Arnold Kling  

Financial Reform

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I will be interviewed on June 25th at 2 PM eastern time in a "webinar," which means that if you participate live then you can ask questions. You can register here. I have attended a couple of these as a listener, and they were pretty high caliber. My guess is that I will be better than my usual self, because David Evans is a good interviewer.

Today, I was at a conference that David helped organize. I am not at liberty to disclose the other participants, but below I will offer notes on what was said.

One participant noted that the Obama Administration White Paper was heavy on blaming the folly of the private sector and defects in regulatory structure for the crisis. It was light on flaws in regulatory policy or execution. That is also my view.

There is a risk that the white paper serves to increase the uncertainty of the business environment. If you are operating a financial institution today, you cannot set up a new division or line of business without knowing whether it will be whacked by regulators down the road. One of the risks of having a "financial product safety commission" is that it will knock down products after the fact, which in turn will have a chilling effect on innovation.

It is very typical of government to respond to a failure with a re-organization. That appears to do something, but in fact does little. (Me: that may be the best possible outcome--a reform that appears to do something but in fact does little)

One participant argued that we need to re-invigorate securitization. He pointed out that you cannot replace the hundreds of billions in financing that was flowing through that system with straight bank financing (banks holding mortgages the old-fashioned way). He suggested that the problem with securitization previously was the high leverage involved in the way banks held mortgage securities. If instead the securities were pooled into mutual funds, then there would not be so much leverage. (ME: how much more net financing do you get out of a non-leveraged securitization model than out of a reversion to old-fashioned banking.)

One participant pointed out, as even the Obama folks have admitted, that regulatory structure cannot be the key issue in the financial crisis. Other countries, with regulatory structures along the lines recommended in the White Paper, have done as badly as we have, and in some cases worse.

One participant pointed out that most of the bad mortgage loans went to finance new housing developments in suburbs in key sunbelt states. Those are not CRA areas, making this another reason not to blame CRA.

More in a subsequent post'


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COMMENTS (8 to date)
TA writes:

"He suggested that the problem with securitization previously was the high leverage involved in the way banks held mortgage securities. If instead the securities were pooled into mutual funds, then there would not be so much leverage."

What the hell does this mean? Most of the securities in securitization did go straight to households, or to mutual funds, pension funds, the "rest of the world" (as the Fed calls it). Some went to commercial and investment banks, but not all that much. And, if you consider the problem with the financial system in the US right now, it's not securities held by intermediaries. It is bad loans on the books of commercial banks, and the unwillingness of savers themselves (households, the mutual funds and pension funds that hold their savings) to keep on buying asset backed securities.

Arnold Kling writes:

A lot of mortgage securities ended up in off-balance sheet entities at banks. Also, by the time they ended up in pension funds or mutual funds they had been sliced and diced and repackaged into CDO's and CDO-squareds and what-not.

I think that the guy probably had in mind was that the mortgage securities should be plain vanilla pass-throughs, with clear disclosure of the underlying mortgages, instead of having rating agencies blessing fancy structured tranches with AAA ratings.

Lafayette writes:

In case you missed it. My rebuttal to your article in the Washington Post.
Kling: "... it is hard to pin the decline in mortgage lending standards or the surge in leverage at banks on this development."

I submit that the manner in which a realty bubble morphed into a SubPrime Mess, with the connivance of all the components in that chain, effectively substantiates that the above sentiment is wrong-headed.

There were, in fact, two failures:
* The first was the repeal of Glass-Steagal which reinforced a certain laxity in the federal watchdog agencies, foremost of which was the Fed under Greenspan, with his "markets are self-regulating" nonsense. (Five global financial systemic failures before our own SubPrime Mess, shows that markets are NOT self-regulating and that national supervisory agencies - with teeth - are a clear necessity.)
* The second was the profits feeding frenzy that induced both Private Finance and Semi-private Finance (Fannie; Freddie) agents to loosen creditworthiness criteria, which spawned the bad loans. This happened in the face of TILA (Truth In Lending Act) that should have prevented "teaser loans" and down-the-line "balloon payments". Some federal agency (naming names, the Fed), responsible for supervising TILA, was asleep at the wheel.

