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Thursday, September 18, 2008

How Did We Get Here?

See UK Bubble's current post on the topic:
So why are financial institutions collapsing so quickly? It is a lack of bank capital. Every prudent bank should keep a buffer to absorb losses. Roughly speaking, this buffer is the difference between total bank assets, which are basically loans, and total liabilities, which are deposits and loans from other financial institutions. Banks on both sides of the Atlantic minimized this difference; their capital. They reduced their buffer because holding capital meant reduced profits. Banks reduced their safety zone down to the absolute minimum. When the sub prime losses began to arrive, bank balance sheets could not cope. The buffer was too slim. This is one of the reasons why the Fed and the US treasury are finding it so hard to save Lehman. In principle, Lehman is on sale for $3.5 billion. Based on past valuations, this is a ridiculously low price. Yet why can’t Lehman find a buyer? Other banks simply don’t have the resources to pick up this bargain.
That's pretty much it.

The problem for the international financial system is not so much that US has dicey assets, but that these dicey assets are distributed across the world through most countries with decent or fast-growing economies. This is a global problem because there have been global bubbles, most specifically, global property bubbles. However, there has also been a commodity bubble, a number of equity bubbles, corporate debt bubbles, and the growth of thriving international markets in largely unregulated fields such as credit default swaps. Worse yet, property bubbles have dominated the big Asian players and several of the ME financial centers. While property bubbles have recurred across different markets throughout financial history, the global extent of the current property bubble is close to unique, and was partly fostered by an innovation known as....

The REIT structure (Real Estate Investment Trust) has huge tax advantages, but it requires distributing the bulk of your profits every year in most countries which have this structure. REITs aren't really allowed to hold sufficient reserves (to prevent tax evasion). Unfortunately, REIT structures have spread across large parts of the world, and encourage verticalization plus guarantee thin reserves. A good resource page on REITs. Note that Germany did not join (READ THIS LINK) the trend, and avoided an RE bubble. France was a late entrant, and thus is not facing a huge internal problem although it has some losses to bear.

REITs commoditize real estate, draw huge investment into real estate, and seem to create an atmosphere in which property bubbles blossom. One of the problems is that this creates correlations which are unfortunate in any easy-money environment, to say the least. While real estate values ought to be independent and local, large amounts of REIT investment tend to unify movements in property values across much larger areas and link property values to the overall investment climate and money flows. For example, you are likely to see a consistent sales trend by investors when stock markets go down, and a consistent buy-in by investors when stock markets go up. This is the last thing you ever want to create; unifying and correlating prices of different types of assets produces volatility in the financial system. Because the tax treatment of REITs is generally favorable, there has been an additional impetus for companies not to hold their own facilities, but to transfer ownership to REITs, use the capital, and lease the facilities back. This, in essence, strips some of the corporations of their last reserve position.

Systems of bank regulation vary across the globe. The most basic elements of bank regulation are enforcing required reserves and forcing correct reporting of assets and collateral valuation. Reserves, to be effective, should be risk-related. You can, for example, require your banks to keep 30% reserves, but that constrains the money supply and makes borrowing far more expensive. Limitations on bank-allowed activities and activities allowed to non-banks also vary widely around the world.

Locally, in the US:
Investment banks aren't real "banks" as we know them in the US, and the difference is important. US banks, credit unions and thrifts are regulated ( not always well) by one of the various agencies (FDIC, OCC, FRB, NCUA, OTS). Investment banks are non-bank financial institutions, and their primary regulation comes from the SEC and other exchange regulators. The SEC and exchange regulators do not have the same auditing structures nor mandates to control bank type risks, nor do they have the staff to do so.

For an example of the types of determinations and guidances made by US banking regulators, see the OCC's site which lists current issuances. Scroll down to about 2005 and look at the interagency guidances on things like complex structured finance (debt securitizations), appraisal standards, home-equity lending, non-traditional mortgages, and asset-backed commercial paper liquidity facilities. The strength of the examination-based system is that it looks at practices in situ and assesses risks as practices change. Its weakness is that it is largely reactive and depends on having enough examiners to examine practices as they change. In in an extremely fast-moving and complex environment there are a shortage of senior examiners who can assess and evaluate changing practices in a timely fashion. It's approximately a two-year cycle on most issues at best. Additionally, Congress has been limiting funding for bank regulators and so they were relatively short-staffed during the recent period.

