Monday, in the face of the gravest American banking crisis since the Great Depression, Secretary of the Treasury Henry Paulson will give a speech about a new Bush administration banking regulation proposal.
The speech will introduce the latest legislative Trojan horse of the conservative right--a proposal which would nominally increase financial market regulation but which would, in fact, decrease regulatory oversight over things like new financial instruments.
In the speech, according to The New York Times which was provided with an advance copy, Paulson will say: "I do not believe it is fair or accurate to blame our regulatory structure for the current turmoil."
That statement will mark Paulson as either a lying hack or utter idiot. I'll give Paulson--a former CEO of Goldman Sachs--the benefit of the doubt and kindly accuse him of lying hackery, since everyone with a thorough and sophisticated knowledge of the current banking crisis understands that it was precisely a failure of our regulatory structure that led the US banking system over the past few weeks to the brink of system wide insolvency. And make no mistake, system wide insolvency was exactly what was at stake as Bear Stearns teetered on the brink of failure (its failure would have touched off a domino of defaults that would have swallowed nearly every other major commercial and investment bank).
How did deregulation get us into a the situation where a handful of defaults on a few billion dollars in mortgage loans threatened (and still threatens) to collapse the multi-trillion dollar US banking system?
Here's my oversimplified version of the story. In 1999 Bill Clinton signed a law repealing Glass-Steagall, the law which, since the Depression, had separated the activities of investment banks which dealt certain kinds of securities from those of commercial banks that dealt with mortgage loans and consumer deposits. This act of deregulation placed commercial banks--with their tighter regulatory oversight, significant capital set aside requirements, and limits on their leverage--in direct competition for investment dollars with securities firms like Bear which faced few of the same restrictions. (Investment banks could borrow money to invest without limit, piling on leverage--in Bear's case reportedly as much as 30-to-1--while commercial banks were stuck with regulated leverage limits and the requirement to set aside enough capital to keep them solvent in the face of investment losses.)
At the same time the business of lending, the core business of banks, was changing dramatically, moving away from the practice of institutions extending loans directly to borrowers, towards the practice of institutions investing in asset backed securities which represented an interest in the future stream of income generated by a pool of loans of all sorts: mortgage loans, construction loans, loans to finance leveraged buyouts, just about any kind of loan you can imagine. This kind of securitization, it was proposed, would created greater stability in the credit markets, and wider access to cheaper money, by spreading the risk of lending over the entire system. To a certain degree that worked.
But the system carried with it new risks that were easily identifiable.
First, since the risk was so widely shared the potential for widespread catastrophe, should catastrophe strike, was also greater than before.
Second, since commercial banks were now in competition for returns with less regulated investment vehicles (like hedge funds), the market now contained an incentive for commercial banks--who were barred from piling on the kind of leverage i-banks and hedge funds could--to move more and more of their investments off balance sheet through the use of special purpose entities. By investing through special purpose entities, commercial banks could evade the additional capital set asides that would have been required if those investments had been on balance sheet, providing more competitive returns to investors. But this practice heightened liquidity risk in the market as a whole--there was less money than ever in the system to cover investors if loans went bad--and decreased market transparency--looking at a bank's balance sheet gave investors a very limited sense of that bank's true risk profile.
Third, the securitization system was allowed to "self-regulate" relying on private bond ratings agencies to certify the risk profiles of asset backed securities. But the system had few hard rules or guidelines, and, since ratings agencies were paid by the issuers of securities when those securities were rated for the market, there was, built into the system, a financial incentive for ratings agencies to give securities the highest possible risk ratings with the least friction (as a result, for example, during the height of the structured finance boom, ratings agencies routinely rated subprime piggyback loans--in which first and second mortgage loans are extended at the same time to a low-credit borrowers--as equally safe from default as prime first mortgage loans, an assertion that is absurd on its face).
Fourth, since securitization mean that loan originators were not going to carry loans on their books, but instead sell them into asset pools owned by off balance sheet SPEs, lenders no longer had a market incentive to thoroughly vet the credit risk of the loans they were making--since they would not be at risk if the loans, once sold into pools, failed. Instead, loan originators now had a market incentive to generate as many new loans as possible at the highest possible rates of interest--an environment which led directly to the subprime mortgage boom and bust.
