Musings on Structural Challenges to the Financial System

One thing that has me troubled about the financial mess is the degree to which the powers that be are wedded to a system that it clearly broken. In part, that results from financial capture of the government apparatus by the banking industry. But an equally sticky problem is the attachment to a rather recent vision of how the financial system works. And that in turn is oddly reminiscent of destructive patterns in the Great Depression.

If you go back to 1980, the world of finance was very different, The Federal Reserve was considerably larger than any single bank. On balance sheet lending was the norm. Banking was most decidedly not sexy, unless you were Ciitbank, which loved to innovate and push regulatory limits, even though lots of banks then became free riders on its pioneering.

No one in 1980 (outside of MBA programs and certain parts of New York City) knew what an investment banker was. If you used that term with most middle or upper middle class Americans, they would assume it was some sort of glorified stockbroker.

To make a very long story short, securitization changed all that. Banks saw their lunch eaten by investment banks as they were increasingly disintermediated. By 2006, only 15% of the non farm, non-financial credit was via the banking system. What Timothy Geithner called “market based credit” became the norm.

The problem is, as we know, as the model didn’t develop as much as devolve. There have been massive information losses. Much of sound banking credit processes has been replaced by sophistry, such as score based credit models that have been demonstrated to perform badly, incomplete loan files (so no one has enough borrower G2 to do updates and triage for mods), a reliance on ratings and hedging in place of credit analysis, even a mortgage registry service that only reduces transparency. And the very worst element is that securiitzation vehicles make debt restructuring, a key element to resolving a financial crisis, well nigh impossible.

And securitization was and remains the epicenter of the crisis. Gillian Tett of the Financial Times tells us:

What is imploding though is the securitisation world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds were sold in markets, and this year market issuance is minimal.

Now as we have said, some shrinkage is necessary. Too many people borrowed too much.

Yet there has been absolutely nothing in the way of seeing whether the model can be fixed, or scrapped. John Dizard suggested last year that central bankers expected the world would revert to more on-balance sheet intermediation, but that would entail even more equity in the banking system than the amount needed to plug the loss holes. And the Treasury and Fed actions, of creating a myriad of guarantees and special facilities, instead says that they are trying to put in place a government backed securitization process (witness in particular how Fannie and Freddie pretty much are the mortgage market these days) in place of its formerly private version.

But the lack of any thought, much the less action, on the securitization front is troubling. And I suspect no real fix is possible.

It’s surprising nothing has been done on the rating agency front. That’s a contained element. many good proposals have been made, yet not a peep from anyone in authority. If small fry like them can’t be reformed, clearly nothing serious is in the offing.

But ex the rating agencies, it would seem at least two things would need to happen, and even then I am not sure either would be sufficient.

One line of thought is that more of the intermediaries need to have some skin in the game by retaining paper they originate, rate, or sell.

But the reason that securitization beat out lending was that it was cheaper. And the big cost of banks holding loans was equity and FDIC insurance. The more players along the food chain have to retain some of the deal, the less favorable the economics, since they will have to put up some equity to support the assets they keep. Some securitization deals might still work even with a higher level of expense, but the market would be smaller.

But of course, that assumes the players do bona fide keep a long position. What’s to prevent them from hedging their credit risk? And if they do that, we are back to square zero in terms of fixing incentives.

Problem two is unless I missed it, I have heard no serious suggestions as what restrictions to impose on securitization vehicles and servicers going forward to facilitate mods. One problem now is that deep enough mods aren’t being offered (principal reductions have a much higher success rate). Probably more important, mods, just like the lousy credit decisions that helped create this mess, are being done via decision rules using simple borrower metrics rather than case by case assessment. The US has suffered falls in housing values in individual markets in the past that were as severe as the national declines we are witnessing now. I keep hearing from old style bankers that mods were always viewed as the better solution if you has a borrower with some ability to make payments. But they also made those assessments individually and with a knowledge of the community (as in stability of various local employers).

But again, would the securitization model work if you incurred the extra costs to do things right, as in better borrower assessment at the outset, establishment of good loan files (I hear repeatedly that servicers seldom have any good borrower documentation), and required investors to pay the costs needed to do mods? Again, by increasing costs, it would mean fewer deals would “work” from an economic standpoint.

So I would surmise that even if securitization were reformed, the market would indeed be considerably smaller. Paul Volcker thought we needed to roll the clock back and go to more traditional bank lending. It is pretty clear that the rest of Team Obama is not on that page and wants to restore the brave new world of fancy finance ASAP. But I don’t see how we get there, save waiting ten years for memories of the problems of this period to fade and the bad practices to start all over again.