To varying degrees, the bank, thrift and credit union regulators do go in, pull samplings of loans and deposits, and review loan portfolios for safety and soundness. FI examinations are really very comprehensive, but for going concerns every area doesn't get a thorough onceover every examination, and examination cycles may be more than one year. Further, the focus is not just on initial credit-granting programs, but on examining loss areas, which necessarily introduces another level of delay into the cycle. Examiners can and will beat an institution up for setting up new and innovative loan programs without adequate controls and risk assessments, but very often the real risks arise in implementation, so a program that looks decent up front blows up on the back end because of inadequate controls on underwriting, appraisal review, policy exceptions, etc. Loan assessments include risk of raised defaults, adequacy of loan loss reserves, and the risk of non-compliance with applicable regulations. However this applies to portfolios of held loans rather than complex structured debt (securitized loans) and equities (in the form of collateral, participation, or as capital), which are rated by....

NRSROs (Nationally Recognized Statistical Ratings Organizations) are an integral piece of the US regulatory structure. These firms have been granted determinative status by all the agencies. These non-governmental firms rate the debt quality for securities (such as mortgage and commercial mortgage bonds), corporate debt, etc. Until last year, all the NRSROs were paid by the firms issuing the securities, and there has in recent years been considerable competition for the business of the big players. It seems now demonstrated that this competition changed the results of the assessments. The agencies had not recognized any new NRSROs until last year, thus ensuring that a small group of private firms controlled risk ratings on trillions of dollars of financial assets. Let's just say that this was a recipe for disaster under certain circumstances, and go on to describe those circumstances.

When Gramm-Leach-Bliley was passed in 1999, the Glass-Steagall protections implemented to prevent a repeat of the Great Depression were largely repealed. See Wikipedia. One of the reasons Wall Street was pressing for the repeal of the Glass-Steagall protections was that other countries without the US financial regulations were getting a lot of business, and Wall Street argued with some passion and a lot of political cash that over time, the US economy was being disadvantaged by overly stringent regulation. It was true that money was flowing elsewhere, but recall that in the early 1990s the US economy was coming off a recession, and also recall that the US status as a reserve currency was largely the result of our stringent system of financial regulations. Also recall that Japan's asset bubble had already collapsed by the mid 1990s, and I think one could fairly argue that over time, the reverse of the IB arguments were true - the regulatory constraints in our financial system prevented soaring to the heights, but over time fostered a healthy economic climate and sustained growth. Some of the IB people are now willing to admit this contention. Greenspan refuses to even discuss it.

The distinction between activities allowed to banks and non-bank financial institutions was largely removed by the passage of GLB, and these institutions were allowed to conglomerate. Note that waivers granted by the Clinton administration earlier in the decade allowed evasion of Glass-Steagall, and GLB's passage essentially levelled the playing field as well as legalizing the 1998 merger that created Citigroup. ( The Clinton administration's role in creating the current situation is one of the reasons I considered Hillary's campaign truly an exercise in Boob Power. Not that the Republicans can escape blame, because a GOP-dominated Congress passed the legislation urged by the Clintons. )

The result was that overall regulation was reduced, the incentives to verticalize were massive, counterparty buffers were eliminated, and within less than 10 years, the financial system imbalances that produced the Great Depression in the US had returned.

Not only am I claiming that I know what caused the once-in-a-century event that Greenspan considers so random, but that it will recur very predictably if our regulatory system is not revamped.

My assertion is that if you create certain systems of incentives, human nature will reliably produce consistent and lunatic results. The system of incentives is:
A) Transportability (the belief that one can easily remove or transfer gains from one investment to a safe store in another investment),
B) Accurate short-term measures of gains, but no or very inaccurate long-term measures of gains,
C) Compensation for internal players on short-term measures of gains, paid in the short-term, and compensation high enough to overwhelm expectations of returns from on-going employment or investment,
D) A large consuming class of "outsiders" which are essentially unknowing but optimistic buyers of the end product of the investment-generating system.

