"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.