The bank crisis we are currently living through came about when suddenly declining real estate values froze the market for asset backed securities, forcing banks, i-banks and hedge funds to sell other assets to raise cash to replace the money that they were otherwise churning through a system of investment by which they sold short term asset backed securities at a given interest rate and used the proceeds of that sale to invest in longer term asset backed securities at higher interest rates. That system of selling short term debt to invest in long term debt represented nearly all the liquidity that ran the American banking system, and the unregulated investors had become the biggest part of the market.
There is no doubt that the inflation of the structured finance bubble, and the scope of damage from its collapse, was created by deregulation--not only the repeal of Glass-Steagall but also accounting changes that made off balance sheet investing easier and more attractive as well as the lack of firm guidelines for and oversight off private bond rating agencies.
Had the fiscal innovation of structured finance been accompanied by prudent new regulation to address these predictable outcomes, there's no doubt that the damage from declining home values and increasing mortgage foreclosures could have been contained long before the need for the kind of emergency measure the Fed has lately undertaking (like taking bad asset backed securities onto the tax payer's books in exchanged for treasury notes).
Here are just some of the kinds of regulations that might have helped: limiting the amount of leverage allowable for investors in asset backed securities, particularly in areas where the assets in question are crucial to the social good and national economic stability (like mortgage loans); limiting the total value of off balance sheet assets that could be held by investors in those same sorts of loans; providing bond ratings agencies with stricter risk guidelines for defining what constitutes AAA and other ratings levels; setting stricter guidelines for subprime loan eligibility evaluations (at the height of the boom lenders were offering no-income-verification, no-money-down mortgage loans like Halloween candy to trick or treaters).
Yes, these kinds of regulations would have limited the growth of the recent boom and limited the wealth of investment bankers, but they also would have improved the stability of the markets to the benefit of the greater number of Americans perhaps insuring that the economy would still be growing today instead of teetering on the brink of disaster.
In the absence of prudent regulation, all that institutions like the Federal Reserve, Federal Housing Authority, and Treasury Department can do is bale water after the economy starts sinking. In the end bail outs are more socially disruptive and much more expensive to the federal government than prudent regulation.
Sophisticated financial minds understand all this and now favor tighter regulation over the so-called "shadow banking system." Even Larry Kudlow, former Fed and Reagan administration economist and as loud a public voice for laissez faire economics as this nation has, told New York Times columnist Joe Nocera on Friday “I think investment banks need to be regulated.”
But that's not what Hank Paulson will propose tomorrow. Paulson will propose the consolidation of regulating agencies (probably a good thing) but also oversight without teeth over hedge funds and investment banks. Worse, he will propose giving the Federal Reserve more power to intervene in markets but only after markets have collapsed--giving it power to act only after "overall market stability is threatened" instead of proposing the kind of legislative regulatory solutions that could prevent threats to market stability in the first place. The plan would also reportedly call for the industry wide self-approval of trading in new financial instruments without vetting by the Fed or Congress.
For a Secretary of the Treasury to address one of the gravest crises in US banking history by proposing more industry self-regulation and limiting the power of government involvement to after the horses are out of the barn is the height of irresponsibility, a pure, venal effort by one of Wall Street's own to keep the gravy train flowing at any expense to the American people. Paulson ought to be ashamed.
One final note, in this political season, last week all three of the major presidential contenders delivered speeches on economic matters but Barack Obama--confirming again why I support his candidacy--was the only one who displayed a sophisticated understanding of the nature of the current crisis. Where John McCain sounded clueless--arguing that the cause of the problem was reckless speculation by American families buying homes--and Hillary Clinton sounded like someone pandering to her demographic--offering only talk about bailing out mortgage borrowers but no talk about how to address the systemic banking industry problems--Obama offered a six point plan for revamping the regulation of the US banking system. Although the speech, being political, was not a detailed fiscal proposal, it was more detailed and focused than those of the other candidates offering provisions on banking regulation--prepared with advice from Columbia University economist Joseph Stiglitz, former chairman of Bill Clinton's Council of Economic Advisers--that are real solutions that cut to the heart of the actual crisis. You can watch the video or read the text of the speech here.
I think this is a turning point in the downward spiral that will accelerate the descent to irrelevance and potential bankrupcty. While newspapers face daunting challenges from the Internet, I think more of their problems are due to the toxic and delusional culture that rules the staffs. Shifting to an ESOP majority ownership will only accentuate that defect. Moreover, just who will end up being the real power in the ESOP? The moderate, business- oriented types or the true radicals? And finally, there’ s the...
Posted by: foreclosure companies | May 24, 2008 at 06:32 AM