The Public Policy
Improving the Financial System for the Next Cycle
A half-dozen proposals you won’t hear from the regulators.
Asset bubbles inflate because enough people believe that the good times of expanding credit and rising asset prices will last forever, but of course they don’t. In the midst of the bust that follows, it seems that the bad times of defaults, scarce credit and falling prices will last forever, but of course they won’t.
I don’t believe financial cycles can be avoided any more than business cycles can. We are still vastly better off with functioning markets, for all their boom and bust cycles, than with socialist stagnation.
“Our regulatory system has failed miserably, and we must rebuild it,” Congressman Paul Kanjorski said recently. After every bust, politicians enact new regulations and reorganize regulatory agencies. This is to make sure, they say, that the problems “will never happen again.” In time, they happen again anyway. In 1914, the then Comptroller of the Currency pronounced that with the new Federal Reserve Act, “financial and commercial crises or panics seem to be mathematically impossible.” They weren’t.
This is not to say there are not ways to improve the financial system, and mortgage finance in particular. Here are six suggestions, which in my view are much more important than reorganizing regulatory bureaucracies:
1. Countercyclical LTVs. Leverage at the mortgage borrower level is expressed as the Loan-to-Value ratio or “LTV.” An LTV of 80% means the homebuyer has borrowed 80% of the price of the house, and made a down payment out of savings of 20%. An LTV of 100%, not uncommon during the housing bubble, means the buyer has borrowed all the money and made no equity commitment. Did it make sense to make these loans? No, but it seemed like a good idea if you believed house prices would always go up.
There is a strong and reliable statistical relationship between LTVs and mortgage defaults. Not surprisingly, the higher the LTV, the higher the defaults. When the house price declines, the LTV automatically increases.
In a housing boom, as house prices rapidly inflate, the risk that they will subsequently fall is increasing. So in a rational system, LTVs would be lowered as house prices accelerate over their trend. What in fact happens in the boom is that as rising prices induce optimism in both lenders and borrowers, LTVs tend to rise, up to and including 100%: exactly the opposite of what should happen.
Reversing this perverse LTV behavior would make for a much sounder housing finance system.
2. Old-Fashioned Loss Reserves. We should return to the old-fashioned idea of building loan loss reserves in good times. As an old banker told me long ago, “Bad loans are made in good times.” This is just the time to be building reserves against the inevitable vicissitudes of any firm bearing credit risk.
Spain, now involved in its own housing bust, is glad that in 2000, it forced its banks to begin a system of countercyclical “dynamic provisioning,” building up reserves far beyond current losses to prepare for possible future losses. This system, old fashioned as it is, is becoming the international model.
Unfortunately, in this country the SEC went in just the opposite direction from what the Spanish regulators did. It actively opposed building large loan loss reserves, because it regarded them as undesirable “earnings management,” which would understate profits in good times, while providing a cushion for bad years. The result was to overstate profits in the bubble and to have insufficient cushion in the bust.
The reality of all businesses built on credit risk is that they experience, on a cyclical basis, periods of high losses, often far beyond expectations — like now. If you don’t reserve against this reality, you create, as American official accounting did, illusory profits in the good times. These in turn trigger bonuses and also induce financial firms to reduce equity through buybacks of their shares. Alternately stated, in the good times financial firms book what are really insurance premiums for bearing risk instead as profit in advance, while the risk builds without prudent enough reserves. This is obvious, now that the risk has come home to roost.
3. Risk Retention in Securitization. We should combine mortgage securitization with credit risk retention by the mortgage originators who perform the credit underwriting and make the credit decisions.
A prime lesson of the 1980s savings and loan collapse was that for financial institutions to keep long-term fixed rate mortgages on their own balance sheets was extremely dangerous in terms of interest rate risk, although it was not a problem in terms of credit risk. The answer was to sell the loans to bond investors through securitization and divest the interest rate risk to those better able to bear it. As a side effect, the credit risk was also divested.
In the wake of the mortgage bubble and bust, everybody now realizes that divesting mortgage credit risk created huge problems of its own, breaking the alignment of incentives between the lender making the credit decision and the ultimate investor actually bearing the credit risk. Some commentators have referred to the good old days when the savings and loans kept the loans themselves — displaying notably short memories.
