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.
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Heeyyy, I’m sharing the NC greenroom with Alan Blinder. I must be doing something right. : )
Here is a shortlist of how securitization might be saved. Not, to be clear, that I would recognize a CDO prospectus if I was lighting a Franklin stove with it. Nor am I, personally, even sure that securitization should be saved, but a functioning financial economy has some larger value for society. 1) The concept of tranches—dedicated payment streams _without_ actual ownership of the underlying assests as I understand them—is inherently ripe for abuse, and distorts the sense of what is being bought. It would be better if these were largely eliminated so that a CDO buyer was holding the intsturments, the risks and the profits outright; y’know, like _BONDS_, friends. NOT like derivatives. 2)Such fairly unitary insturments would better be _smaller_ per security, so that investors take bite size chunks of asset classes, and make a risk assessment of their own with each purchase. If someone wants $3B in T-bills, they buy them in blocks not en bloc. Oh, by the way they can _sell_ them in blocks or individually, too. Smaller chunks would also allow investors to diversify the asset class and region themselves. Yes, it’s more work for the investor but look where they got themselves to speeding down Easy Street. 3) These instruments need to have real cash bundled into them as a form of ‘first loss recovery’ overcollateralization. Say, one has a certain value of T-bills, just for the argument, of similar term tied into the instrument; this is part of the profit that the investors ‘buy’ in buying the security and holding it to term if none of it is sold to offset losses depending upon the design of the instrument. There could be many variations on this, but the constant is that there needs to be _real_ reserves locked into the securities themselves so that their face values don’t plunge catastrophically in the event of internal losses.
Oh, and the inability to do mods on the underlying debt notes in the CDOs wasn’t a bug but a feature as far as the dealers and the wheelers in these things were concerned. If you can’t do mods you don’t _have_ to do mods: the suckers with the debt just have to pay up. Surprise, surprise: they can’t. So 4) clear, legally enforceable provisions _with consumer protections_ need to be written into the collateralization covenants. This will take an Act of Congress most likely, but will make the securities more functional in actual practice, and so, y’know, ‘save the investors from [their greedhead] selves.’
“I gasped out loud when I heard that the list had been expanded to include securitized credit card and car loans.” I did myself; this is so beyond absurd—at face value. Those _car loan_ securities are guaranteed to take massive losses in an economic downturn, they’re the worst definition of ‘collateral.’ “Here, collaterallize yourself with this No. 4 best bar anchor while you try to swim to the rescue ship.” The point is, to me, that the whole ‘collateral’ requirement is just a fig leaf. The Fed will hold this stuff until the banks recover and buy it back, is the idea. So it’s the equivalent of someone’s personal IOU, there is never any intention to cash out the stuff. (Famous last words.) The Fed would hardly be less exposed simply giving T-bills in billion dollar blocks to banks on a simple promise to repay. And I fully expect we will reach that point of nonsense in the determination of the Fed + Treasury to keep asset prices from falling. They are prepared to go to ANY LENGTH INCLUDING GIVING MONEY AWAY FOR A SONG to prevent a real correction of asset prices. . . . Won’t work. There is such a thing as gravity, and running as fast as you can doesn’t get your appendages going up to helicopter speed so one simply burns calories on the way to the canyon floor below. Sez I.
Just as soon as you read Alan Blinder — or anyone else — say, “This seemingly convoluted model has given the United States the world’s broadest, deepest, most liquid mortgage markets”, you immediately know you’re reading nonsense.
Where be thy broad, deep and liquid mortgage markets TODAY, Alan?
Yves’ experience of mingling with the true believers at the Milken Conference, is available to all of us every day. We just need to read Alan Blinder and any one else who utters nonsensical comments that carry within them characterizations of time frames that no loner exist.
“This seemingly convoluted model gave Holland — indeed, the known world — the broadest, deepest, most liquid tulip markets.”
“This seemingly convoluted model has given the United States the broadest, deepest and most liquid ‘dot.com, hits-based’ new economy and equity markets”
“This seemingly convoluted reasoning has given the US and the World the broadest, deepest and wisest financial and economic commentary and, thereby, opinion markets”.
I thought the banks’ position was that they didn’t have to consolidate an asset-backed commercial paper entity they’re sponsoring (at least on formation) because the bank’s investment in the entity didn’t exceed the “estimate” of the entity’s “expected” losses. I’ve heard this referred to as the “expected loss tranche loophole”. I thought the rule is in Paragraph 9(c) of FIN 46. I thought FASB and the SEC ended up approving of this practice.