A) is pretty obvious. Few people with other options would voluntarily dig for diamonds in a mine for low wages if they were searched every time they left the mine, and any diamonds found on their persons were confiscated. On the other hand, there are gold prospectors to this day in the US and in other places.

B) is less obvious. Our system of measuring profits, especially the profits of financial institutions that trade (investment banks rather than banks) is good at assessing returns on a quarterly basis, less effective at predicting returns on an annual basis, and horrible at predicting losses on a long-term basis, as numerous individuals who held large portions of stock in companies such as Thornburg Mortgage and Bear Stearns have now discovered.

C) is clear. The methods used to value financial assets are market-based, meaning that you tot up your losses or profit at the end of each valuation period based on the market value of what you have, what you exchanged, and any cash payments received at the end of the period. This is not true for banks. Because banks have assets (loans) and liabilities (borrowings in the form of loans from other institutions or deposits), banks are required to accrue ALLL (Allowance for Loan and Lease Losses). Thus there is a fundamentally different valuation process involved in market representations of loan portfolios held versus interests in financial assets of commoditized (securitized) securities backed by loans.

When you look at the gatekeepers of any system, you can intuitively assess risk by asking whether compensation rests on long-term performance or on short-term performance. Thus, a loan officer compensated in long-term stock vestings in his or her bank for reaching performance levels has a completely different set of interests than an individual mortgage broker who gets paid in YSP for each loan she writes. A loan officer who receives immediate and outright gifts of stock may have a large incentive to run it up for a few years, and then take his proceeds and run to another bank.

Needless to say, the people who set up all the non-bank mortgage companies were raking in the money, got the money immediately, and were able to transport (invest elsewhere) their gains. Within 5 years, many of these individuals racked up tens of millions of dollars in personal proceeds. The investment banks paid on levels that made many players wealthy within a few years. With such a compensation program, the incentive to ignore risk is monumental. Players are essentially paid to ignore risk. They do.

D) Maximizing your short-term returns with a blithe disregard for the longer term requires chumps and marks, and the chumps have been supplied by the globalized financial system abetted, in the US, by the NRSROs. Even though on most of the securities accurate financial filings reflected real risks, most investors (many of them institutional) relied on the ratings firms to make decisions about risk. For example, it can take several days to read through and analyze one set of MBS-related filings, and then additional days of research to evaluate counter-party risks. There just isn't time for most institutional investors. It is not that US debt issues are the only bad ones. The Spanish mortgage bonds are collapsing, the mortgages in the UK and Ireland are weak - the list goes on and on. But an atmosphere of heedless confidence is a prerequisite for bubbles, and we managed to generate that on a global scale. People are still ignoring the obvious in favor of the optimistic, such as recent pronouncements put out by some of the ME property developers touting their massive increase in population, without mentioning that most of the population increase comes in the form of foreign workers with no security, who are in many cases not even allowed to buy property.

For US persons, the concern has to remain the US. That is the part of the system we can control. Allowing financial institutions to conglomerate a la GLB creates a set of massive risks. If you are going to allow it, you have to restrict leverage ratios and pay a lot more for a vastly enhanced system of regulation with a vastly enhanced workforce of examiners. Restricting short-term vs long-term compensation is only one piece of a fix.

The primary reason for the enhanced risks to a financial system that involves vertical lines of production and conglomerated functions is that it destroys counterparty checks and balances. Here is a somewhat simple example using mortgages.

Old way:
Bank writes mortgages. It lays off portions of its larger commercial loans to other banks (participations), keeps some shorter-term and variable mortgages, plus home equities, and sells the other consumer mortgage loans either to GSEs or to larger institutions which then batch them and securitize them. When selling mortgages the bank often retains servicing rights on the mortgages.

