"The Dreaded 'R' Word"

Alan Blinder outlines the regulatory changes he would like to see enacted in financial markets:

The Case for a Newer Deal, by Alan S. Blinder, Economic View, NY Times:  Part of the New Deal was a new financial deal. The shameful shenanigans leading up to the 1929 stock market crash and the frightening wave of bank failures during the Depression led directly to the creation of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation.

As we emerge from this, the worst financial crisis since the 1930s, a New Financial Deal may follow. If so, what should some of the reforms be?

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...

An inordinate share of the dodgiest mortgages granted in recent years originated outside the banking system. They were marketed aggressively, sometimes unscrupulously, by mortgage brokers who were effectively unregulated... The need for a federal mortgage regulator — including a suitability standard for mortgage brokers — is painfully obvious.

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

But the model needs some nips and tucks. A far less radical, though still regulatory, approach would require both originating banks and securitizers to retain some fractional ownership of each mortgage pool. ...

And while we’re on the subject of M.B.S., we must end the regulatory fiction that off-balance-sheet entities like conduits and S.I.V.’s are unrelated to their parent banks. ... Since last summer, we have seen one financial giant after another brought to its knees by losses that originated off balance sheet.

What’s the solution? ... The remedy here is simple: Apply appropriate capital charges to off-balance-sheet assets.

That brings us to leverage. After all, high leverage means owning a lot of assets with only a little capital. This is where something fundamental changed on March 16. Before that day, only banks had access to the Fed’s discount window; broker-dealers took large risks without a safety net. But... Because securities firms are now under the Fed’s protective umbrella, they must start operating as safely and soundly as banks. That means both closer supervision and less leverage.

How much less? You may recall that Bear Stearns ended its life with leverage of around 33 to 1, meaning that just 3 cents of capital stood behind each dollar of assets. That won’t do any longer. Leverage of 10 or 12 to 1 is more typical for a bank. ...

Next come ratings agencies, whose recent performance has drawn criticism. The good news is that they are making good-faith efforts at change. ... The bad news is that they face an acute incentive problem when they get paid by the issuers of the very securities they rate.

What to do? The third-party reviews should help. ...Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Robert Pozen ... wants independent investors in the conduits to hire the agencies instead. Another idea would have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers. ...

Last, but certainly not least... Everyone knows we live in a world of giant multinational financial institutions... Such an environment demands ever closer international cooperation and coordination among the world’s major financial regulators. But today’s level of international cooperation is wholly inadequate...

Finally, let’s be clear about the purposes of all these New Financial Deal reforms. They would not banish speculative bubbles from the planet. After all, there have been bubbles for as long as there have been speculative markets. But with each bursting bubble, new flaws in the system are exposed. Like a good roofer after a soaking rainstorm, we should patch the leaks we see now, knowing full well that more leaks will spring up in the future.

Sometimes, it's best not to wait for more leaks if you know full well they will reoccur. You may not catch them all when you try to repair them in a piecemeal fashion, and with each new set of leaks the dry rot spreads further into the supporting structure, and if nothing is done, at some point the rot will cause the entire roof to collapse leading to very costly repairs.

Sticking with the dreaded "R" word analogy - roofs - when there is a danger of this happening, then the shingles, supporting plywood, and sometimes part of the frame need to be replaced, i.e. much more is required than simply plugging holes as they occur, the roof needs to be fully repaired. So the question for financial markets is how deep the repair needs to go. Do we plug a few holes, or do the repairs need to go deeper, into the supporting structure? With roofs, what is it, three sets of shingles before they all need to be scraped off and redone? Financial markets might be similar - at some point, as we layer on new regulation after each crisis, it might be best to scrape it all off and replace it with a thinner, more effective shield before it is too much for the underlying structure to support.

For financial markets, I'm not sure plugging a few holes is enough, and minimally I want us to strip the shingles off and examine the plywood and deeper supporting structure closely to see if it needs attention, then make the repairs as needed to prevent leaks for a good number of years. There are no guarantees that this will prevent all troubles, there's always the danger that a raccoon or something will dig a hole in your roof, a tree could fall on it, etc., but I do think we need to scrape the shingles off the regulatory structure that is currently in place, examine the underlying structure closely, and do what we can to prevent more leaks in the future.