Letter to the Editor View all comments (27) | Leave a comment
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Bob| 1.12.09 @ 8:05AM
Alex, I am usually a thorn in the side of most of the bloggers here because their posts lack reason. However, you are so "right on" with these thoughts -- they are the same I have been posting now for months. I worked in sub-prime and prime financial services in the 90's and early 2000's and there was no "skin in the game". Your solutions basically give originators a piece of the action so they will self regulate. This has the benefit of letting the market work to help the problem instead of hurting it. We used to make 125% loans and verification was minimal. Emphasis was placed on initial monthly payments on variable loans and not on what may be required in 2 years. As long as the risk could be transferred, the company did not care. And the people who bought the CDO's didn't care as long as housing prices continued to rise.
This is the right solution -- kudo's....
Pat| 1.12.09 @ 7:00PM
All good ideas, all about as likely to be adopted as a sudden outbreak of world peace. How can we induce the Feds to embrace such ideas? We can't. That's the point, where's the fun (or the insider profits) in a rational market/govt. interraction?
What would work in a more pragamatic sense? Leavenworth Penitentiary, long prison sentences for Wall St. moguls and their joined at the hip helpmates in the federal govt. called "regulators" and our beloved elected employees who deal in favors, hard to trace but unabashed graft, the entire gamut of petty and not so petty swindles involving trading legislation for personal wealth.
Long, healthy walks in the prison yard, explaining to your new roommate Big Leroy that you're already in a committed relationship and don't want to be his "girlfriend", not worrying about what suit to wear to the office or trying to get a last-minute dinner reservation - all those benefits could be realized by former Wall St. slicky boys and their federal govt. friends while on their way to permanent rehabilitation. Of course, wishful thinking is a pleasant way to pass the time, but none of these so-called "rational" remedies ever work - they're not supposed to.
Paul Nelson| 1.12.09 @ 9:14PM
About ten years ago, I tried to interest the FBI in fraudulent mortgage apraisals in Kankakee Illinois. I recall telling the agent that I was unconcerned if the lenders lost money , but that I thought that in the end the gummint would be stuck with the losses. If I, a poor humble slumlord in a corrupt decaying midwestern mill town, could see the coming trainwreck many others should have been just as aware.
Marcia C| 1.13.09 @ 12:02AM
A particularly desirable form of increased competition would be from ratings agencies paid solely by investors, as opposed to those paid for by the issuers of securities.
Yeah, let the foxes be in charge of the chicken coop. In fact that is exactly what happened. The companies want nothing more than that the rating corporations and the other corporations are all in it together.
Regulations when applied to human beings, are called LAWS. The Republicans think that there should be no laws for financial criminals, who destroy the economy in fits of rightwing-supported greed. Yet America, thanks in large part because of privatized prisons, has the biggest prison population in the world. After 28 years of mostly rightwing government and catpulated propaganda.
If you want to end booms and busts, it's easy: take back all the ill-gotten money ceo's who presided over the bust took from us, and be forced to work at WalMart as cashiers for the rest of their lives. Only being forced to find out how their victims feel and being totally humiliated can stop the endless boom/busts that Marx told us is one of the huge capitalist flaws.
Marcia C| 1.13.09 @ 12:06AM
Paul Nelson | 1.12.09 @ 9:14PM
Millions of Americans could see this coming from the time of Reagan's Class Warfare against the majority of Americans - Class Warfare that has intensified immensely since then- Americans who really work hard to make ends meet.
Only the Republicans seem to be mystified about how it happened "overnight". Because they can't and won't ever admit that they did it.
Bob| 1.13.09 @ 9:26AM
Marcia, I was in this industry in the 90's and early 2000's. I can tell you there is plenty of blame to go around on both Republicans and Democrats. Much of this is due to the fact that both hard core Democrats and hard core Republicans depend on ideology over pragmatism and facts. Republicans since Reagan believed so much in deregulation that they overlooked necessary regulation. Democrats felt so good about the lower socioeconomic group being able to own their own homes they overlooked poor verification and sales practices. Certainly the greed of Wall Street Republicans AND Democrats loved the fact they could get the fees and unload the risk.
The entire system lacked personal responsibility at every level -- and that's what this article addresses. When you make someone responsible for their actions, they tend to self regulate because they understand the limits of their business better than anyone else.
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