In writing its mortgages, the bank employs:
- An independent appraisal staff. These appraisers are reviewed annually by the board to see if their loans have produced losses on default, and the approved appraiser list is checked against the lists provided by the mortgage buying entities. The appraisers know that, and know that their profitable relationship with the bank will be jeopardized if they overestimate valuations. Thus their incentive is to be conservative and protect the bank from loss. By doing so they are maintaining their business lines.
- Independent title companies. The title companies used are bonded, licensed and and insured. If there is a problem, they will end up covering it.
- Property insurance companies. The approved ones are state-licensed and examined. The incentive to the bank is just to make sure that they are covered and their risk of loss is controlled. Property insurance companies are also rated and approved by the entities buying the mortgages.
- Mortgage insurance, if required by the bank's loan risk assessment and/or the mortgage buyer. Again, these companies are reviewed by the major players, such as GSEs.

When the bank sells mortgages, it does so under a system of covenants and representations, which basically require the bank to take back loans that are not properly documented and evaluated. So, for example, if a loan defaults almost immediately after initiation, the bank is going to be stuck with it or get it back. Likewise, if the loan later defaults and loss review at the buyer turns up an erroneous original verifications of income, or bad DTIs, or misrepresentations of income, or a funky appraisal, the bank gets its bouncing baby back. If the buyer doesn't review on default but MI is involved, the mortgage insurance company does review.

Further, the fundamental structure of Fannie-type mortgage securities was the pass-through, in which Fannie bought back defaulted loans from the investment pool. The way this system evolved tended to maximize longevity of players and accountability of players. To preserve access to Fannie, one generally anted up when asked to do so. And the same was true for the title insurance company, etc. In general, it was a trust-based system with a lot of accountability for the end results. The aggregator (the GSE) took nearly full responsibility for the outcome and passed that responsibility back down the line.

In this system, the profit of each counterparty largely depends on meeting mutual commitments (sustaining line of business) plus controlling one's own risks. Management of risks is independent. If one of the companies becomes financially unstable, it will lose business rapidly and pose potential losses to the other parties, so company "certification", whether formal or informal, tends to take place at several levels. Adequate capitalization is one of the prerequisites for maintaining your business relationships. The system as a whole is much bigger than any one bank or company, so participants can fail or be shuffled off to pasture without rocking the entire system.

As it ended up in the GLB era of bright and shining financial innovation:
Investment bank buys holding company. Holding company owns a bank and a bunch of mortgage companies that are non-banks, an insurance company, a title firm, and an outfit that contracts for appraisals. In addition, IB wants to maximize profits, so it sets up a subprime servicing company of its own. IB will generate mortgages through this origination arm, plus securitize them, plus write interest rate swaps on the resulting securities. In order to get large enough pools of mortgages, the IB also buys from other such non-bank companies and banks. In order for the banks to get enough mortgages to sell, many of the banks do wholesale mortgages, buying loans from mortgage brokers to sell through to the aggregators.

Note that the IB gets profit from virtually every step in this process. When one leg of it fails, it can plausibly argue that it is merely moving money from one arm to another. Further, the eventual investment product does not truly protect the investors. Unlike the old-fashioned, non-innovative, Fannie pass-through mortgage bond, buyers of the resulting tranched bonds do accept the risk of default in most circumstances.

Access to capital under the old way (through GSEs) is accomplished by performing under your covenants and remaining solvent.

Access to capital under the new way is accomplished through plausible deniability. There are virtually no independent checkpoints - for example, mortgage insurance on this sort of pool is the exception rather than the norm. Because you are not actually getting rid of risks, the incentive to find out who done wrong is quite nonexistent in the captive portion of the business. Indeed, virtually the only independent checkpoint is the NRSRO who eventually gives your resulting mortgage bonds a credit rating.

When loans go bad that were purchased outside of the captive portion, they are passed back. In most cases, the banks who were doing wholesale mortgage ops then shove them back to the broker, who may or may not be able to cover the tariff. The broker is most likely effectively unsupervised and unregulated (brokers working for the GSEs are generally audited). There is a high correlation between mortgage fraud and default ratios and states with slim to none mortgage broker regulation.

If the loans don't default and result in a loss, no one ever checks for performance. There are no substantial audits. Until failure, there is no set of corrections working its way back down the system.

