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.