Which brings me to the Depression. There are many theories of why it spiraled downward, but the one I find most persuasive was that it was the result of the efforts to restore the gold standard in the mid 1920s (worsened by France pegging the franc too low and accumulating massive gold reserves). The key observation from works by scholars of that era like Peter Temin is that the banking and political leaders of that day felt restoring the gold standard was pro stability, and perhaps even more telling, they were virtually unable to imagine a world without it.

Our paradigm is quite different, but many of the key actors seem hopelessly anchored by it. And I worry that like the Depression, we will have to see it break down completely before we can start to rework it in significant ways.

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  1. Richard Kline

    The complete lack of any whisper of financial reform _of any scale_ from inside the Beltway speaks volumes regarding the perspective of our present political class. They have not yet come to accept that the financial system as of July 07 is irretreviably busted and dead. Yes, credit markets froze. Yes bunches of mortgages were sour and have gone bad. Yes, that and the slowdown in the real economy means that many big banks have big losses. Well, some of those big banks have been killed previously in the last generation, only to be resuscitated by the Government. So the Beltway types are banking on resuscitation. The pervasive lying about loss levels indicates that the American political class is simply not willing to accept the responsibilities thrust upon them yet. They want business as usual, and they are holding their breath until the money turns green again.

    Part of the perception of governmental failure here results from our being conditioned to rapid response in a contemporary 24-hour media environment. Consider the Great Depression. It was some 30 months after the crash before any meaningful reforms were pushed through, an on the order of 50 months before thoroughgoing investigations and a comprehansive program of remedies was cobbled together. And that in an environment of much more severe employment and real economic collapse (though in a period when living standards were much lower and previous severe contractions were recent and had been endured). We are presently only 22 months into this one. Our Semi-stimulus Bill of two months ago counts as a Hooveresque Old College Try of less then meaningful scale. Given that we flopped the election in Nov 08 on reform with respect to who we’ve put in power (though _not_ with respect to who we deservedly through OUT), we’ve probably set ourselves back at least 24 months on getting any real remedies supposing that we do at all.

    We could have reform under way now. We should have reforms under way now. For that to happen, we need reformers. Any on the way, now? No? No. So . . . we aren’t even at the starting line of change. The saddest fact of all at present, to me, is that much of what our ‘crisis response’ consists of is likely to make our subsequent outcomes WORSE, both economically and politically. This is the first major crisis the US has completely flunked on since the 1850s. Our exceptional luck in the grim 20th century has about run out with the turn of Century 21.

  2. bobo bobo

    Yves: Problem two is unless I missed it, I have heard no serious suggestions as what restrictions to impose on securitization vehicles and servicers going forward to facilitate mods. One problem now is that deep enough mods aren’t being offered (principal reductions have a much higher success rate).


    The banks are pushing legislation to give securitization servicers the ability to reduce the principal of first lien mortgages without reducing second lien mortgages. This would help banks at the expense of other investors because the banks hold something like $400B of MBS backed by interests in second lien mortgages. Other investors are fighting the banks on this, and preparing to sue the Feds under the 5th Amendment for a taking of property without compensation if the legislation passes and servicers start hurting first lien investors. Instead of letting losses flow to the junior liens consistent with contract law.

  3. "DoctoRx"


    I share your worry. In “The Structure of Scientific Revoluions”, Thomas Kuhn introduced the concept of paradigm shifts. Sadly he said that the ancien regime in the scientific establishment had to die out for a new paradigm to truly be accepted. We see the same phenomenon here. Instead of the gold standard then, it is the concepts of Keynes and buy-on-credit rather than grow via retained earnings.

    Even more fundamentally, what is so critical about a super-rich country like America always “growing”?Isn’t that in conflict with sustainable, green living?

    That’s the deeper paradigm shift that DC and the MSM won’t talk about. Sometimes small is beautiful.

  4. Independent Accountant

    Nothing will be done to fix the ratings agencies. For 32 years nothing has been done to fix the CPA business. Both result from the classical agency problem.
    My take on the cause of the Great Depression differs from 99%+ of people who’ve “looked” at it. While the Brits trying to return to their pre-War gold parity was coincident with the depression, I believe it only changed its timing. I say the Great Depression was the world’s way to pay for World War I. Real consumption had to be cut to pay for the war. It was in the 1930s, not 1914-18.

  5. sangellone

    Important and insightful post Yves.

    I do recall some talk of ‘covered bonds’ as a possible ‘new model’ for US banks but that doesn’t seem to have gone anywhere and, given what is happening with European banks, doesn’t seem to be much of an answer anyway.

    This seems to be something like a Titanic moment. You try and bail as fast as you can even knowing that won’t work in the long run.