Throwing easy money on top of this type of structure is a recipe for a run-up and a crash. During the run-up phase, everyone is making money. Housing is appreciating (and so is commercial real estate). Sure, the underwriting quality tends to become worse every year, because there is no penalty for bad underwriting, good underwriting is expensive, and some goof is always going to cut standards and margins, thus forcing the other competitors to either sacrifice profit or standards. And the goof who cuts underwriting cuts expenses, and provides a better profit to the aggregator, so that goof gains business.

Yet no one's going to detect the fraud, because although maybe DTIs are too high and people can't pay their mortgages, yet the easy refi or sale for profit is always out there. The investors get paid, the IB gets big bucks, the NRSRO makes easy, large chunks of money, and the realtors are very, very happy. All of these people manage to maintain high levels of campaign donations to local, state and federal politicos, so the Congress Critters are very happy. The Congress Critters also like their cheap loans, and those cute and profitable real estate deals in which they just happen to be offered silent partnerships.

The only people who really see what's happening are the old-fashioned people working in underwriting. Many of them try to fight it. Most of them end up out of the business.

Here it is worth noting that in 2002 thousands and thousands of appraisers petitioned the FFIEC to control appraisal fraud originated from the contracting (loan originating) party. Here is one signer's comment:
10680. RENE C. CHIRINO 7760 W 20TH AVENUE #6 HIALEAH, FL 33016
CW is CountryWide. You can see how the honest brokers and appraisers got forced out. Many brokers attempted to contact federal and state authorities to warn of the problems in the mortgage market.

By 2005, the better part of the prospective buyer's market had already been vacuumed up. At this point, the universe of brokers, realtors, agents, appraisers had been skewed to the new, ignorant, criminal or just reckless, and the IBs accelerated their drive to buy originators and related companies. In 2006, loans started defaulting in the first and second month, but the IBs still didn't pull back. Instead they blithely started sending the loans back down the line for indemnity, or writing meaningless covenants into their broker contracts to sustain plausible deniability. In 2007, the originators started going bankrupt because they didn't have the assets to cover their losses.

At the worst point, Fannie's share of the overall mortgage market had dropped to about 25%. Inevitably, the GSEs loosened their guidelines. By late 2006 and through much of 2007, Congress was pressuring the GSEs to buy and guarantee the non-GSE MBS. They did buy and guarantee a lot of it, and much of their losses are coming from that portion of their business. Then Congress pressured the GSEs to buy jumbos. Then Congress passed laws cutting the required capital reserves of the GSEs. Now you own the GSEs.

So that's the story. No politician has an incentive to tell the truth about this. Both parties were deeply involved.

Further, I must note that other types of financial operations were experiencing the same sea change. From LBOs (Leveraged Buy Outs) that saddled companies with debt which nearly ensured their demise, to commercial mortgages that appeared to rely on future income streams derived from an alternate universe in which profits always go up, to junky corporate debt, historical standards of risk assessment were simply dumped in the trash.

The NRSROs (credit rating firms) were a big part of the entire process. The truth is so incendiary that their role has barely been publicly discussed. However, there were early warnings on the NRSRO situation as well (Enron, for example) and part of the 2002 Sarbanes-Oxley legislation was a mandate to SEC to buck up and start engendering more competition in that business. It did not happen. The SEC just started adding new NRSROs such as Egan-Jones and R&I.

I end this post by appending two texts from AEI.
AEI, Sept, 1998:
Statement No. 149

For Information Contact:

Charles W. Calomiris
(212) 854-8748

In November 1997, the Federal Financial Institutions Examination Council (FFIEC) released for comment a proposal to use private agencies’ credit ratings to set capital requirements for securitizated loans. The Committee opposes linking capital requirements to ratings. As the Committee has noted (Statement No. 81, February 1992), micromanagement of capital standards by setting arbitrary rules for measuring risk, or by passing the buck of risk measurement to ratings agencies, is no substitute for a regulatory process that encourages banks and bank debtholders to measure risk exposures properly by forcing them to bear the consequences of underestimating risk. The FFIEC proposal represents another example of dysfunctional regulatory micromanagement.