The demise of Glass-Steagal paved the way for the consequences that we know all too well today. And who is paying more the aftermath of the above inanity? Wall Street or Main Street?

Moreover, at about the same time as the demise of Glass-Steagal, here is the suggestion of the American Community Banker's Association submitted to Congress when that body, in 1998, was considering reform of TILA:

"Addressing Abusive Practices Must Occur Separately From Streamlining and Simplifying Mortgage Disclosures

Abusive lending practices exist and are a threat to both unsophisticated borrowers and the general mortgage lending industry, but any proposed actions directed at curbing and eliminating these abuses must be explored separately from a discussion focused on streamlining and simplifying TILA and RESPA disclosures."

and,

"Conclusion

ACB supports and is committed to the simplification and streamlining of the disclosures provided to consumers under TILA and RESPA. We will continue to work with other groups, the regulators, and Congress to achieve meaningful reform. Education for and understanding by consumers about the mortgage process is in the best interests of all parties. We look forward to continuing our discussions with all concerned parties, as well as assisting the subcommittees in any way toward this end."

Yeah, right ... more than ten years later and how many American families are suffering because of our lack of foresightedness and unfounded trust in BigFinance?

Just when are we going to get Financial Regulation right? Meaning this: Any "financial engineering" must comply exactly with the same principle as engineering projects anywhere in the world. They must demonstrate clearly that they adhere to "fail-safe" guarantees -- a process that is both arduous and long, but it saves lives.

TA writes:

Two more comments, in response.

Off balance sheet liabilities of banks are often cited as a very bad thing, but I've never seen a serious attempt to put numbers to it. Is this a big deal, or a little deal? This goes to a frustration I have with the continuing debate about the financial system and its reform -- it's conducted largely through assertions without numbers.

Second, if mutual funds and pension funds make stupid investments -- so what? I'm having a hard time seeing that as a public policy issue.

Bob writes:

Lafayette,

You present as fact two presumptions that are far from certain.

Not clear what you mean by "Five global financial systemic failures" but large failures can be interpreted as evidence that markets *are* self-policing - institutions that make large mistakes disappear.

Not fair to condem flawed innovation ex post without recognizing the benefits of real innovation that might never see the light of day under your preferred regulatory regime.

Not even accurate to characterize the last ten years as a realty bubble. Suppose that bubble = irrational belief that an investment will pay off because prices will continue to rise, despite evidence that prices are already high.

Subprime borrower with little or no down payment does not fit this bill. Borrower has an asymmetric payoff - if prices rise, they make money; if prices fall, they default. No down payment = minimal explicit cost to default. Poor credit (they are subprime, after all) = minimal implicit cost to default.

Prime borrower with little or now down payment may not fit this bill. Same asymmetric payoff. Strong credit creates an implicit cost to default, but this means that a prime borrower should either invest in real estate in a big way or not at all (the implicit cost is largely fixed). It might be irrational for a prime borrower to speculate on a single, small house, but not on a dozen million dollar homes.

The real bubble behavior was in real estate finance - the lenders who took the other side of the asymmetric payoff. This includes banks that retained significant exposure to the residential real estate market and the buyers of crappy MBSs.

Securitization has been blamed for the bubble. This just kicks the question down the road. Sure, securitization creates agency problems, but any sort of specialization creates agency problems. You don't solve them by forcing everyone to fix their own car and paint their own house. The question is why did investors buy the crappy MBSs, or why did the problems blow up?

One answer is that the private sector screwed up. This is part of the story. The "market" isn't a magical, all-knowing entity. Investors make mistakes. The market's magic is that investors are punished for making mistakes, so they learn from them. Looking at it this way, it seems that the market performed pretty well. Three of the five major investment banks are gone. Two of the six largest US bank-banks are gone. Major bank stocks have been crushed and CEOs have lost their jobs. Banks are raising capital. The credit-rating-organizations are updating their models. People are learning.