  6. Gentlemutt

    Excellent post, Yves.

    This debacle rhymes with previous ones; it does not simply repeat them. You hit on one key rhyme, wherein the leadership of the day attempts to restore the financial machinery which they associated with “the good old days.”

  7. NicktheLame

    Business 101 is about “borrowing” at cheaper rates to “lend” at higher rates. Employee compensation is the difference between those two rates and the velocity of the money.

    Employee compensation can be maximized by increasing the arbitrage or by increasing the velocity of money. Absence regulation, it was easy to increase the abritrage (by reducing the costs to do business) and also the velocity of money.

    There is simply no incentive to facilitate mods from an employee compensation perspective. The high arbitrage (thanks to the near zero govt. rates), compensates for the decrease in the velocity.

  8. VangelV

    Which brings me to the Depression. There are many theories of why it spiraled downward, but the one I find most persuasive was that it was the result of the efforts to restore the gold standard in the mid 1920s (worsened by France pegging the franc too low and accumulating massive gold reserves). The key observation from works by scholars of that era like Peter Temin is that the banking and political leaders of that day felt restoring the gold standard was pro stability, and perhaps even more telling, they were virtually unable to imagine a world without it. I like Rothbard’s take on the subject of the Great Depression. The central banks bungled it by allowing credit to expand too quickly. Had there been a real gold standard as there was prior to 1913 there would have been much less meddling and no Great Depression.

    Of course, once the collapse began, meddling by Hoover and FDR made the contraction turn into a Great Depression.

  9. bobo bobo

    nick the lame: There is simply no incentive to facilitate mods from an employee compensation perspective. The high arbitrage (thanks to the near zero govt. rates), compensates for the decrease in the velocity.


    The banks (which own the servicers and a boatload of 2nd lien mortgages and securities backed by them) are pushing legislation to let their servicer subsidiaries do mods screwing the investors they sold first lien mortgages and securities backed by them, and get their servicer subs a fee for doing the mods.

    If this goes through, it will screw the value investors that have been buying first lien mortgages and securities backed by them. So they’re telling Congress if the legislation passes and servicers start screwing them, they’ll sue the feds under the constitution for doing an unconstitutional taking without FMV compensation.

    If Congress screws the investors in mortgages, we’ll see how easy it is for them to persuade people to buy MBS from banks.

  10. joebek

    A good case can be made that this crisis really started in 1989 with the collapse of the Japanese real estate and stock market bubbles. So we are really nearly two decades into the crises with each period of reform actually setting up for a deep crisis into a few years time. I wonder what it does to the securitization model if central banks were to announce that since the bias of a capitalist system is toward inflation (through credit expansion) the goal of monetary policy would be modest annual deflation. This might not make the securitization model any less financially attractive but it would probably increase the frequency of systemic flushing of bad assets. More frequent flushing will mean less overall systemic risk. Could it be that simple?

  11. Joe Costello

    If you remember Timmy’s infamous first speech in February he said, “no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses.”

    He must have been truly confused that the markets reacted so badly, for he in fact said exactly what he thought the boys wanted to hear.

    Of course, that’s really all anybody needed to hear to know it was going to be a very very long winter.

    You’re absolutely right and I’ve taken to saying, “No reform, no recovery.”

    No matter how many hot dollars or how much hot air, the bubble will not be re-inflated.

  12. In Debt We Trust

    The biggest problem is that off balance sheet lending is inimical to the gold standard. Transparency was so much easier to price and follow in the old days.

  13. marcum

    It’s not just the securitization of mortgages confounding the problem but also basic elements of a mortgage like PMI. Here’s an anecdotal example of my own situation. My Wells Fargo mortgage (subsequently fobbed off into Freddie-Mac) has PMI thru a different company. And when I call Wells Fargo and try to refinance via Obama’s ‘Making Home Affordable Refinance’ (MHAF) program they say they CANNOT help me because they don’t know how to ‘RENEGOTIATE” my mortgage insurance with the PMI folks. Kinda convenient for Wells Farge since I’m paying 6.75% and can’t refinance thru normal channels because my LTV is about 90%. I should be the PERFECT candidate for MAHF but am stuck. Never late on my mortgage and have a solid job history.

  14. nadezhda

    I agree with the overall thrust of Yves' post — we're going to have to get a thoroughly restructured system before this is all over. But beware of simply equating disintermediation with securitization. Disintermediation trends antedate by several decades the explosion of securitization that has been so destructive.

    I'm not concerned about the steps the Fed and Treasury have been taking to support bank funding and securitization markets — they're basically just fingers in the dike. I also don't think calls for scaling back the banks — in size or function — is going to get to the heart of the problems produced by disintermediation, which have been building since the 1960s.