The use of private ratings to measure credit risk for purposes of establishing banks’ capital requirements is fraught with potential for abuse. Ratings traditionally have been issued as a service to investors. Consequently, private ratings agencies that overestimate a security’s credit quality place their reputations at risk with investors. Thus private agencies’ ratings are often reliable indicators of credit risk. But, when ratings are rendered to and paid for by bankers only for regulatory purposes, there is a risk that the ratings agencies will engage in a "race to the bottom," competing for fees earned for overestimating the credit quality of issuers.

The problem arises because ratings are used to reduce the capital ratios required of institutions that enjoy the protection of government safety nets. Potential abuse is greatest in closely held, non-publicly traded securitizations, where the penalties imposed by outside investors on ratings agencies that exaggerate credit quality would be negligible. Under the proposal, the benefits to originators from obtaining exaggerated ratings are large. For example, in some cases an exaggeration that elevates AA securities to AAA, and BB securities to BBB, would result in a near halving of currently required capital.

Other approaches to linking asset risk and bank capital are superior to the FFIEC proposal. Those alternatives include reliance on market discipline to encourage appropriate combinations of capital and asset risk by insured institutions (e.g., subordinated debt requirements).

AEI, Dec 2002:
Statement No.183

For Information Contact:

Franklin R. Edwards
(212) 854-4202
Paul M. Horvitz
(713) 743-4765

During recent years the effectiveness of credit-rating firms has come under attack from bondholders and the Congress because of a failure to predict more accurately the financial decline and ultimate insolvency of Enron and other high-profile firms. As a consequence, Congress in the Sarbanes-Oxley Act of 2002 directed the Securities and Exchange Commission (SEC) to study the credit ratings industry to determine if changes can be made that will improve the "role and function of the credit rating industry in the operation of the securities markets." As part of this study the SEC is directed to examine "any barriers to entry into the business of acting as a credit rating agency, . . ." (sec. 702(a)(2)(D)). The SEC is now in the process of reviewing the standards it uses for designating credit rating firms to determine if changes in these standards can be made that would improve the operation and efficiency of this industry.

The SEC adopted standards for designating credit rating firms in 1975 when it began to rely on the use of credit ratings issued by nationally recognized statistical rating organizations (NRSROs) in its rule 15c3-1 (the "Net Capital Rule") for brokers and dealers as an indicator of a security's liquidity. Since that time the use of NRSRO ratings in federal and state securities laws and regulations has expanded dramatically, as has reliance on those ratings by investors and the marketplace for determining the creditworthiness of debt securities. However, the term "NRSRO" remains undefined in SEC regulations, whether under the Net Capital Rule or elsewhere (such as the purchase criteria for money market mutual funds under rule 2a-7 of the Investment Company Act), as has the process for obtaining NRSRO designation from the SEC.

Currently the SEC reviews the qualifications of applicant credit rating firms to determine if they meet the criteria for becoming an NRSRO. In making its determination the SEC considers a number of criteria, including whether the rating organization is "nationally recognized," or is recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities markets. In addition, the SEC considers the operational capacity and reliability of the applicant--specifically, the firm's organization structure and financial resources, the size and quality of its staff, its independence from the companies it rates, its rating procedures, and whether the firm has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed.

Since 1975 there has been very little entry into the credit rating industry. At that time the SEC "grandfathered" Moody's, S&P, and Fitch. Subsequently, it designated as NRSROs Duff & Phelps in 1982 and McCarthy, Crisanti & Maffei in 1983, and IBCA in 1991 and Thomson Bank Watch in 1992 as NRSROs for banks and financial institutions. The SEC has not granted NRSRO status to any new entity since, despite several applications. Today, due to a series of mergers and acquisitions by Fitch, there are only three bond rating firms in the United States: Moody's, Standard & Poors (S&P), and Fitch. Moody's is a freestanding company specializing in rating activities; S&P is owned by McGraw-Hill which provides a variety of financial services; and Fitch is owned by FIMALAC, a large French company.