Comments

[wogie]

Like your Roof analagy, Mark. Question whether Congress will have the stomach to scrape of all the shingles.

[Bruce Wilder]

I have not thought deeply about the problems of the financial markets, and I don't have the time or resources to do so, so I'm not going to. But, I know what thinking deeply about reform of industry structure would look like. And, I don't see any such thing in Alan Blinder's musings. Mark Thoma's analogy is much more suggestive of what needs to be done.

Two things would impress me: one would be some serious architectural design analysis of financial intermediation and carry (borrowing short, lending long). This, to my mind, is the analogy for structural engineering analysis for a roof repair.

There's a fundamental economic function at the center: financial intermediation. Borrowing short, lending long. How much leverage is required is strictly a function of central bank guarantees of liquidity; prudential precautions are a responsibility entailed by insurance for short-term depositers. The New Deal had a rationale, which was a little more sophisticated than chauvinistic hand-waving about what a broad and deep mortgage market we have.

The other thing that would impress would be some suggestions for improving information flow and analysis.

Economists, instinctively, think about incentives, of course, and are right to do so. But, all the incentive in the world is no substitute for appropriate instruments; you cannot incentivize an astronomer to see deeply into the heavens without a telescope.

The failures of the ratings agencies and missteps of the monolines (monolines and ratings agencies are competitors -- I wonder how many commentators realize that?) and the prolonged difficulty in figuring out which banks hold the really hot potatoes suggest that there are serious information flow problems.

We live in the information age. A complete census of every mortgage, and every property, ought to be available in real-time. Friends tell me that about half of mortgages are in private databases. But, what's with the other half?

I don't know why anyone thought Bear Stearns had to be rescued, but I've heard it suggested that it had to do with derivatives and Credit Default Swaps to which Bear was a party.

To my mind, cutting the balls off of investment banks is a truly bad idea. If the problem was derivatives, maybe the problem is not investment bank capital requirements and prudential decision-making -- maybe the problem is . . . (wait for it) . . . derivatives. Now, I've seen Blinder admit that he knows no more about derivatives than I do, so I fault him with full knowledge of his shortcomings. My point is this, why was it not possible to sort out the derivative positions of Bear Stearns and proceed with an orderly liquidation?

Of course, we don't really know what the problem was with Bear Stearns. Our Masters have not shared this knowledge. But, if the problem is a deep entanglement with undocumented derivatives positions, than let's create a clearinghouse, and with it transparency. But, more than transparency, I am looking for a data structure and flow that is detailed and authentic and that enhances decision-making.

As far as the housing market itself, and the question of asset bubbles, I am not that concerned. I think think things went awry not in the market for houses, but, rather, in the market for mortgages.

But, if someone wanted to go for bonus points in impressing me with their reform proposals, she would propose not just additional government regulation, but additional market measures. To wit, construct a way to go short in housing, as a way of relieving the pressure of an asset bubble.

[mrrunangun]

A new New Deal will take a lot better leadership than we currently see in Congress or on the horizon for the White House. Most likely we will see ineffectual regulation that does little but provide political cover for those who feel a need for it.

A young couple in our town is looking at buying a home in preforeclosure status. The people who bought the house were put in touch with a mortgage company who loaned them all of the money in two loans, the smaller at 20% interest. The buyer used a real estate agent who probably put them in touch with the lender. The buyers never paid much on the mortgage and have been able to live in the house rent-free while legal foreclosure proceedings continue. If the homeowners can sell to the young couple before the foreclosure, they avoid the foreclosure going on their credit record and the real estate agent makes another comission. Real estate agent and the loan agent made good money, the young couple will get a good price, the current "owners" save on rent they would otherwise pay, and the owner of the CDO including the mortgage is the only loser.

[robertdfeinman]

There is something unnerving about reading an article and the following discussion on the day before it's published.

This makes reading the Sunday New York Times an exercise in deja vu. The choices are to ignore the blog posting and miss out on the liveliest part of the discussion, or skip big chunks of the Sunday paper...

[anne]

"There is something unnerving about reading an article and the following discussion on the day before it's published."

