Tuesday, December 11, 2007

We've Got Bailouts. How About Fixing the Banking System?

Just in time for the holiday season, the federal government is trying to climb down the chimney with bailouts in hand. It's brought a rate freeze for some mortgage borrowers, a super conduit for SIV-bedeviled banks, and another interest rate cut courtesy of the Federal Reserve Board. There have been many of the usual holiday-season reactions to these gifts. Many borrowers claim that the rate freeze doesn't benefit enough homeowners, and the stock market threw a hissy fit today when the Fed's interest rate cuts felt too much like anthracite from a stocking. Unfortunately, regifting isn't possible here.

The government has only been treating symptoms. If things go well, it might stabilize the situation. But all of the government's announced measures simply re-allocate the mammoth risks and losses from the mortgage mess. The rate freeze benefits some borrowers and hurts banks and investors. The super conduit will provide liquidity to certain SIVs and their affiliated banks, but at risk to the investors in the super conduit and its commercial paper. The Fed's latest interest rate cut, like all its other rate cuts, benefits banks and reckless speculators while shifting some of their losses onto savers and other holders of capital. Re-allocating losses, often in seemingly arbitrary or random manner, does little to promote rational future behavior. It might, indeed, exacerbate the credit crunch as holders of capital simply avoid the asset-backed investments that have given rise to the current financial mess.

That points to the missing piece of the government's response to the mortgage crisis and credit crunch. Securitization of loans is big business today. Most types of loans that banks made and held 25 or 30 years ago are now bundled into investments with various alphabet soup acronyms and sold to investors. These include home mortgages, home equity lines of credit, credit card balances, auto loans and corporate loans. Those things called "banks" are in many respects just administrative functionaries that screen borrowers' creditworthiness (we hope) and process paperwork associated with loans. But actual loans are made by investors. The real bank is the securitization process.

Asset backed securities, as we all know, are not protected by federal deposit insurance. That's much of the reason for the credit implosion this past summer. Investors, who functionally speaking are depositors, were frazzled by mortgage losses and tried to offload their mortgage-related exposure. Cash values of these investments plummeted or became unavailable. Hedge funds and other investment vehicles shut down. If you step back, it all has an uncanny resemblance to the financial panics and bank collapses of the pre-FDIC world. That shouldn't be surprising, since the asset-backed securities market is now a crucial de facto segment of the banking system.

Neither J.P. Morgan nor Jimmy Stewart is around to calm the panic. Federal insurance of asset-backed securities wouldn't fly, for both political and practical reasons. The $100,000 limit on federal insurance of bank accounts is a trivial amount in the multi-millions and billions world of asset-backed securities. A higher amount would look like a bailout of the wealthy, and would probably result in federal examiners moving into the offices of the investments banks peddling these investments in order to prevent undue risk to the U.S. Treasury.

There are ways to improve the asset-backed securities market and thereby strengthen the true banking system:

1. Simplification and standardization. Many asset-backed investments, such as CDOs, are a witch's brew of different loans, including mortgages, credit card balances, auto loans and corporate debt. An important reason why these things can't find cash buyers right now is because a cash buyer would need a supercomputer to analyze the constituent components of the asset pool and calculate a value. On Wall Street's trading desks, buy and sell decisions are often made in seconds. There's no time to dally around with complex, hinky derivatives of derivatives. Simplifying and standardizing asset-backed investments, such as limiting them to just one type of loan--e.g., home mortgages with a first lien, auto loans for new cars, or credit card balances with credit ratings of at least a certain minimum--would go a long way to ensuring that they can find a ready market. Overpaid financial engineers have mixed and matched too many different kinds of debt in a now discredited effort to squeeze AAA ratings out of risky investments. Their cleverness and a half has been costly for all of us.

2. Margin Regulations for Derivatives. Much of the reason for the sudden and severe losses of the past six months is the mainlining of leverage by the investment community. The reckless lending by banks and reckless borrowing by money managers magnified every flaw in the securitization process, and rubbed vats of salt into the wounds suffered in the financial crisis. Borrowing with abandon to buy stocks was one of the reasons for the stock market boom of the 1920s and the flood of margin calls that aggravated the stock market crash of 1929. The Fed has successfully regulated margin lending on stocks ever since. It should get and exercise regulatory authority over margin lending on derivatives.

3. Regulation of Hedge Funds and Derivatives Trading. One of the major reasons for the make-it-up-as-you-go-along quality of the government's response to the financial crisis is that regulators don't know much about the problems. Getting firm information about the full extent of derivatives holdings and trading has apparently been extremely difficult or impossible. It's really hard to formulate effective policy if you can't see the complete contours of the problem. Federal regulators don't effectively regulate either hedge funds or derivatives trading, partly because of a lack of inclination and partly because of questions about their lawful authority. Both of these problems can and should be fixed. Given the hundreds of billions of dollars of losses that now appear certain, there remains no excuse for a regulatory void. The regulation need not overstep reasonable bounds--the crucial things are to be able to gather information about who holds what, who has sustained what losses, and what the trading activity has been.

4. Listed Markets for Asset-Backed Securities. A logical corollary to the preceding measures would be the creation of exchanges or similar markets for asset-backed securities with publicly displayed price quotations and transaction reports. Nothing would instill public confidence and investment interest as much as an open and readily observable market. That's exactly what happened with stocks and bonds. It can happen with asset-backed securities.

The securitization process isn't going to go away. The regulatory structure of the formal banking system, with its risk-based capital requirements, will continue to subtly push banks to offload credit risk. And the securitization process is a primary means of accessing the vast amount of capital it takes to fund banks' lending activities. Back of the envelope bailout proposals won't make the banking system truly functional. Only meaningful reform can accomplish that.

School News: parents with high school age kids, rethink your plans to move to Montpelier. www.wtop.com/?nid=456&sid=1307882.

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