The Shadow Financial Regulatory Committee (SFRC) believes that the SEC should revise its certification standards to permit other qualified firms to become NSROs. In particular, the SEC's "national recognition" criterion is too exclusionary and has little to do with the ability of a new rating firm or an established foreign rating firm to provide informative and reliable credit ratings. Indeed, a "national recognition" criterion is a Catch 22--a firm cannot become an NRSRO unless it already is an NRSRO. The SEC should propose regulations that make explicit its criteria for designating and monitoring NRSROs and these criteria should have as their focus the ability of rating firms to provide credible and accurate credit ratings. A "national recognition" standard should not be part of these criteria.

Permitting more qualified rating firms to compete for the business of rating securities can be expected to lower the cost to issuers and investors. In addition, a more competitive rating industry should make rating firms more responsive to changes in the marketplace and over time should result in a more innovative credit rating industry.

While the SFRC considered the possibility of eliminating all impediments to entry into the credit rating industry, and in particular eliminating all SEC certification requirements for credit rating firms, the Committee believes that so long as the SEC (and other regulatory bodies) continue to rely on credit ratings as part of their safety-and-soundness regulatory apparatus, it will be necessary to have a process for certifying the quality of firms doing the rating. At some point, however, we may want to review this regulatory process.

Finally, critics of a more open credit rating industry argue that more competition may reduce the quality of credit ratings as credit rating firms compete to obtain additional business by providing more favorable ratings to issuers, especially since credit rating firms are typically paid by the issuers of the securities that they are rating. The Committee believes that this is unlikely. Firms that have been certified by the SEC will presumably have substantial "reputational capital" that they will not want to depreciate by diluting the quality of their ratings. Further, the SEC will still have the power to withdraw a credit rating firm's NRSRO designation if it determines that the firm no longer meets the certification requirements.

Superb summary, MoM.
What about companies that are "too big to fail"? Should we take steps to disallow those? How?
Outstanding article.

One outcome is I may never see another housing bubble again in my lifetime.
NJCommuter - we already have antitrust laws that prevent us from becoming dependent on one or two companies.

Other than that, I think we need to be willing to let companies fail.

John - it's just glancing on the surface, but it is pretty accurate.
Anon - it depends on how old you are. Usually there is about a 20-25 year cycle. I expect to see another RE bubble in FL if I live to my 70s.
This is great, MoM. It outlines how GLB and the SEC enabled this whole massive greedfest. I've linked to it several places.

I have to disagree completely on G-L-B. I can feel your indignation with regards to deregulation, but I don't believe you'll be able to lay out a causal link between G-L-B and any specific risk-taking activity that wasn't already widespread prior to G-L-B.
An excellent post, MOM. I feel much more knowledgeable about banking and mortgage lending.

I'm 75 and have owned 13 houses because I have moved a lot and I like to design and build houses. I have lost money on two of the 13 houses. In both cases I had to sell into the teeth of a collapse in housing prices because of a job transfer.

I have seen many fluctuations in housing markets both on a local and a national scale since I bought my first house (Which cost $18,500.) in 1960.

I lived in California for quite a number of years and became aware that the California market fluctuates much like the stock market. I took advantage of that on two occasions, buying low and selling out near the peak. I also have lived around Denver and saw much the same kind of cycles there. Made money on a couple of houses there as well.

IMO one reason why this market got too frothy was low interest rates for too long, which lead to the idea that this time the home building boom "was different."

I visited friends in Naples, Florida back in 2005 and saw a virtual mania going on there. There were many, many nice subdivisions going up in which people would buy a house before the foundation was poured and then sell the house for a profit when the house was completed. Many people were into this and many were buying multiple houses to flip. When interest rates went above 6% and buying interest cooled, many of these people were left stuck with their "investments." As I understand it the same thing was happening all over Florida, in Arizona, in Las Vegas, and in California. That is where the major mortgage defaults and the major decline in housing prices are.

I now live in Puget Sound. The real estate market here has slowed and houses take 110 days to sell versus 60 a year ago. Prices are soft, but not declining a great deal. In fact prices increased in the county I live in during the second quarter. Boeing, Microsoft, and bio-techs are doing well, but if they falter things could go down here as well.