    Disintermediation goes back to the liberalization of interest rate regimes that started to break down the highly segmented post-Depression financial system, the development of the Eurobond market which started the process of hiving off a lot of bread-and-butter corporate lending to the capital markets, and the introduction of competing cash and savings management vehicles, for retail via the mutual funds industry, and for business via a host of treasury and portfolio management services that have eventually made their way into the shadow banking universe. By the time we got to the repeal of Glass-Steagal, the genie had long been out of the bottle.

    The plain vanilla securitization of conforming mortgages and reliable receivables cash flow streams weren't dangerous in and of themselves, though they did take some balance sheet business away from the banks. The first couple of decades of securitization in fact did a pretty good job of matching up assets and cash flows on one side with varying preferences for term structure, yield and risk on the other. They were standardized and transparent which made them easy to rate, which eliminated most of the banks' information-based competitive advantage. The resulting disintermediation of those chunks of "banking" (or S&Ls) was efficient in all senses of the word — both borowers and lenders got better services at an overall lower cost than running the same transactions through the banks.

    What got out of hand with seucritization, and eventually went insane, was the proliferation of techniques to manufacture and monetize apparently "low risk" (AAA ratings or monoline wraps or screwed up models for CDOs) with highish yield. And most of the sources for monetizing ephemeral low risk weren't even sitting anywhere on balance sheets where someone could evaluate them, but instead in contingent liabilities (off balance sheet vehicles, no-collateral CDS sales, etc).

    Turns out, as Felix Salmon has recently suggested, that there wasn't nearly as much appetite for high-risk/high-yield as all that securitization necessarily implied. Because the risk hadn't been eliminated, it had just been opaquely shifted or disguised.

    So what we wound up with was a run on the credit markets instead of (or in additon to) a bank run. The government had to stop the credit markets run, and with its guarantees, it is now providing the equivalent of "deposit insurance" for the banks to be able to continue to access market funding. That's the purpose of all those various Fed lending and FDIC guarantee faciltiies.

    The credit markets we're going to have 3 years from now aren't going to come back in anything like the same form as before. The amount and type of securitization isn't going to recover because no one — public or private sector — is going to be able to provide the amount of credible insurance to replace what people thought they had through AAA backstops or monoline insurance or fancy-dancy structures. So I'm not worried that we're rushing to recreate what blew up.

    But we should be able to gradually recover the plain vanilla stuff that worked without all the tricked-out "enhancements". Correct me if I'm wrong but it seems to me that's pretty much what the government's attempts to "revive" the securitzation markets have focused on — conforming mortgages and plain vanilla ABS, especially receivables.

    The bigger and longer-term question re disintermediation is whether the banks can compete. Can they recover the sort of "relationship" business that used to be their bread and butter before the capital markets became so dominant. The credit markets are going to take a long time to return to handling stuff that smacks of risk. So that will give banks the opportunity to reclaim some of the classes of business which were disintermediated into the capital markets, but only if as Dizard suggests, they're able to build up the right side of their balance sheets through equity and an improvement in their access to the credit markets. But that will, unfortunately, require that we continue to bail-out/restructure the banks in a way that won't defeat their future access to market-sourced funding. Hence the concern (rightly or not) about the treatment of current bondholders.

    But a shift back toward reintermediation won't totally avoid the same dilemmas of disintermediation. In the long run, the banks will again be faced with an uneven playing field against the shadow system in competiton for funding costs (FDIC fees on deposits, tougher leverage ratios etc), which will encourage disintermediation or higher risk-taking by banks. And the financial system will remain exposed, via the banks' balance sheets, to another run on the credit markets, where the government has to intervene to stop the run.

    If we want the banks to become boring again, it seems to me we have to first tackle the competition to the banks. That means bringing the shadow system into a regulated environment that imposes leverage limits and some sort of "fee" on funding via the markets which helps to level the playing field. A fee would help compensate the government for its regulatory role and its implicit guarantee that it will intervene to stop "credit market runs".

    I don't think we'll ever return to the notion that the capital markets are going to be left to their own (destructive) devices. The moral hazard was already there, we just didn't acknowledge it. So now let's make it more explicit and have folks pay for the service so we can limit the downside of moral hazard. Bringing the capital markets under some sort of control, it seems to me, is the elephant in the room that calls to "make the banks boring" (or smaller or less powerful) are missing.

    I don't see anything that the Fed and Treasury are currently doing that undermines future attempts to bring the capital markets into a regulatory structure.

  15. Yves Smith


    That’s a fair point, and I was sloppy with nomenclature. As the same, time, having lived through this, as of the mid 1980s, banks were alarmed as how they were losing out to investment banks. So it was not perceived to be benign to them. And that in turn led them to start shifting their business models.

