Arnold Kling  

Some Notes on Financial Reform

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This afternoon, I'm scheduled to join a press call with Simon Johnson and two Senators discussing a proposed amendment to the financial reform bill. Simon and I have been in alignment since the day we "debated" the issue of nationalizing the then-insolvent banks. I was supposed to be against nationalizing banks, but I thought for some reason they were talking about solvent banks. I thought that banks like Citigroup should have been nationalized and sold off, rather than bailed out. I still think so.

Anyway, Simon and I agree on breaking up big banks. My ideal financial reform would actually, you know, reform stuff that was at the heart of the financial crisis, as opposed to just trying to put Humpty-Dumpty back up on the wall with some regulatory glue and tape. I would try to break the addiction to lenient, subsidized mortgage credit by closing down the government pushers. I would take the credit rating agencies down from their perch by using market discipline instead of capital regulations that reward AAA ratings. I would let securitization die if it can't survive without a government feeding tube.

Here is Anil Kashyap giving what seems to me a very different view of what went wrong and how to fix it. He says,

it was like a Ferrari that hits a pebble and crashes.

There is a presumption that the type of finance we had five years ago was basically a good thing--we just need to put in some better controls. The thinking is that securitization created real wealth. I think it created wealth artificially by exploiting capital regulations. I believe that with a public policy less friendly to Wall Street, we would have a very different financial system, not just an approximation of the system of 2005 with a few safety features added.

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COMMENTS (3 to date)
Mike writes:

I made a good living for a few years in the mid '90s scouring the countryside looking for loan portfolios to purchase. My employer purchased loans originated by franchise companies, equipment manufacturers/dealers and the like.

Every portfolio we purchased had some percentage of recourse back to the seller. This percentage would vary given the type of credits the portfolio was constructed from.

Worked pretty well. We were very successful. At some point the market drifted away from us, mostly, I believe, because banks began offering way better (for the seller of the portfolio) terms than we would ever entertain. It became very hard to generate business that had a recourse component when there were so many other lenders without that requirment.

In a world that did not favor rated securities in bank capital structure, I think securitization would still have a place. Especially for smaller banks and lenders. Most community banks have a rainmaker that generates business in one location or from one industry. Risk diversification through syndication or securitization seems natural for these types of companies.

But then again, I'm talking about a world that doesn't exist.

As an aside, I wish I could find a way to short the Commerce Department's portfolio of SBA loan guaranties.

Mike Rulle writes:

Yes, CDO issuance was absurdly exaggerated due to regulatory arbitrage. Also, the so-called SIVs---which technically did transfer risk away from the banks---always were believed to be effectively guaranteed by the banks (analogous to Feds and Fannie/Freddie). Hence, there was more of these due to effective regulatory subsidies than would be otherwise.

But----any distribution method which truly diversifies risk more broadly is a net benefit to the financial system. Obviously there needs to be a level playing field.

The other problem with these structures is they have been used to obfuscate, not clarify. But that is not inherent in the structures themselves.

The pebble-induced Ferrari crash analogy is actually a rather good one... And it supports the Kling narrative if framed correctly.

Basically, Ferraris were the wrong car for the conditions... Just as conditions did not suit the banks we had.

Ferraris are only fast & safe on smooth, dry, solid, ice-free surfaces. In off-road conditions a Range Rover is faster and safer.

A Ferrari is useless on sand dunes, loose rocks, deep mud, rushing water, steep icy hills, drifting snow.

We wrongly thought the banks were operating on perfect highway conditions. Speed limits were too high (subsidized housing finance), the road was bumpier than expected (rating agencies waved green flag while supposedly investment-grade credits were littering the track), the road was not solid (repo financing dried up amazingly quickly)... Basically we ran a Ferrari race on a Range Rover course.

One final point: Range Rovers are "easy to fix". Roll cages, winches, on-board tool kits... They are designed to get out of trouble.

Ferraris, on the other hand, are horrifically expensive and time-consuming to repair after a rollover.

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