cycle” in the response to the crisis. In the middle of a crisis, when circumstances look dire and chunks of the financial system are falling off, proposals get radical. I recall in December 1992, with the UK and Italy having already been ejected from the European Exchange Rate Mechanism and Spain and Portugal looking vulnerable, some European policy makers flirted with capital controls. But a few months after each crisis is over, these radical plans are tidied away and we are left with three things. And they are always the same three things: better disclosure, prudential controls and risk management.

These measures are the regulatory version of apple pie and ice cream. Who would say no? The thing is – we have been investing heavily in these areas for the past twenty years and do not have much to show for it in terms of financial stability. Over the past eleven years we have had the Asian Financial Crisis, LTCM, the “dotcom bezzle” and now the credit crunch. While more disclosure, controls, and risk management are generally good things and necessary fraud reducing measures, there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that sub-prime was a poor risk – it is called sub-prime, after all.

Regulatory shortcomings

The problem is more fundamental, and, unless we address these fundamental issues, we will be condemned to repeat the cycle of boom and bust. Lying close to the heart of the problem in all of these recent crises, from today’s credit crunch to the Savings and Loans debacle and beyond, is the inappropriateness of financial regulation.

My own view of banking regulation would be considered quaint next to today’s practice. I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is therefore puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices. I have discussed this before many times so I will focus on the secondary objective, which is to avoid the discouragement of good banking.

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

Market finance

This switch to market finance improved “search liquidity” in quiet times. Credit risk that was previously bundled with market and liquidity risk was separated, priced and traded. This has improved the transparency and tradability, but it comes at the expense of systemic liquidity in noisy times.

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilising but destabilising and the only way to short-circuit the systemic collapse is for a non-market actor, like some agent of the tax payer, to come in and buy up assets to put a floor under their prices. (I wrote about this liquidity trade-off with some colleagues; Laganá et al. 2006)

Now this is a legitimate model: the marketisation of finance and the resulting improvement in search liquidity in quiet times, coupled with direct state intervention in the crisis. It is the model we have today. But I venture that it is a highly dangerous model. It is expropriation of gains by bankers and socialization of costs by taxpayers. Paying for a decade of bank bonuses can be very expensive for the taxpayer and the opportunities for moral hazard are enormous.

An alternative approach

The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.

The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers.

Former Fed Staffer Savages Bear Rescue

Greg Ip of the Wall Street Journal reports on the harsh criticism of the Fed's role in the Bear deal by Vincent Reinhart, who rcently was the Fed's most senior staff member.

What is ironic about the Fed's bailout is that it is unpopular on the left and the right. The left does not like the spectacle of subsidies to the until-recently-highly profitable financial services sector, particularly when salvage programs for individuals are getting more talk than action. Reinhart, who was on a panel at the American Enterprise Institute, illustrates the views of some (many?) on the right: perhaps Bear should have been saved, but not via the government shouldering the risk.

Two further points: Reinhart describes other options the Fed could have taken, yet omits the most obvious: lending to Bear for 28 days via JP Morgan, which appeared to be the initial plan, but which the Fed retracted and instead made a mere commitment through the weekend. Bear officials had thought they could pull through with the longer loan, particularly since the new Term Securities Lending Facility was going to become operational before that loan matured. The only explanation I can come up with (aside from nefarious ones) is that the Fed did not feel it could lend to Bear after it was downgraded on Friday March 14 by the rating agencies to just above junk.

The other is that Reinhart comments approvingly on the Fed's role in the LTCM rescue. Yet at the time, a lot of observers were critical of the central bank orchestrating a deal for an institution it did not regulate with a lot of institutions it similarly did not regulate. This was seen in some quarters as a significant and unwarranted increase in the Fed's reach. But remember even then that while the Fed assembled the exposed firms (not telling them who else would be there) and told them why it would be in their interest to rescue LTCM, the Fed played no role in the negotiations. Thus, while Reinhart says that the Fed can no longer act as an honest broker, that is counterfactual. The Fed was not a broker in the LTCM deal.

From the Journal:

The Federal Reserve's rescue of Bear Stearns Cos. will come to be seen as its "worst policy mistake in a generation," a former top Fed staffer said.

The episode will be seen as comparable to "the great contraction" of the 1930s and "the great inflation" of the 1970s, Vincent Reinhart said...

His appraisal is one of the harshest yet by a high-profile observer.....Mr. Reinhart said the bailout "eliminated forever the possibility the Fed could serve as an honest broker." In 1998, the Fed coaxed private creditors of Long-Term Capital Management to bail out the hedge fund but didn't have to put up its own money. If it ever tries a similar maneuver on a Wall Street cohort, he said, "The reasonable question any person in the room will ask is, 'How much will you contribute to the solution?'"

Mr. Reinhart said the Fed's move may have been justified if the alternative was a chain-reaction run on many other investment banks. But he asked if other options were available, such as taking a "tougher line" with J.P. Morgan, seeking other suitors, removing certain assets from Bear's portfolio or quickly implementing its previously announced offer to temporarily swap Treasury securities for dealers' less liquid assets. "All those things were possible but not pursued," he said.

Henry Kaufman Proposes a New Regulator for Uber Banks

Henry Kaufman, aka Dr. Doom in his heyday as Salomon's chief economist when the firm was at the peak of its power, argues in "Finance’s upper tier needs closer scrutiny," that the very biggest financial institutions need a regulator with the savvy and reach to supervise them effectively. Kaufman put the number at roughly the top 15 in the US; this would represent a broader universe than what the Bank of England called "large complex financial institutions" (16 globally made the cut).

