Regulatory Reform – Look at Systemic Financial Risk, But Don't Forget the ABCs

Scott Brown's Senate win in Massachusetts has reset negotiations on U.S. financial risk and bank regulatory reform, particularly in the Senate.  Heavyweights like Paul Volcker, Joseph Stiglitz and even some guy named Obama are weighing in with proposals that emphasize consumer protection, increased capital requirements and restricted investment scope for banks, maybe even new bank taxes.   With all due respect for the heavyweights and the fact that the recession may have been triggered by a bursting credit bubble that had causes far more complex than declining real estate values and busted mortgage backed securities, can we please FOCUS on including a fix for some of the specific problems that were most clearly uncovered when the music stopped, even as we ponder a more systemic fix for financial system risk.

A.  Mortgage Lenders  Should Keep Skin in the Game - Finance companies were making mortgage loans without regard to the borrower's ability to pay.  Making loans, hey they were flogging them like lottery tickets to feed the voracious market created by mortgage backed securities.   Consumer protection regulation will actually help prevent some abuses here, but why not include a little reliance on greed.  If the company originating the mortgage loan and making the credit decision has to keep some financial risk on each loan and take some consequences from any default then you will restore credit discipline in a way that will work hand in hand with any new consumer protection rules.  Stiglitz keeps making the point that regulatory systems can't assume financial markets will always function efficiently, but it always helps to get a little greed on your side. 

B.  Long Term Greed is more sustainable than Short Term Greed - Financial institutions bought the shaky mortgage loans, bundled them into mortgage backed securities and sold them like, well, very expensive lottery tickets.  Buyers didn't notice that the borrowers on the underlying mortgage loans were shaky credits, instead they focused on the fact that the underlying loans were secured by real estate (which never declined in price in their valuation models) and often hedged with credit default swaps and  highly rated by Moody's, Standard & Poors and Fitch – the rating agencies. (more on these below).  Both the bundling institutions and the buyers (often institutions themselves buying for resale) also focused on the big profits everyone else was making and the fact that they needed to keep up.  Me Tooism and a short term focus that overcome the need for really diligent inquiry and analysis will be forever with us in many different forms, but, an effective compensation structure will do more to combat these problems across the board than any  regulation addressed to a specific financial risk.    Every bonus a bank pays should be paid out over several years, with strings attached.  Writedowns, earnings restatements and similar subsequent events that show some or all profits earned in the bonus year were illusory should result in an appropriate reduction of the bonus.  Paying bonuses only in stock that can't be sold for five years has many similar beneficial effects, but somehow I think the callback feature weighs more heavily on the mind of the executive.

C.  Don't forget history - Credit default swaps (a contract in which a company like AIG would promise to pay an amount to the owner of the mortgage backed security to offset diminution in value due to mortgage borrower defaults) hedged against the risk of real estate decline, making the mortgage backed securities higher rated and more attractive to buyers.  Unfortunately, AIG had no plan or means to pay its credit default swap obligations when real estate tanked.  Bundlers, buyers and raters all did not get enough information to evaluate AIG's credit thoroughly and acted recklessly  in the absence of that information.   What to do? Some would ban the credit default swap, others would turn it into a true insurance product subject to regulation and mandatory reserves to mange the financial risk.  I say remember your history – not Glass-Steagall but the Commodities Exchange Act.  Before the swaps exemption (and subject to some squabbling from the SEC) this type of contract would have been regulated by the CFTC as a commodities futures contract.  Trading would have been forced onto an exchange with some good results:  Visible positions, recorded at the end of each day; Effective netting to actually reduce exposure of and to a party with large positions on both sides of a contract but a small net position; An effective margin call and collateral delivery system; and, Position limits.  This approach preserves the economic benefit of the credit default swap, but eliminates virtually all the problems of a big player like AIG secretly taking a lopsided position. Maybe it's too much to completely eliminate the swaps exemption (which facilitates private trades between big players) but in light of what has happened, let's take the highest volume, most commonly traded swaps and force them onto an exchange – old school!  No amount of banking regulation will solve the problems that non-banks can create with huge, undisclosed positions on one side of a derivative trade.

D.  Pay the Agencies to Rate, Not Sell – The ratings agencies missed the boat on several issues, assuming their way around problems in order to assign high ratings to mortgage backed securities.  The ratings agencies were also competing vigorously with one another for business under a fee system in which the rater was paid only when the rated security was sold.  If a Bundler gets a B- from Moody's and cancels the proposed issue of a mortgage backed security because it won't sell at that rating, Moody's gets nothing.  Once all the work is invested, Moody's can earn a nice fee with a B rating if it can just convince itself that the B- is a little too harsh.  The Bundler can even ratings shop, talking with more than one rater and paying only the “winner”, the one that seems likely to rate the highest.  This problem isn't unique.  Lawyers and accountants are sometimes in a position where a portion of a fee or a continuing relationship will depend upon an opinion or a certification, but the fact that it's not unique does not make it acceptable.  Once again, please, FOCUS.  Given what happened, can't we muster the political will to fix this problem for the ratings agencies.  How about  some financial regulatory reform that says  an issuer picks one rating agency and pays the fee, even when the issuer doesn't go forward with a sale of the security.  The desire to get selected again is more than enough incentive for the raters to accommodate the issuers, we don't need to make it any worse.