I mostly refuse to, but....

[ken melvin]

Agree, best thinking and inspection are in order.

[A.Citizen]

I was talking to my second mortgage holder manager the other day and she outlined the following scenario:

Step One: The Federal Goverment make her business impossible with over regulation.

Step Two: Banks in exchange for 'regulation' are allowed to create mortgage companies using massive amounts of funds from wherever they can get them.

Step Three: Problem solved.

Except for the majority of folks who no longer qualify for a home loan. Not 'credit worthy'.

They can rent.

Forever.

[Winslow R.]

Bw wrote:"Friends tell me that about half of mortgages are in private databases. But, what's with the other half?"

100% are in public databases otherwise the lien holder has no recourse. From what I know of title companies, 100% of mortgages are in private databases as well. Call your local private title company and ask for a copy of your mortgage (or your neighbor's), it is public record. It helps if you know the document number.

I agree we should have public databases of any asset that has a taxable value, especially patents, copyrights etc. It would allow the economy to more easily monetize a variety of assets.

Bw wrote: "The failures of the ratings agencies and missteps of the monolines (monolines and ratings agencies are competitors -- I wonder how many commentators realize that?)"

I see them as collaborators more than competitors? Kind of like dividing up a pie. Rating agencies rate a bond and the monoline insures it. The rating would seem to help determine the insurance cost. Not sure I understand where there is competition?

[david]

Fix the leak, or fix the roof. Typically, the reason to do the former is that you don't have or won't spend the money to do the latter.

In this case, it's political capital. Fix the leak, we've got the capital for that. Fix the roof, you'll see the people used to telling politicians what to do rebel.

This is apart from what fixing the roof means, which I'm sure I don't know how to do. I'm equally sure that Blinder's weak tea is not going to get us very far.

[RW]

Not sure I see Monolines -- actually some of them are duolines who will soon by bankruptlines after making the mistake of taking on CDO's and default swaps rather than sticking to their cushy core bidness of municipal bonds -- as competitors of rating agencies either. I mean, it was (and possibly will be again) a great strong-arm game: Municipalities rarely default but if they wanted to issue debt at a lower cost they had to pay the monolines for insurance so, in turn, the rating agencies would increase their rating and reduce the interest rate on their bond issues.

Never mind that the monolines lacked the capital necessary to cover the debt they insured (and this was true even before their greed and stupidity led them to take on swaps) and never mind that the rating agencies were granting to the monolines (who lacked sufficient capital) what they apparently would not willingly grant to municipalities with the capacity to tax: A low probability of default.

Strong-arm aside the purpose of municipal bond insurance and rating was to spare investors the need to investigate individual bond issues and provide confidence their investments were secure even though neither insurance nor rating guaranteed anything of the sort.

Ain't capitalism grand? All the sins of organized crime with none of the stigma.

says...

A lot of people are calling for new regulation of the financial regulation. A lot less people are actually providing clueful analysis of what's really wrong with it.

If one really wishes to create good and useful regulation, one must understand the structural problems we are dealing with. In most things I've read, authors have only barely touched these, while dealing with the more pressing matters at hand. But it's a very bad idea to make regulation based on the instance of problems we have, instead of an understanding of the structural problems.

So what are those structural problems we are facing? I'm not an economist, so I know I'm out of my league here - but here's a few things that have crossed my mind while following this crisis:

The typical problems one would encounter would be at least commons information asymmetries, and potentially come things that arise from the difference between uncertainty and risk. What else? And how do these things come together to create a problem? And what are the notches that allow us to solve these problems with as little collateral damage as possible.

At least, it seems to me that there is a commons of liquidity within the financial system. A commons, as economists should well know, has a number of drawbacks and requires regulation in order not to be misused. (Traditional villages had regulation for such).

Information asymmetries within the housing markets combined with the potentially real grouding effect may be partial answer to the housing bubble (grounding = people partially ground their estimates about value to the price they see).

Information asymmetries within the banking system regarding the goodness/badness of different deposits.

Lastly, talking about these things with the structural underlying names (commons, information asymmetries) allows us to take our heads off the things right in front of us and see further. It may also provide surprises on where and how we should act.