Some readers have taken umbrage at earlier remarks by Kaufman on the regulatory front, noting that he is on the board of the awfully-close-to-edge Lehman. Let me take issue with that view. If Lehman were private and Kaufman were on its management committee, the criticism would be well founded. But public boards are an odd beast. Operational decisions are explicitly the preserve of management. The board's duties are limited to matters such as hiring and setting compensation for the CEO, making sure there are adequate succession plans, setting broad policies. Thus a board member might express concern about undue risk-taking, but his only remedy if he felt his concerns were ignored would be to fire the CEO (which would require the support of other board members) or quit.

Interestingly Kaufman's article spends a great deal of time on the boards, He sees the new supervisor as playing an important role in improving the competence of directors (!) and in emboldening them in asking tough questions (although the good doctor does not put it that baldly, it's the drift of his recommendations). The fact that Kaufman suggests that supervisors meet with board members about their duties has another implication of which he is no doubt aware but did not spell out: the fact that the directors would have a relationship with the top supervisor would give boards more leverage in dealing with management.

From the Financial Times:

The performance and behaviour of leading participants in our financial system must be improved if we are to avoid future calamities. What is urgently needed, as I have proposed for decades, is a new kind of institution we can provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest US-based financial institutions – the giant conglomerates engaged in a broad range of on and off-balance sheet activities. It would monitor and supervise these conglomerates – assessing the adequacy of their capital, the soundness of their trading practices and their vulnerability to conflicts of interest as well as other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions, but rather of the upper-tier players. In the US, the 15 largest institutions have combined assets of $13,000bn. They dominate many areas of trading, underwriting and investment management. Several command leading positions in derivatives and in the esoteric financial instruments that have grown so rapidly. The current regulatory and supervisory authorities should remain in place for smaller financial institutions. But assuring the soundness of the dominant companies would go a long way towards preventing systemic risks, even if smaller institutions occasionally failed.

The new authority should be a bipartisan body operating under the auspices of the Federal Reserve. The FFOA chairman also should serve as a voting member of the federal open market committee in order to bring valuable input about the well-being of the largest private institutions. Members of the FFOA should possess recognised expertise across a broad range of financial services. Finally, the chairmen of the Fed board and the FFOA should co-sign an annual report to Congress on the safety and soundness of the institutions under their purview.

Other leading economies should be encouraged to consider a similar approach. Such institutions would be effective if they supervised the functions of only the top five to 30 financial conglomerates in each country. That more consolidated and rigorous oversight might be limited to the largest financial institutions in the European Union, Canada and Japan. Moreover, because of the transnational reach of many financial conglomerates, FFOAs would need to co-operate closely. Unified supervision is essential.

One main focus of the new authority should be the training and competence of board members in financial corporations. Qualifications should include a better than working knowledge of accounting as well as competence in quantitative risk analysis techniques and proficiency with information technology. The information that reaches directors should be detailed and forthright. Directors need to be educated about transactions with affiliated companies and about transfers of assets and debts to special-purpose entities in order to achieve “off balance sheet” treatment.

New board members should be required to meet representatives of the supervisory organisation. Through these meetings, new directors should be informed of their responsibilities from the perspective of the supervising authorities. These authorities should also meet the board periodically to review the results of examinations and to be assured their recommendations are understood and will be followed. Independent directors should have separate, periodic meetings chaired by the designated lead director, with outside legal counsel present. These meetings should be guided by prepared agendas that address critical issues including the company’s risk policies, growth aspirations and succession planning.

Today’s compensation packages often favour aggressive risk-taking. Instead, managers in leading financial companies should be compensated on the basis of the long-term and sustainable profits. This can be achieved in several ways. Stock option awards should have long maturities. They should be exercisable not on termination of employment but years after termination. Contractual cash settlements on employment termination should not be paid on termination; they should be paid out later and include claw-back arrangements.

Finally, I urge that supervisory organisations be made responsible for issuing credit ratings for the institutions under their supervision. I doubt that the private rating agencies can obtain enough information – especially about large, integrated conglomerates – to enable them to render meaningful and timely ratings. The Fed already rates quite a few of the institutions under its supervision. It is called a “Camel rating,” taking the first letters from capital, assets, management, earnings and liquidity. The new authority should be charged with a similar task rather than outsourcing the function to private agencies.

Buiter on the Failure of Financial Capitalism

We have the rare spectacle of Willem Buiter admitting he doesn't have an answer, but in fairness, he is looking at a throny problem.

Buiter considers the question of what to do about the financial sector once the crisis has passed. He provides a scathing assessment of the workings of financial capitalism, but is pessimistic that regulation can be effective. Highly paid traders will outsmart supervisors; regulators, out of prolonged contact with their charges, will be corrupted intellectually, identifying overmuch with the industy's world view; the minders will be inclined to one of two extremes, either to restrict bank activity unduly, or to go too far overboard in their salvage operations should anything bad happen.

There is a flaw in Buiter's reasoning, however: he assumes the status quo ante will return in the absence of government intervention. Enough pieces of critical infrastructure are hopelessly impaired that I doubt that will happen.

The biggest, and one that poses a major conundrum, is that private securitization has ground to a halt. It depended on credit enhancement, which is now suspect, and has also become scarce and costly. The monolines are no longer in that business; with bank balance sheets impaired, there are far fewer credit default swaps protection writers. Plus, given concerns about counterparty problems leading to more generalized failures in the CDS market, it's not clear how receptive investors would be to CDS as the means for providing credit enhancement.

Plus with so many investors burned directly or indirectly by supposed AAA paper that fell rapidly from grace, it may take a generation before memories fade and willingness to buy the product returns.

So in the US, we see Fannie and Freddie stepping into the credit enhancement breach, even though that will soon create problems of its own.

That is a long-winded way of saying that the industry is already losing important businesses that led to high profits, swagger, and outsized pay. Give it two more bonus cycles, with