Another answer is that the public sector screwed up. Financial services are one of the most regulated parts of the economy. Might some of those regulations have contributed to the problems? Why are we so focused on reigning in the private sector, which has been punished severely and has every reason to avoid making the same mistakes in the future, while we expand the political/ regulatory sector, which has neither been punished nor shown sign of learning from the crisis?

Matthew C. writes:

I find comments like Lafayette's very curious. It seems beyond obvious to me that the people who made all of the mistakes that caused the financial meltdown, are the same folks in charge of things today at the Fed and Treasury, and will be the same people who will write the new regulations. Foxes and henhouses, anyone?

Bill Drissel writes:

It seems to me that the history of US government intervention in the financial affairs of Americans has been primarily to take away from the prudent and thrifty and give to imprudent and demonstrably incompetent gamblers ... in investment companies, banks, insurance companies, auto manufacturing and all the stimulus recipients. One thing that escapes mention (probably even notice) is the intention to give more money and power to demonstrably incompetent regulators.

In his address at M Friedman's 90th birthday, Dr Bernenke noted that the Fed caused the Great Depression. He blamed the inability of one of his (in effect) predecessors to understand the financial dynamics of the time. I have looked in vain for public record of Dr Bernanke's understanding of current financial dynamics.

I think we need less regulation. I hear it argued that ordinary people need to be protected from chicanery, misjudgment etc. Therefore some elaborate mass of demonstrably incompetent legislators, administrators, auditors etc. must be funded. Despite (or because of) inabilities of these people, once a generation, the ordinary people are victimized anyhow.

I propose that banks for ordinary people, institutions that use the word "deposit" or "withdrawal" or "saving" or "bank" be required to keep 100% reserves in the building where the account is established. All other investment organizations must have the word "risk" in their names and every investment instrument must be called a "risk" something or other. From time to time, regulators would establish a threshold of say, $20,000 in current money. A person must have more than the threshold amount "deposited" in a "bank" before "risk" investment companies could allow him to be a customer.

Owners of banks and "risk" companies (all of them) would have unlimited liability for fiduciary misconduct.

Other than our current laws against fraud and current fiduciary and accounting standards, there would be no more (incompetent) regulation of "risk" investment.

We had an opportunity over the last year or so to have a new financial services industry with all (most?) incompetents washed out. This would have required our incompetent government to do nothing. Instead, the resources of prudent, competent, ordinary people have been devoted to saving the old, rusty, creaking, inadequate mechanisms.

Bear Stearns had 85 yrs of consecutive, profitable quarters and went bankrupt in six months. I defy you to find a bulldozer operator that incompetent.

Regards,
Bill Drissel

Lafayette writes:

Bob: "Not clear what you mean by "Five global financial systemic failures"

Yes, it is not clear. My apologies.

I should have used the word national, not global -- but all five happened around the world. So, in that sense , they were global. I should have, perhaps, put it differently.

The two financial systemic failures of note were Japan and Sweden. Brazil and Indonesia were two others of lesser importance comparatively, except to Brazilians and Indonesians ...

The point is that property bubbles created financial systemic failures of highly dangerous proportions, both in Sweden and Japan (examples of advanced economies). Why did no one think that it could possibly happen on Wall Street? Did those bankers responsible for Risk Management gobble wholly the Greenspan nonsense that "markets are self-regulating"?

Apparently and much to our discomfort ...

Bob: "Not fair to condem flawed innovation ex post without recognizing the benefits of real innovation that might never see the light of day under your preferred regulatory regime."

My condemnation is not ex-post.

"Fail safe" is an engineering standard that is common throughout the world. Do you take a flight in an aircraft that has not obtained a air-worthiness certificate? Do we build buildings in quake zones that do not have higher stress-level construction to consolidate them further?

So, why, pray tell, should financial engineering be allowed to develop and employ sophisticated investment vehicles (and other derivative devices) without having been tested/prototyped under different banking conditions?

Why did no one say, "Hey, are these instruments fail-safe?" Why did no one ask "what if" questions, like "What if these instruments are massively non-productive? What happens then?"

Any answers?

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