    I am probably being simplistic, but I started getting concerned when credit card receivables were securitized. Again, it was a gut reaction, but I saw that as going too far down the path of hollowing out banking.

  16. curious

    Yves: Which brings me to the Depression. There are many theories of why it spiraled downward, but the one I find most persuasive was that it was the result of the efforts to restore the gold standard in the mid 1920s (worsened by France pegging the franc too low and accumulating massive gold reserves).

    VangelV: I like Rothbard’s take on the subject of the Great Depression. The central banks bungled it by allowing credit to expand too quickly. Had there been a real gold standard as there was prior to 1913 there would have been much less meddling and no Great Depression.

    Me: I’m going here from memory of reading done over twenty years ago, but as I recall, in his book America’s Great Depression Rothbard made the case that the primary reason the Fed overexpanded credit in the 1920’s was to try to assist the Bank of England in getting the pound re-tied to gold (after having gone off it for WWI) at the old, prewar rate rather than at a price more appropriate to its inflated postwar status. Rothbard’s saw that official overvaluing of the pound as having led to a tremendous US trade surplus and concomitant whopping gold flows to the US, so the Fed tried to inflate US prices to counter that process. He cites a fair bit of communication between NY Fed governor Benjamin Strong and Bank of England Governor Montagu Norman to back up these claims.

    So Yves’s view above was not really inconsistent with the Rothbard view.

  17. Joe Costello

    nadezhda — “That means bringing the shadow system into a regulated environment that imposes leverage limits and some sort of “fee” on funding via the markets which helps to level the playing field.”

    So wouldn’t that mean they just become banks? I’m very hard pressed to see advantages of the shadow banking system outside of making more money for a few people on Wall Street.

    In the end, all you’re doing with securitization is leveraging leverage. That’s when you get to a system that spins out of control.

    All the banking reforms of the 30s recognized this. Reform #1 was to limit leverage — with regulation, reserves, separating investment banking etc go down the list. Once you have a conservative banking system, then the government can come in and backstop the whole thing, thus you get a very stable banking system for five decades.

    Now we have the government frantically trying to backstop a money system that completely removed itself from the “real” economy. Very hard to see how that works. Everyone needs to take their losses and quit putting it on the tax payer.

    I really dont see the value of middlemen who simply make money off money, outside a very conservative banking system. The further money disassociates from the “real” economy, the bigger the fall — so we learn again. No one needs a bunch of complex equations to understand that.

  18. VangelV

    So Yves’s view above was not really inconsistent with the Rothbard view. I agree if the intent was to argue that the peg was set at the wrong rate but that is not the way the comment was written. The way I read it the argument is that the Depression happened because of the effort to go back to a gold standard. Rothbard argued that hard money was necessary because it was a way to protect individuals from confiscatory activities of corrupt governments. He clearly blamed the eventual crisis on going off the gold standard in the first place and on giving central banks the power to create purchasing power out of thin air.

  19. john bougearel

    Wow Yves,

    I love how you picked up on the Depression era locked into its 1920 paradigm mindset sought to restore 1920’s status quo is similar to how today’s leaders paradigm mindset is locked into restoring the status quo of flawed mindsets with respect to gen’ securitization and lending practices, protecting the too big to fails and making them even bigger, etc.

    This is a theme worth parsing out and exploring further.

    If the main characters of yesteryear clung to their flawed paradigms, beliefs and values contributed to a prolonged depression and non-cleansing of the financial system at the expense of the rest of the country…and the main characters on today’s stage who are clinging to their flawed paradigms, beliefs, values, mistaken goals are contributing to a prolonging of financial crisis…the lesson is that what is most required during a crisis of this magnitude is precisely a paradigm shift. National and global crises demand a paradigm shift for resolution, forces resisting paradigm shifts worsen and prolong the crisis. Insofar as Warren (not the painted commie they would like to color her as)and others who represent paradigm shifts are quashed, the more enduring our crisis becomes. In Amity Schlaes FOrgotten Man, it took until the 1940 election, a full decade after the Depression got underway that the forgotten man found a renewed sense of purpose and the realization that he too must be required to move the nation forward.

    We can not move our nation forward today until we can sweep aside these flawed mindsets and embrace a paradigm shift, unfortunately with epochal crises like this, it probably takes a great deal more pain until a Pecora comes along and a perhaps decade or longer until a meaningful paradigm shifts occur

    These changes take a great deal of pain and time to play out

  20. Joe Costello

    I’d also like to say, Yves has hit on a very fine point with this, “But they also made those assessments individually and with a knowledge of the community (as in stability of various local employers).”