[Farrar]

It looks to me as if Blinder has made a very clear and comprehensive analysis of where the problems lie, and he has not gone so far as to propose detailed solutions. A useful analysis for us ordinary folk.

It is also clear that the essential problem was one of credit judgement at or near the level of mortgage origination, and that's where most of the new regulatory attention and man/womanpower must be concentrated.

Several levels upwards, in the realm of derivatives and insurance lie problems I know next to nothing about. I would hope, however, that the Wall Street golden boys use some statistical studies of past levels of mortgage repayment and default. But if such studies cannot be based on sound credit standards applied consistently over time, what good are they? Which leads us to profound skepticism about the utility of slicing and dicing to reduce credit risk.

[juandos]

Hmmm, Blinder whines: "An inordinate share of the dodgiest mortgages granted in recent years originated outside the banking system. They were marketed aggressively, sometimes unscrupulously, by mortgage brokers who were effectively unregulated; we have now lived to regret that arrangement"...

So is Blinder saying that these were just poor, naive kids having a gun held to their heads and being forced to sign a mortgage contract?!?!

Apparently Blinder isn't the least bothered by the cost of federal regulatory compliance today which isn't cheap: Complying with government regulations consumes $1.4 Trillion ($1,028 billion federal mandates, $343 billion state & local government mandates) 14.9% of the economy $4,680 per man, woman and child

[Farrar]

Juandos:
Who's whining now?

"Apparently Blinder isn't the least bothered by the cost of federal regulatory compliance today which isn't cheap"

If there weren't so many crooks involved, it wouldn't cost nearly so much. Let them whine all the way to Federal prison.

[James]

We must 'firewall' public money guaranteed by the government from banks that engage in market speculation for profit.

The distinction between commercial banks and investment banks was a good one.

Bring it back. And while we are at it, pass some stiff anti-usury laws nationwide. The Fed proposal does not go nearly far enough.

Is there a chance of fixing the roof? I think so, if Obama gets elected. If it is McCain forget about it. If it is Hillary its a tossup. People forget how entangled Billary had been with folks like Enron and how 'buyable' they had been.

[juandos]

Farrar in true socialist fashion says: "If there weren't so many crooks involved, it wouldn't cost nearly so much. Let them whine all the way to Federal prison"...

Well Farrar, I'm all for it as long as its YOUR money used to support YOUR socialist paradise...

I've still yet to see the supposed, "crooks" in this saga of stupid people getting mortages they couldn't afford unless it was the stupid people who are the crooks...

[anne]

"Well ------, I'm all for it as long as its YOUR money used to support YOUR socialist paradise..."

Socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise, socialist paradise....

Get it? I get such rubbish.

[anne]

"------ in true socialist fashion...."

Socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion, socialist fashion....

True socialist fashion, true, true socialist fashion, true.

[juandos]

Hmmm, Anne do you really get it?

[Bruce Wilder]

Winslow R: "Rating agencies rate a bond and the monoline insures it."

RW explained this well. If a monoline insures a bond, the bond effectively gets the rating of the monoline, and does not necessarily need its own rating.

[anne]

True socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion....

True?
True.

[anne]

"Complying with government regulations consumes $1.4 trillion per man, woman and child...."

"Complying with government regulations consumes $14 trillion per man, woman and child...."

"Complying with government regulations consumes $140 trillion per man, woman and child...."

"Complying with government regulations consumes $1400 trillion per man, woman and child...."

"Complying with government regulations consumes $14000 trillion per man, woman and child...."

True socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion, true socialist fashion....

[Sarah]

juandos says...

Farrar in true socialist fashion says: "If there weren't so many crooks involved, it wouldn't cost nearly so much. Let them whine all the way to Federal prison"...

Well Farrar, I'm all for it as long as its YOUR money used to support YOUR socialist paradise...

Wait. Being in favor of enforcing the laws is now socialist? I'm so confused...

[Cynthia]

But this dreaded 'R' word can't possibly be as dreadful as the other two dreaded 'R' words:
Republican and Recession. And for some strange reason, unbeknownst to me, Republicans have this strange tendency to go hand and hand with Recessions!

