Today, in a comment at the Financial Times, “This is where Freddie and Fannie step in” (subscription required), Harvard’s Larry Summers argued that the subprime crisis highlights three questions. Most commentators focused on the one question he not only posed but answered, namely, what role government should play in aiding the flow of credit to the housing sector. Summary: while Summers is dubious about the wisdom of how Freddie Mac, Fannie Mae et al. have operated, he thinks they have a legitimate role when to play when mortgage funding becomes scarce.
I find Summers’ unanswered questions more interesting:
First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default. There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that – as in previous financial crises involving Mexico, Asia and Enron – the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? What is the alternative? Sarbanes-Oxley was a possibly flawed response to the problems Enron highlighted in corporate accounting. What, if any, legislative response is appropriate to address the ratings concerns?
Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve’s payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments. Central banks that seek to instill confidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?
To Summers’ first question on what to do about the rating agencies, the answer is that the options are few and not very attractive. You can’t get rid of ratings and you can’t get rid of the rating agencies we have.
Credit ratings are tightly wound into regulations and investment processes. Ratings are used in domestic and international bank capital adequacy standards, pension fund and insurance investment standards, even in the Fed’s definition of acceptable types of collateral for discount window purposes. Similarly, credit ratings are fundamental to bond pricing. Traders and investors routinely look at the spread over Treasuries, that is the number of basis points over the comparable risk-free rate investors are paying to assume a certain level of credit risk.
If we were to get rid of credit ratings, we’d have to replace them with something that served exactly the same function.
Similarly, like it or not, we are stuck with our current rating agencies. In the wake of 2002 corporate accounting scandals, some large accounting firms had to be allowed to survive, no matter how bad their malfeasance proved to be, because the workings of our capitalist system require audits of large companies, and only large accounting firms can perform that function. Smaller firms could not step into that breach.
Ditto the rating agencies, except what will prove more galling as this sorry sage progresses is that the rating agencies are so few in number, which has the effect of giving them a free pass. We cannot afford to have a public execution of one of them to satisfy the public’s need for justice and instill a little fear into the others. Any legislation that provided for penalties even an order of magnitude lower than the losses they caused would put them all out of business.
Accordingly, Summers mentioned Sarbox. The best policymakers can do is give the rating agencies tougher guidelines, restrict them from playing a quasi-underwriting role (they worked fist in glove with investment bankers in structuring asset backed securities) and perhaps establish much greater penalties for issuers that provide incomplete or misleading data to rating agencies. All in all, not a very satisfactory solution.
Summers’ second question is worded oddly (“how should policymakers address crises centred on non-financial institutions?”) I think he means “financial non-institutions”, players that are not subject to oversight by the Fed or the Office of the Comptroller of the Currency but whose actions can and do have a big impact on regulated banks. That isn’t just hedge funds. Investment banks, which are regulated by the SEC, can also tank the banking system (that’s precisely why the Fed rounded up 24 firms, most of which were not under its regulatory oversight, to stem the collapse of LTCM).
Another way to put it is that financial intermediation used to happen almost entirely through the banking system. Individuals and companies put their deposits with banks, which then used them to make loans. Only very big companies used the capital markets for debt finance.
But since 1980, banks have been losing market share in financial intermediation to investment banks. US banks now hold only 15% of non-farm financial debt.
Now recall that the banking regulators oversee players that have become more and more peripheral over the last 25 years. Note that this limited scope impedes their understanding. The Fed kept assuring the public that the Brave New World of financial innovation was working just fine. What basis could they have had for such rosy views?
For example, in a March 2007 speech, New York Fed president Timothy Geithner essentially admitted the Fed and other regulators lacked a complete, or even good, picture of what was happening. His argument boiled down to,”Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK.” This quote was telling:
….these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.
Those fat tails will get you every time.
The good news, is, as Summers stressed, these issues are now on the table. Regulation will increasingly be seen as necessary and desirable, so long as it is not done to excess.