    This is something that really needs to be thought about, the more comprehensive depth of people compared to models. I’m finishing an excellent book called “The Great Transformation” by Karl Polanyi, 1944. A real thought provoking look at the evolution of market economy in the last several centuries.

    Two things in particular, the first is direct to this point and the second to Yves point on gold standard and Depression — sorry about length.

    1)”In contrast to the nomadic peoples, the cultivator commits himself to improvements fixed in a particular place. Without such improvements human life must remain elementary, and little removed from that of animals. And how large a role have these fixtures played in human history! It is they, the cleared and cultivated lands, the other buildings, the means of communication, the multifarious plant necessary for production, including industry and mining, all permanent and immovable improvements that tie a human community to the locality where it is. They cannot be improvised, but must be built up gradually by generations of patient effort,and the community cannot afford to sacrifice them and start afresh elsewhere. Hence that territorial character of sovereignty, which permeates our political conceptions — for a century these obvious truths were ridiculed.”

    I’d say this remains an important point today, especially with generic modeling that has come to dominate finance.

    2)”In the 1920s, the gold standard was still regarded as the precondition of a return to stability and prosperity, and consequently no demand raised by its professional guardians, the bankers, was deemed too burdensome, if only it promised to secure stable exchange rates; when, after 1929, this proved impossible, the imperative need was for a stable internal currency and nobody was as little qualified to provide it as the banker.” — replace the mindset of gold with financial “innovations.”

  21. 1FmD89N.j.3miCf1vKjmXpbsKVzyDXx563Us2g--

    Very good post and good comments. The oddest thing is that wildly disintermediated securitization only prevailed for a few years.

    Part of the reason plain vanilla securitization worked for a while was because it rested on an existing infrastructure of competent, conservative, low-paid loan officers who would enforce consistent standards.

    By contrast, the 2003 to 2007 version never made any sense. How could all those Wall Street parasites possibly suck that much money out of a bunch of 5.5% mortgages and still have something to sell that yielded 5%? They obviously couldn’t.

    The system only worked when home values were rising fast enough that consumers could be persuaded to refinance and tack on a few thousand dollars of extra fees every six months or so. Rapid refinancing had the additional advantage of making the go-go vintage pools self-liquidating before anything could go wrong.

    Other subsidies in the system included chump “insurers” like AIG who could afford to write very cheap insurance because they were not required to have any reserves to pay claims in the event of default. And the ability to charge another fee to resell the same loans in new packages, or to sell synthetic versions of any of the above.

    The post-2003 system can’t possibly be made to work again.

    The pre-2003 system might be able to work again, but only if there is a system of competent, conservative local loan officers to originate the loans. Unfortunately that system has mostly been wiped out and replaced by chain banks with local personnel whose knowledge and experience is comparable to the grocery cashiers located across the aisle from the bank branch.

  22. nadezhda

    Yves wrote:… having lived through this, as of the mid 1980s, banks were alarmed as how they were losing out to investment banks. So it was not perceived to be benign to them. And that in turn led them to start shifting their business models.

    I am probably being simplistic, but I started getting concerned when credit card receivables were securitized. Again, it was a gut reaction, but I saw that as going too far down the path of hollowing out banking.OK, Yves, this is going to be really long, but the structural forces of disintermediation is a central dilemma that I think has been somewhat ignored in the "oligarchy" criticisms of Geithner et al, and I'm really glad you framed it so clearly. I also think that looking back over the past few decades has some value. So I'll give it a whirl.

    I agree with you that the degree of disintermediation, and the angst that it produced, increased substantially in the 80s. There was a scramble for a "better" business model where the banks could find a ground on which they could compete. Bulking up via interstate banking to obtain larger geographically-diversified deposit bases, cross-selling retail services at lower distribution costs (hence the dream of selling to the same depositor base checking accounts, credit cards, mutual funds, brokerage, insurance, pensions etc.), bigger balance sheets in theory giving them more clout in the global capital markets to lower their wholesale funding costs, and so forth. And of course looking with envy at the investment banks.

    Receivables securitization was indeed a hit to the banks' business model, especially for the money center banks. But the viability of the old model had been eroding steadily in the prior 10 to 15 years. Once the interest rate controls were lifted and the segmentation by type of institution started to erode, disintermediation just kept building up steam. And the money market funds that started taking off in the early 70s were as big a threat as receivables securitization ever was. The combo was tough on the banks, but it made S&Ls obsolete by the mid-70s. Unfortunately with help from Washington, the S&Ls were encouraged to double-down on risk to somehow magically stay in a business that no longer made any sense. And a decade later we paid the high price for legislative gimmicks and regulatory forbearance.