[OhNoNotAgain]

"I've still yet to see the supposed, "crooks" in this saga of stupid people getting mortages they couldn't afford unless it was the stupid people who are the crooks..."

Wow, the capacity for right-wingers to blame the victim always amazes me. Have you been asleep for the past two years ? What we have here, through and through, is fraud, fraud, fraud.

We have:

- Brokers and lenders moving people into dangerous and complicated adjustable and interest-only mortgages, even though they would qualify for a fixed-rate mortgage. All for the purpose of getting them into a house that they cannot afford, thus gaining them larger fees and commissions.

- Realtors and appraisers conspiring with lenders to inflate appraisals, thus driving prices up further and gaining the lenders, realtors, and appraisers larger fees and commissions.

- Lenders describing a fixed-rate mortgage to a buyer, only to switch the buyer to an ARM at closing time.

- Ratings agencies slapping quality ratings on a bunch of sliced and diced mortgage-backed paper that actually isn't worth crap because the people paying the ARMs won't be able to afford the payment when the ARM resets.

- Homebuilders offering guarantees and other worthless promises to buyers, knowing that they would simply walk away from them if the shit hits the fan.

Since when is someone in the US supposed to just "suck it up" when they've been the victim of a crime ? Is this what we've come to - caveat emptor with no consumer protections whatsoever ? If so, then good luck having a functioning economy. Most economies that I've seen that operate like that are in the second or third world category. Consumers must have recourse in the case of fraud or other criminal actions, and they must be fairly certain that such criminal actions are rare. Anything else, and they'll simply just hold on to their cash.

[Andrew]

Complying with government regulations consumes $1.4 Trillion ($1,028 billion federal mandates, $343 billion state & local government mandates) 14.9% of the economy $4,680 per man, woman and child.

I looked around the link for the methodology, and couldn't find much more than hysterical repetition of the huge costs of regulation.
Regulation which seems to include such frivolous rules as the minimum wage, preventing acid rain, protecting wetlands (the author clearly has no clue as to the ecological importance of wetlands), and tax compliance.
A bunch on nonsense.

[Organic George]

Patch the roof?

It's the foundation that needs fixing.

The entire financial system went into the crapper and if not for the Fed's generous heaping helping of taxpayer funds, these bastions of financial integrity would have closed their doors.

Stop thinking about tinkering with the roof and start thinking about building, from the ground up, a new financial system for the 21st century.

Here is an example of how unworkable the current system is: Most farmers and grain elevator companies can no longer use the CBOT to hedge since the volatility is to extreme in the markets. Where does this volatility come from....Hedge, pension & commodity funds. These financial players need volatility to make $ and the highly leveraged commodity markets serve that purpose. But with such wild and exaggerated swings the usefulness of these markets as hedging instruments is not long viable. Yet these funds have been lobbing to be allowed to have bigger market positions and the new regs to allow that were only recently scrapped when there were protest from hedgers.

Why should the US have financial markets that are skewed towards the bigger players to such an extent that only the big funds have an advantage in the market place?

The financial system has be be rebuilt so that there is a equalibirium for all players. There also has to be a social justice aspect to investment regulations. While this will be the single most difficult aspect of this new system, it will be the single most important reform. Destroying the environment, unsettling the social fabric of developing and domestic peoples is not acceptable in a modern capitalist society. Profit for the sake of profit is an out dated paradigm, that attracts sociopaths and sycophants, which there is an abundance in the current financial system.

I'm not talking about sitting in a board room and singing Kum-ba-yah, but at some point the current acceptable ponzi scheme mentality has to be destroyed.

The biggest obstacle to change is that everyone in the current system made a lot of money in the past few years and everyone is waiting for the next big scheme to resume the party. So when you read that nobody was talking change at the West Coast financial conference it was no surprise, since it's the corrupt system made them so much money.

This is the core of the problem, it not the roof that needs attention it is the very foundation that is corrupted

[Organic George]

Patch the roof?

It's the foundation that needs fixing.

The entire financial system went into the crapper and if not for the Fed's generous heaping helping of taxpayer funds, these bastions of financial integrity would have closed their doors.

Stop thinking about tinkering with the roof and start thinking about building, from the ground up, a new financial system for the 21st century.