Steve Forbes pointed out a couple of weeks ago that the big problem for so many of the financial institutions was that the FASB was requiring them to mark their CMOs to market. Since there is no auction market for CMOs, that means the financials are having to write these instruments down drastically just because they can't value them rationally without going through each mortage and finding out if it's performing.
His suggestion was toi suspend the rule for 18m months and allow these comapnies to carry the C drivatives on their bokks at cost while they go through them and determine if the mortgages are sound and revakue them on a rational basis. That seems like a good idea to me if they can keep the companies from cheating in the process.

The resolution trust idea by Paulson can work, but, IMO, it just injects the government unnecessarily into the the business of dealing with the CMOs. And if the government is going to buy these instruments from the companies that creates an element of risk for the taxpayers.

Would be interested in your views on that issue.
Very good analysis. I especially like the discussion of how independent competing companies at the various stages of the mortgage process, tend to self correct excess, sloppiness and fraudulent behavior within a framework of regulatory oversight. I agree with the line of reasoning that “our stringent system of financial regulations” under depression era Glass-Steagall law created a stable, profitable and effective banking system, and the Gramm-Leach-Bliley repeal of these time proven guidelines created a new environment where creative new ways of financing could be explored.

Trial and error is essential to progress and (as the old adage goes) we learn more from our mistakes than our successes. There are products and practices that have undeniably failed, however, excessive regulatory restrictions may stagnate American competitiveness in a global economy. For example, the Good Faith Estimate is an estimate, not an exact template for the final HUD. I hope our leaders, business and political, are wise enough to make the operational corrections that rebalance separation of functions with some flexibility to still be innovative.
C'mon, MOM. Here's the Senate vote before they added the Community Reinvestment Act amendments, consider it GLBA in its purest form.

YEAS 54 - 53 R 1 D
NAYS 44 - 44 D

Gramm had maintained that he did not want anything in the bill that would expand the application of the Community Reinvestment Act because it was, he said, unnecessarily burdensome to banks.

After the compromise:
NAYS 8 - 1 R 7 D

Veto proof, so Clinton couldn't have vetoed successfully even if he wanted to. How you can not acknowledge this wasn't authored and championed by the Senate Republicans? And grudgingly agreed to by Senate Dems after CRA mods? Your bits about Clinton are disingenuous in the extreme.

I've got source links but Blogger thinks it's spam?
Your bits about Clinton are disingenuous in the extreme.

Hardly. Clinton was lobbied heavily for GLB and lobbied heavily in return. See here for details.
Some of your comments are very interesting, and I will address them this weekend.

Some of them frankly left my mouth hanging open.
People are still ignoring the obvious in favor of the optimistic, such as recent pronouncements put out by some of the ME property developers touting their massive increase in population, without mentioning that most of the population increase comes in the form of foreign workers with no security, who are in many cases not even allowed to buy property.

Do they count them as three-fifths of a person?
Is there a fundamental mismatch between the concept of "mark to market" and the nature of an asset-backed security? Real estate is, by its nature, relatively illiquid (as I understand the term). You can't sell it at need at a market price; you have to find a buyer for whom that particular piece of real estate is particularly valuable. So what is used to determine a market value for the security? Is it the payment stream on the underlying mortgage? The value at a forced sale? The expected value on a sale that can be carried out in a few months?
NJCommuter - market prices would be based on the expected return (payment stream) compared to other currently available investments.

Expected return is calculated by projecting the expected losses over the life of the investment.

Not that it matters right now, because I can't tell what any of this actually means, therefore I can't calculate the value of almost anything. I would suspect the institutional investors are in the same boat, because why the heck would Treasury be buying agency paper if it were truly guaranteed? You'd think institutions would be piling into it.
I'm not sure I understand the role of Gramm-Leach-Bliley; others don't blame the current crunch on repeal of Glass-Steagall:

Investor's Business Daily

Tyler Cowen

Megan McArdle

Justin Fox
More on Gramm-Leach-Bliley from Megan McArdle.
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