    So I certainly agree with the general thrust of your remarks, that trying to keep an unworkable status quo spinning is very bad policy. I just don't think the Fed and Treasury have yet made that sort of irrevocable and costly commitment to the status quo. Though we have to remain on the lookout so they don't, with the help of Congress, make the same type of mistake that was made with the S&Ls.

    Before we got to securitization of receivables in the 80s, the banks' corporate business was already in the 70s being threatened on a number of fronts. The international bond markets were becoming a serious alternative to bank corporate lending, at least for medium-term finance (CP was yet to fully develop), breaking the old "relationship" model. Milliken's creation of the junk bond market was just premature — a bridge too far for where the markets had reached by that point, so he had to cheat to keep it spinning until it crashed. But it worked the second time around when the capital markets were ready to move on to a new asset class.

    Another source of competition for the banks came via information technology, such as nightly sweeping of accounts, which increasingly allowed businesses to bring their corporate treasury functions in-house, buying only specific services from a much more competitive set of providers. The fuzzy cross-subsidization of services characteristic of "relationship" banking couldn't be maintained — every product or service had to justify itself independently (distribution, customer satisfaction, revenues and expenses, use of the financial institution's increasingly constrained balance sheet, etc). The banks were getting threatened competitively on both sides of the balance sheet, as well as being threatened by small providers of low-barrier-to-entry services who generated fees but required very little capital, such as portfolio management.

    I lived through those changes as a corporate lawyer. For example, I can recall when my bank clients required corporations to maintain compensating balances as part of a revolver. A few years ago I explained to someone what a compensating balance was, and first he didn't believe me, and then looked at me with complete horror. Non-interest-bearing cash accounts? of millions of dollars?!?

    Anyhow, the point of revisting old war stories is that there are a whole host of factors, apart from securitization, that produced disintermediation of a range of financial services out of the banking system. And we aren't going to be able to disinvent many of those factors. Nor would we want to, because some of them did indeed produce superior service at lower costs for customers without increasing risk (other than the risk that over time the hollowing out of the banks was going to lead to tears).

    So, Yves, although I agree that we have to address the disintermediation dilemma, I'm suggesting you rethink the "securitization accelerated disintermediation so we've got to get rid of securitization." Here's how I'm (very preliminarily) sorting through where we've come from and where we're likely to go, with or without regulatory changes.

    What I think history can teach us is to tease apart the competitive bases of various financial services, their implications for different business models, and where they present risks to whatever future system we're trying to work our way towards. One of the ways I like to look at competition in financial services is to view "information" as one of the main sources of competitive advantage. Gerry Caprio, who used to be the World Bank's lead financial sector economist and who's now at Williams, has a nifty way of thinking about financial institutions, services and markets as producers and transmitters of information.

    When we look at the financial system via the prism of "information", we see how once the segmentation of the financial system started to break down (geographically, by currency, by type of financial institution, by types of services that could be offered), bond markets that focused on certain types of instruments, issuers and investors could become competitive with banks that had benefited from their long-term relationships with and knowledge of corporate clients. As the financial system desegmented, so that banks no longer had virtual monopolies on sourcing their funding, the banks also had to pay an increasing price for their funds (fees on guaranteed deposits or wholesale prices) and charge a profit margin. By contrast, the emerging corporate bond markets could cut out paying the bank intermediary while still compensating the information providers (underwriters, rating agencies, etc) and come out ahead for both the borrower and the ultimate source of funds, the investor or saver. The saver no longer needed to have the "safe" bank interpose its balance sheet between the saver and the borrower. This competition model has over decades disintermediated the banks out of one asset class after another. For example, the petrodollar recycling by US banks to Latin American sovereign borrowers won't happen today because the bond markets have almost completely taken over the class of emerging markets sovereign financing.

    So the bond markets have a huge competitive advantage over the banks, but they can retain it if and only if they are efficient at producing credible information. If they're not — either because the costs of producing the information are too high relative to the banks, or because the information is seen as unreliable — then the markets lose one of their primary source of competitive advantage to the banks. They do, however, retain a funding advantage over banks in that they have fewer balance sheet constraints and they don't have to pay the government a guarantee fee.

    The banks after the 1960s have operated at an increasing disadvantage to the capital markets on the funding side — they have to pay for funding (especially now they have to compete for deposits with interest rates, not toasters). And the banks also have to pay a fee for the government's commitment to stop bank runs. However, as long as it was generally assumed that only the banks had the benefit of the government guarantee, then the payment of a fee wasn't a significant disadvantage for banks and, in fact, could be viewed as a small price to pay for a competitive advantage over other issuers of debt.