Here is an example of how unworkable the current system is: Most farmers and grain elevator companies can no longer use the CBOT to hedge since the volatility is to extreme in the markets. Where does this volatility come from....Hedge, pension & commodity funds. These financial players need volatility to make $ and the highly leveraged commodity markets serve that purpose. But with such wild and exaggerated swings the usefulness of these markets as hedging instruments is not long viable. Yet these funds have been lobbing to be allowed to have bigger market positions and the new regs to allow that were only recently scrapped when there were protest from hedgers.

Why should the US have financial markets that are skewed towards the bigger players to such an extent that only the big funds have an advantage in the market place?

The financial system has be be rebuilt so that there is a equalibirium for all players. There also has to be a social justice aspect to investment regulations. While this will be the single most difficult aspect of this new system, it will be the single most important reform. Destroying the environment, unsettling the social fabric of developing and domestic peoples is not acceptable in a modern capitalist society. Profit for the sake of profit is an out dated paradigm, that attracts sociopaths and sycophants, which there is an abundance in the current financial system.

I'm not talking about sitting in a board room and singing Kum-ba-yah, but at some point the current acceptable ponzi scheme mentality has to be destroyed.

The biggest obstacle to change is that everyone in the current system made a lot of money in the past few years and everyone is waiting for the next big scheme to resume the party. So when you read that nobody was talking change at the West Coast financial conference it was no surprise, since it's the corrupt system made them so much money.

This is the core of the problem, it not the roof that needs attention it is the very foundation that is corrupted

[Guarantee]

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

Since foreign savers won't buy many securitized mortgages anymore without guarantees, another widespread mortgage default would directly require backing up the guarantees.

[lark]

So, this is the new 'New Deal' and it involves tinkering with the financial system. Figures. No one cares about working Americans anymore - though that is where a new 'New Deal' is most urgently required.

[mrrunangun]

Requiring the originator of the mortgage, the only party effectively able to prevent an unwise loan in the first place, to guarantee the principal and require the corresponding capital reserve, does not seem too heavy a regulatory burden to be borne. Risk/return balances could be more accurately transmitted to any downstream buyers. The incompetence of and the frauds by and upon the originators are the roots of this mess. Collusion by real estate agents, appraisers, syndicators, and rating agencies is predicated on the failures of the originators.

[Lafayette]

Article: Because securities firms are now under the Fed’s protective umbrella, they must start operating as safely and soundly as banks. That means both closer supervision and less leverage.

True enough, but, call it what you may, it means bringing back the precautionary notions of the Glass-Steagall Act. There seems to be three key elements:

1) There must be less leverage, yes, and that means more capital requirements to offset the risk. But, that will only mitigate the next crisis, if lenders take leave of their senses and lend willy-nilly to all comers, and not avoid a calamity.

2) A standards set for housing mortgage or credit agents is fine, but they are useless if not audited. The lending agents MUST understand that somebody is snooping about in their files looking for errors/faults that could cause their dismissal from the profession and perhaps even fines.

And, then, (3) follows the forward selling the debt into investment vehicles. The risk assessment agents must finally take their rosy glasses off and also police the products for which their assessments are being requested. Anything less is negligence on their part.

Because, as we have seen, whilst the cat's away the mice will play.

[john c. halasz]

Well, rather than offering my own belabored comment, I thought I'd just cross-post a comment from a star commenter at Yves Smith's site, Richard Kline:

"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."

I'd only underline that last point about preparing beforehand a nationalization option, which, er, actually enforces "market discipline", and strikes me as probably the most efficient use of limited fiscal resources to get us through this slow-mo train-wreck/financial melt-down, in marked contrast to de facto efforts to prop up fictitious financial asset "values", which is almost certainly the least efficient option. Since the depth of the gathering crisis will require resorting to fiscal policy, in contrast to the defunct nostrums of monetary policy that have gotten us to this point.