I thought sponsors made their “estimates” based on historical loss experience (maybe historical losses of $0), despite the fact that losses looking low due to things like the sponsors previously taking back distressed assets from the conduit, or perhaps not having operated in a long-term credit crisis.
The SEC and FASB have gotten some complaints about allowing this. Senator Jack Reed send a letter to FASB and IASB complaining about various rules, including FIN 46, as allowing banks to hide liabilities/losses.
It is impressive how effective the banks are at lobbying for friendly legislation, accounting rules, regulations, and such.
Blinder:
“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.”
The free market ideologues have to get it through their thick skulls that there is no fundamental right to expose others to risk. We do not allow people to build nuclear reactors in their backyards without any sort of regulation so that they can sell power back to the grid, even though in theory it might result in more plentiful and lower priced electricity. The reason we do not do this is because of the _RISK_ of a release of deadly radiation or of a meltdown, even though it’s not absolutely certain that such an event will occur. One can draw a similar parallel to drunk driving laws. The die hard libertarian will claim that one should be allowed to drive drunk, so long as one does not actually crash into another vehicle. This completely misses the point, and assumes that one has the unlimited right to expose others to risk provided that the negative event never comes to fruition. Yet, for some reason, this is precisely what we are doing with our financial markets.
The financial markets, because of the very nature of the payments system, serve as a link between almost all players in the economy. As a result, actions taken by one participant (e.g., highly leveraged speculation) expose the entire economy to risk. So let’s stop apologizing for simply suggesting that such actions be regulated, ok?
I would like to propose a thought experiment, for the purpose of clarifying a few barely questioned axioms
which underly our fundamental notions about houses.
Imagine that a law existed with the following requirements: 1. A person may own as many homes as he
wishes. 2. Any home that he owns MUST be rented out to another person. No person may live in a home
in which he has a financial interest. No bank may make a loan to a home “owner” where the market rent
does not cover interest, amortization, taxes and maintenance, as in a commercial property loan.
What name would you give to such an arrangement?
Well, every person who owned a home would be both a home-owner (which we are endlessly told
is a good thing) and an owner of a wealth creating
asset being paid off over time (which at least is not a bad thing) At the same time, everyone would also
be a tenant. Some, just as today, would be only tenants, but not owners.
The question arises: What would the price of these houses be? Certainly a multiple of market rent to be imputed by the prevailing interest rate,
discounted by the other costs of ownership.
What would be the underpinning of the mortgages
on such houses? Not the income of the owner, but that of the tenant. What would be the propensity to
oversupply? Something close to zero.
How would the prices of these houses compare with
present prices? They would certainly be much lower, for the principal reason that the bulk of their
value would represent their ability to generate an
income stream over time, as opposed to the
“entertainment value” and speculative value which is today such a significant portion of house values.
Such a system, which I am not proposing, would not be immune to losses. When a 1 company town shuts down, the owners still lose. But they lose less, because prices have much lower speculative and entertainment components built in.
Considerable confusion in the above between the notion of reserves for liquidity (balances at the Fed) and reserves for the purpose of recovering losses (capital).
The “money multiplier” based on liquidity reserves hasn’t been operationally relevant in the US banking system (and others) for several decades.
I find all this talk of tranches acting as shock absorbers as highly amusing. It misses one basic point — securitization is about one simple thing: term leverage for the junior most tranche.
In that context, the question, we ought to ask ourselves is this: Why did the banks lose a lot more money in the current mortgage debacle than they did in the equity bubble, where the losses were higher.
The answer can be very revealing: It was because the leverage providers — margins lenders — didn’t provide term leverage. It was on variable terms. If the collateral was good, leverage would eb available. If it wasn’t it wouldn’t be. That pushed the onus on to the equity holder. In the current debacle, because of the termed out leverage and availability of this on a gargantuan scale, when the cycle was turning, the equity tranche holders stake was so little that they were being paid off of the underwriting fee. In other words, they had no effective equity and term leverage to boot. So a solution that focuses on retention of the equity will only work if the size of the equity tranche is large AND if the leverage provided by the senior tranches is either revocable or not fully termed out. Otherwise it just wouldnt work.