    Because the banks were operating at a funding disadvantage, they started looking for ways to take advantage of their client base while not using their balance sheet. Hence the attractiveness of originating for securitization. We know they got their internal incentives wrong, which was guaranteed to produce drek for the investors. In addition, unfortunately too many of them, especially the late-comers to the bubble party, didn't fully off-load the risks to the sucker investors, but in fact just created a bunch of contingent liabilities that continue to produce surprises.

    So where are we now? The capital markets — and the banks who tried to operate in them — aren't functioning because what appeared to be the markets' competitive advantage as an information provider for investors turned out to be totally bogus. Which produced a run on the credit markets, which the government had to stop. Post-Lehman that included the AIG payouts because — given how lousy the market information system turned out to be — no one could tell how far and fast the contagion was going to spread, but it looked like a lot of financial institution balance sheets around the world would have been in shreds. But borrowers and savers can't run from the markets back to the safety of the banks, because the banks themselves are a mess, with information about the banks as unreliable as any in the market. So the government is selling a lot of its own debt and in the meantime guaranteeing their access to the credit markets to stop any runs.

    Going forward, I don't think we're going to get rid of the credit markets and return to bank-centric finance. I do think that the capital markets have, for the time being, lost their huge competitive advantage in information, because it's been proved that what we thought was reliable information was in fact total fantasy. However, for large issuers that attract competing analysts, and for plain vanilla standardized products like conforming Mortgage Backed Securities or receivables from issuers the market can get their brains around like telecoms and utilities, once we get a view on where the global economy is headed in the coming 4 quarters, those particular debt markets should be able to recover. That's because the markets, both primary and secondary, can provide adequate, reliable information for those sorts of credits, so they'll be able to out-compete the banks, even the healthy ones.

    I don't see those sorts of asset classes returning to the banks, nor should they, because we don't need a financial intermediary to interpose its own balance sheet between savers and those classes of borrowers. The markets will provide better, cheaper services than the banks do. And if the banks want to stay in the origination business for those sorts of credits, then they should retain a certain portion — on their balance sheets — of what they sell into the market or securitize.

    What's not going to recover in the capital markets is the opaque, super-structured stuff or the super-high-yield junk, or the LBOs that assumed a never-ending access to roll-over financing. Nor will we see a reemergence of the credits that would only get off if they had a AAA wrap or back-stop. The apparent information advantage the market provided to investors for these sorts of issues has been demonstrated to be highly suspect at best. A lot of these sorts of credits never should have happened in the first place, and the borrowers won't be able to access financing from either the markets or the banks on anything approximating the terms that were available during the bubble. But to the extent that they are financable, they'll be handled by the banks, once the banks themselves get their own balance sheets in order. So the "invisible hand" is going to reduce the aggregate amount of debt financing and encourage some reintermediation, as suggested by Dizard, so long as we get the banks stabilized.

    However, the one thing that might encourage the reemergence of this sort of dangerous activity in the markets again, once the financial system stabilizes, is if non-bank financial institutions (funds, insurers, pensions) have a regulatory incentive to invest in this sort of stuff. Which brings us to the rating agencies. I've just about reached the point that I think the regulatory use of ratings — either as a mandate or a safe-harbor for fiduciaries — should be abolished. They're too easy to game on the sell side, and they seriously erode fiduciary responsibility on the buy side. And they exacerbate the disintermediation dilemma, because they unfairly privilege the markets as information providers over the banks.

    The markets currently enjoy a significant advantage over the banks in funding costs. The banks now must pay not only deposit guarantee fees but wholesale funding guarantee fees. Yet, we know the government is still going to have to bail out the capital markets just as they do the banks, so a portion of the markets' funding advantage is basically unfair, or tilted against the banks. And therefore encourages disintermediation.

    Which brings me back to my "proposal" — that if we want to encourage reintermediation, we'll have to come up with some sort of charge on the markets (either the funding of non-bank financial institutions or a small fee on each transaction) to help level the playing field so the banks can compete with the market on ways — such as information provision and service features — that produce socially beneficial results.

    And that's enough for one comment!

  23. Olesh

    The most interesting aspect of the current securitization and disintermediation system is that Risk gets parsed in several directions. Some of the risk transfers between parties transacting and some gets disbursed into what I will call “The System.”

    The System has no terminal point so that every transaction lets some portion of risk that is involved in the transaction be shed. The risk does not dissapear completely but Seller nor Buyer no longer posess nor price the risk.

    In order for The System to bare the risk, regulation must impose a price (through a tax) for it on those transacting or shift all of the risk onto the parties (i.e. retaining certain tranches in any transaction or compensate dealmakers when the transaction is retired rather than consummated).

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