I might further add that much of the financial "innovation" that has been touted by neo-classicals, under the notion of more "complete" markets", as increasing the "efficiency" of financial markets, and increasing their risk-bearing capacities through further diversification, has actually resulted in an increasing complexity and opacity to the financial system and amounted to a systemic information loss. (Of course, I think the information-transmitting, rather than the incentive-structuring properties of financial markets are the more salient point: the incentives that have grown up in the past generation are the stuff of black, sick comedy). The neo-classical account of the burgeoning over-financialization of our economy in terms of financial "efficiency" not only misses the crucial distinction between calculable risks and incalculable uncertainty, and the fact that no matter how clever the instruments for the passing along of risk, they extract fees from the pool of risks, which distort their estimation without diminishing the aggregate pool of risks to begin with, but, most of all, it obfuscates the plain fact that much of the financialization of the real economy no longer intermediates it, but amounts to an elaborate rent-seeking operation, that is, an extraction of profits displaced and detached from the costs of production in the real economy. One could argue that that is a distortion of the real economy, or that it amounts to a dysfunctional adaption to burgeoning disequilbria in the real economy, or that the real economy has increasingly failed to provide opportunities for real investment in the real economy, at least as currently constructed.

[Winslow R.]

Nice post john h.

"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."

While I agree with the author's perspective that the Fed doesn't really have the money, Ben B. thinks the Fed has the authority to monetize any asset, basically claiming fiscal policy as his own.

[Farrar]

Ahhh, I'm far from alone in thinking there were crooks involved. It seems that even the Bush admin is pretending to enforce the laws:
Government Intensifies Mortgage Investigation
http://www.nytimes.com/2008/05/05/business/05lend.html?_r=1&hp&oref=slogin

[Farrar]

And now we're seeing the same kinds of scams in Medicare as we saw in the mortgage business. Is there no end to the perils of deregulation mythology?

http://www.nytimes.com/2008/05/05/health/policy/05medicare.html

[Lafayette]

jch: The principle benefit, initially, from securitization was overcollateralization against losses. Yes, really.

Selling forward mortgage debt is not new. Fanny or Freddy (I can't remember which, maybe both) have been doing it for years. In fact, the Investment Banks got their idea from them. Great Financial Wizards that they are ...

However, apparently what worked for a great long time, all of a sudden doesn't work anymore. What is the difference?

My answer: Government mortgaging had the deep pockets of the federal government behind it ... and the two cited agencies were not making daft loans. They had standard criteria they adhered to, I should think.

Unless of course all the above is crap ... in which case I expect to be corrected.

Still, housing being a primary necessity, I propose that the two agencies expand their activities to a "first-mortgage" basis. That is, any American citizen who meets their solvency criteria, should be allowed a once-in-a-lifetime First Loan to get started on the road to home ownership - at reduced lending rates.

No, really, it's not a joke .... ! ;^)

[Lafayette]

jch: The neo-classical account of the burgeoning over-financialization of our economy in terms of financial "efficiency" not only misses the crucial distinction between calculable risks and incalculable uncertainty, and the fact that no matter how clever the instruments for the passing along of risk, they extract fees from the pool of risks, which distort their estimation without diminishing the aggregate pool of risks to begin with, but, most of all, it obfuscates the plain fact that much of the financialization of the real economy no longer intermediates it, but amounts to an elaborate rent-seeking operation, that is, an extraction of profits displaced and detached from the costs of production in the real economy.

Well, that's one helluva sentence. Can you chop it up and come again?

Because I still don't see why a firewall does not exist between the two banking models, which is the principle debate, I should think.

There was no intellectual anguish about Over-Financialization of the economy subsequent to the repeal of Glass-Steagall Act. It was all very go-go subsequently, as I recall, before it became recently all very goo-goo.

Either that, or I am Rumpelstiltskin and have just awoken. Elucidate me.

[arkieology]

Just posted this on another thread from a few days ago, but it pertains here too. All the regulation in the world will not fix these "markets". And here's my comment as to why:

Perhaps the reason that an institution or arrangement is "too big to fail" lies in a more fundamental question, the nature and application of modern money. Maurice Allais compared modern banking to legalized counterfeit. Milton Friedman in earlier iterations proposed 100% reserve requirements for banks, seperating the functions of holding deposits and investment, denying them the ability to create and destroy money throught the letting and calling of loans. Ronnie Philips in his book "The Chicago Plan & New Deal Banking Reform" illustrates the missed opportunity of the Great Deppression.
If Money were constituted in a sane manner there would be no such thing as a "liquidity crises" and these firms would simply be allowed to fail, which would have zero effect on liquidity. When the entire economy is dependent on the investor class for its medium of exchange there will never be a different outcome. In the modern world the fox not only guards the hen house, the fox owns it. The rest of us live on chicken shit.

