Arnold Kling  

It's Small Business, Stupid

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Reduce Bank Capital Requiremen... The Pity Fund...

As I continue to be in demand in obscure alternative media, I appeared on another radio program this morning. I was asked to comment on the proposal by the Congressional Republicans to create an insurance fund for mortgage securities.

My response is that we should ignore mortgage securities altogether. Just let things play out for the securities and the institutions holding them.

Just make sure that banks can continue to make good loans, especially to small business. Once again, I'll get on my hobby horse of lower capital requirements. Lower capital requirements for bank lending to small business. The down side of lower capital requirements is that they raise the risk of bank failures, but we have a good system in place for monitoring banks and resolving failures.

The problem of tight credit and the problem of unmarketable mortgage securities can be separated. Focus on the problem mof tight credit, and leave the mortgage securities alone.

Mortgage security trading was a major source of profits on Wall Street, and I know that a lot of Hank Paulson's crowd want to revive that industry. Instead, I'm ready to treat it like the parrot in the Monty Python pet shop sketch. The mortgage securitization model is dead. It is no more. It is deceased. Gone to meet its maker. It has ceased to be.

We need to take care of the living.


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COMMENTS (11 to date)
E. Barandiaran writes:

You write
"The problem of tight credit and the problem of unmarketable mortgage securities can be separated. Focus on the problem mof tight credit, and leave the mortgage securities alone."
If you really knew how to separate them, I'm sure banks rather than obscure alternative media would be demanding your services.

shayne writes:

Arnold:

I'm missing the elegance (or undervaluing the elegance) you see in reducing capital requirements for (local) small business loans, or lower capital requirements for any class of loans for that matter. If I understand correctly, capital requirements provide the approved multiplier for banks to lend against deposits. Reducing capital requirements thereby frees more cash available to loan, as you point out. But doing so for small business loans is inherently more risky than other loan types. Small business is a significant part of the economy, but it also has historically relatively high default rates, and depressed value collateral. That is why the SBA exists - for the government to co-sign on small business loans (up to 40%) to reduce risk of loss to the banks. It's the functional equivalent of the 20% down requirement in home loans.

Reducing capital requirements for small business loans appears to me to be the functional equivalent of the SEC ruling that allowed leverage ratios to increase from 14 to 1, up to 40 to 1, and I'm not impressed with the aftermath of that.

What am I missing? Can you explain further?

Arnold Kling writes:

Shayne,
Reducing capital requirements does increase risk. But taking a $700 billion flyer in the mortgage securities business is riskier.

David R. Henderson writes:

E. Barandiaran writes:

"If you really knew how to separate them, I'm sure banks rather than obscure alternative media would be demanding your services."

Not true. The banks right now are going with their most likely and most lucrative option--a bailout from Paulson. They want to unload their low-quality loans. It might be true that there's nothing Arnold's saying that the smartest among them don't know, but THEY DON'T WANT ARNOLD SAYING WHAT HE'S SAYING.

KEEP SAYING IT ARNOLD. This blog, plus Alex Tabarrok's comments on marginalrevolution.com, are the most valuable things I've found. I've used them in my interviews with "obscure" media such as BBC and in talking to my Congressman on a conference call.

Best,

David

shayne writes:

Thank you for the response, and forgive me if I'm sounding critical of you. I'm not. Your's is one of the few sane, objective voices I'm hearing and reading right now. And I concur (basically) with what you've said and your intent to salvage/bolster credit availability especially to small business.

But it appears to me - especially right now - that increasing riskiness anywhere in the financial system is contra-indicated and multiplicatively counter productive and dangerous to the economy.

I'll try to explain my concern and trust your judgment as to whether I'm just being panicky. There appears to me to be one glaring common denominator underlying this financial mess - the willingness of some to find clever ways of undermining, ignoring, usurping or ignoring the existing legal and regulatory system within which the financial market are supposed to operate. Cases in Point:

1.) The GSE's (Fannie and Freddie) - explicitly granted immunity from the legal and regulatory constraints of the rest of the financial markets. You know this better than I do and I've learned a great deal from you.
2.) So called 'Investment Banks' - created and operated outside of the bank regulatory framework (e.g., capital requirements) and regulated (supposedly) by the SEC. But the SEC relaxed/undermined their supposed regulations by allowing dramatically increased leverage ratios.
3.) Bear-Stearns - should have been allowed to file bankruptcy, in which case a buyer for it's performing assets would have rapidly emerged as was the case with Lehman. Instead, the Fed bailout depleted the Fed's resources and impaired it's ability to do what the Fed is chartered to do - protect our currency and enable economic growth.
Ditto AIG and the GSE's.
4.) Short-selling suspension. The short sellers are the only heroes in this whole mess. They forced to markets to understand just how low the market values of these assets, and the institutions holding them REALLY were.
5.) The current bailout - in any form (bailout, rescue, insurance, 'deal') - is nothing more than a mechanism to buy the financial system out from under the constraints, limits and penalties of the existing legal/regulatory system.

I keep hearing/reading about how broken the legal/regulatory system is and how that is the underlying cause of this. Crap! The legal/regulatory system has never been allowed to work! Or it has been ignored, usurped, bypassed and undermined - you recognize that in your beginning statement on this post.

I adamantly oppose the bailout, in any form. But I oppose it specifically because it is nothing more than a terribly costly mechanism for completely undermining our legal/regulatory system. And I fear that. And I see any further exemptions, relaxations or modifications of the legal/regulatory system to be no more clever than the one's that enabled this mess in the first place. Now, in a time of 'crisis', is precisely the time when the existing legal/regulatory system MUST BE relied upon to help us. It is not a time to undermine it's value to us with tweaks, regardless of how cleverly devised or 'good intentioned' they may be.

John Thacker writes:

The banks right now are going with their most likely and most lucrative option--a bailout from Paulson.

Right, with the exception of the smaller banks (some fairly large, like BB&T) that didn't get into mortgage-backed securities.

gabe writes:

This

http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=311

would seem to make sense - for the FDIC to repeat the WaMu throughout the banking system (?)

Stewdog writes:

Yes! Out in the Midwest cheap seats it the farm reports indicate Farmer Mac "may have some concerns" They say our credits are fine but the capital requirements may be a problem, "because we invested in junk derivative products." Can't blame folks from wanting to participate in a beer and hot dog eating contest.

Ride it out.

shayne writes:

To gabe:

Thank you - your link puts a series of exclamation points behind my previous post.

Whoda thunk it! Every time the system is ALLOWED to work, IT WORKS! Conversely, every time it's undermined, evaded, bought-off, etc., it fails to work!

AMcguinn writes:

I don't understand how reducing capital requirements would have any effect at all. Right now, anyone who is even close to the regulators' minimum capital requirements is seen by the credit markets as not viable. Regulatory minimum is the last thing on the mind of any institution which has short-term debt to roll over.

Am I missing something?

Milky Way writes:

shayne, you lost me. All your examples are exactly the reasons why regulation does NOT work. What are you talking about?

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