[john c. halasz]

O.K. Laf,

I can't quite make out your point, if it's not just taking contrary positions to stir up discussion, as is oft your style. But, yes, I do type out syntactically convoluted run-on sentences. I did mis-speak a bit in terms of a neo-classical account of over-financialization, since, given the neo-classical reduction of questions of "value" to nominal prices, their tendency is to obscure recognition of such an issue, regarding the financial system and its effects as continuous with the real productive economy, though, to be sure, there are ways of differentially assessing the "value" of financial assets in relation to the productive capacities and payment streams of the real economy. But I have no idea what you mean by a firewall between the two banking systems, since, as per earlier discussions on the bottom of these threads, the repeal of Glass-Steagal was effected in practice long before its official repeal, and that narrow issue was just reflective of larger secular trends in terms of the development of the financial system vis-a-vis the narrow banking system. And just to clue you in about that larger secular trend, in the mid-1970's the ratio of debt to GDP in the U.S. was 150%, whereas nowadays it's over 330%. Alan Greenspan, in his memoir, which I haven't read, apparently claimed that the rising debt ratio was a sign of strength of the U.S. economy. I'd beg to differ, but that's a case in point about neo-classical thinking.

At any rate, financial "assets" are just legal paper claims against future streams of revenue from the realized investments/revenues of the real productive economy, and, not only the further out that they extend through their build-up, the more uncertain, in the relevant sense, they become, but the more economic activity becomes determined by or subordinate to such paper claims, and the less likely a "healthy" development of the real productive economy becomes, (as directing real investment toward the generation of productive surpluses, rather than the satisfaction of extant financial claims). In other words, the over-financialization of the economy effects the operations of real economy productive firms, subordinating them to short-term returns, and ignoring the frictional costs of capital improvements and capital switching. (Since I gather that you're an engineer at the production end, I think you might have some idea of what I'm talkin' about, empirically speaking).

As to your being Rumpelstiltsken, spinning straw into gold and demanding the first-born? Or did you mean Rip Van Winkle? At any rate, Fannie Mae originated with the New Deal and Freddie Mac was set up as a competitor when the former was privatized at the end of the 1960's. First mortgage subsidies are the job of the FHA. So, yeah, whichever R you are, you've been asleep at the wheel, failing to put current "developments" in the context of secular trends.

[Lafayette]

Too good to be true

jch: So, yeah, whichever R you are, you've been asleep at the wheel, failing to put current "developments" in the context of secular trends.

You're right, I was asleep at the wheel.

I did not realize that Freddie or Fanny mortgages were not guaranteed by the Federal government. This is no longer true since 1967, WP tells me.

So, once again, deregulation was made ... and the result is that both Fannie & Freddie dipped into the Toxic Waste Market to expand business -- since their management evidently also drinks at the stock-option trough.

They both made public yesterday multi-billion dollar loses. If Toxic Waste is a "secular loss", then, yes, I'm going back to sleep. But it isn't -- it's just plain stupidity.

The only Commercial (Mortgage) Bank to have sunk in Europe is Northern Rock in England -- which the Bank of England bailed out. A Norwegian town went bankrupt because it bought some Toxic Waste derivatives and a couple of German Investment Banks are in poor shape as well. (But German banking is incestuous, so the loses will be covered by "the family" and no hat is being passed around the Federal government in Berlin.)

My point: European commercial banks don't have a firewall between commercial and investment banking. But, they apparently have more Common Sense than American financiers. The Toxic Waste offered in derivatives was largely eschewed as a "bona fide" investment here in Europe. Some banks bought the junk, but most did not.

Maybe the Old World can teach the New World some common sense that the latter has seemed to forget (in its greed)? Such as: If a return on an investment seems too good to be true, it is quite likely a fake?