OK, this is a big topic, but not reforming the financial system will lead to big problems. Here are some of the things that I think we need to see happen.
Consumer Financial Protection Agency
First, we need a Consumer Financial Protection Agency. As it stands now, looking after the consumer is about item number 7 on the list of concerns at about five different agencies that regulate various parts of the financial system.
The talent at those agencies are going to be drawn to the higher-profile parts of those agencies’ missions. People don’t decide to work for the Fed to concentrate on making sure that mortgages are fair and transparent to borrowers, they tend to want to work on the big, sexy stuff like monetary policy. That is the way they will advance their careers.
We would not want to do away with the FDA and just let Merck (MRK) make any drug it wanted to, and hope that the discipline of the market would be enough to insure that the drug was safe. We wouldn’t want to do away with the Consumer Products Safety Commission and just hope that bad publicity about toys with lead-based paint on them would be enough for companies not to sell them. In both of those cases, the manufacturers are going to have a lot more information about the product and its risks than the buyer will have.
The same is true of financial products. As we saw in the bubble, as things stand now, the riskiest and most complicated of financial products were generally sold to the least sophisticated of buyers. While both the borrower and the lender may have been at fault, I think the lender staffed with an army of people with MBAs and CFAs, and who hires the lawyers that actually write the contracts, is far more likely to be the more culpable of the two.
The agency needs to be strong and independent, with its director directly appointed by the president and confirmed by the Congress. It also needs to have its own budget. Ideally, it would be totally on its own, but if it has to share office space with either the Fed or the Treasury, it’s not the end of the world as long as it has its own budget and its director is directly accountable.
Make Sure the Lenders Hold Part of the Loan
Second, the easiest job in the world is to lend money — any idiot can do it. The hard part of the job is getting it back. In the bubble we actually had it set up where the people who lent the money didn’t need to care if the loans got paid back or not.
The loans would be immediately sold off, and the seller’s bonus was the same if it proved to be a good loan or if it eventually defaulted. The loan would go from some store-front mortgage broker, then sold to a somewhat bigger bank, which in turn would sell it to an investment bank like Goldman Sachs (GS) or Morgan Stanley (MS) who would put a whole bunch of them together in a Cusinart and then slice and dice the pile of loans into different tranches based on the pattern of their cash flows and with different levels of risk.
Magically, through the incentive of lots more of these deals coming down the road that the agencies would want to rate, the vast majority of the deals (like over 95%) would be deemed AAA, even if the vast majority of the underlying mortgages were at best BB credits. This was a trick the Alchemists of the middle ages tried in vain for centuries to accomplish — a way to turn lead into gold.
The way to make sure that lenders actually care about getting paid back is to make sure that they have to hold onto at least some of the loans they make. The current legislation calls for 5%. That is a good start, but I would rather see it higher than that, although going above 10% is probably excessive. We don’t want to stop the lend/sell/securitize model altogether, just make sure that there are adequate safeguards.
Adequate Capital Levels
Next we need to make sure that banks and other financial institutions that are the economic (but not legal) equivalents of banks have enough capital. While we may never be able to stop all bubbles from forming, the greater the amount of leverage involved, the bigger the bubble will get and the more painful the collapse will be when it comes.
The current legislation allows regulators to set capital levels, but that is probably not enough. Eventually we will have a top regulator who comes directly from the institutions being regulated and who is only too happy to do their bidding. More leverage allows for much greater profits on the way up, and when times look good there will be enormous pressure to relax the rules.
The legislation should impose absolute caps on the amount of leverage (or to put it another way, an absolute minimum level of capital relative to the institutions assets). Regulators should be free to set more stringent limits depending on economic conditions Ideally, banks — and shadow banks — would be increasing their levels of capital during the good times, but in bad times they would be free to do more lending with somewhat lower capital requirements, thus acting counter-cyclically, which would tend to level out booms and busts.
Break Up the Biggest Banks
I would also favor breaking up the very largest banks. There really isn’t much justification in terms of economies of scale of worldwide reach for a bank to be much over $250 billion in total assets (many very astute observers such as the former IMF chief economist put this figure much lower, down around $100 billion: see here). Our biggest banks, like JPMorgan (JPM) and Bank of America (BAC) are about 10x that size. They have only gotten bigger as a result of the financial meltdown of 2008.
I don’t care who is in the White House, if one of those banks was about to go under, they would be bailed out. Not doing so for a financial institution that represents over 15% of GDP would lead to a second Great Depression or worse. Just swearing that you promise on your children’s eyeballs that you will never bail them out would only result in blind children.
Simply put, “too big to fail” should mean “too big to exist.” Breaking up the banks does not have to be a bad thing for the shareholders of the big banks. After all, shareholders have done OK in holding the separate parts of Standard Oil over the last century or so, as have the holders of the parts of AT&T after its break-up.
On the other hand, breaking up the biggest banks is not a cure-all — we could still have a meltdown if many banks were to all be invested in the same area that went bad, or if they were too interconnected. Still, having 10 banks each the size of say PNC Financial (PNC) would be on balance safer than on Citigroup (C).
Yes, the TARP was needed, but we sure could have done a much better job in negotiating more favorable terms for the taxpayer. The terms the Government got for its investment in Goldman Sachs were FAR worse than those Berkshire Hathaway (BRK.B) got at virtually the very same time. Berkshire got far more warrants on the stock and twice the interest rate on his preferred as we got.
However, that does not negate the fact that almost all of the TARP money has since been repaid, and it looks like the government might actually eventually end up with a small profit on the deal. Given the risk the taxpayer took, we should have made a large profit. The economy is also now in a MUCH better position than it would have been if we had allowed Citigroup, Wachovia, Morgan Stanley (MS) and Bank of America (BAC) to all follow Lehman Brothers into bankruptcy.
A New Fund for Failed Banks
Conventional bankruptcy is not very well suited to large financial institutions. They depend on short-term credit markets for most of their funding, and that credit will dry up quickly during a prolonged bankruptcy proceeding. Even small institutions, when they fail, don’t go through normal bankruptcy procedures. Rather, they are taken over by the FDIC. It has a fund that the banks pay into on a regular basis to facilitate those takeovers.
We need something similar, effectively to provide the huge amounts of debtor-in-possession financing needed in such a situation to facilitate the winding down of a failing large institution. The economic result should be effectively the same as a bankruptcy of a big industrial company; the shareholders should be wiped out, and unsecured bondholders should end up with a big haircut.
The technical form, however, would need to be different. It should be funded through fees paid by the banks and other institutions, not from general taxpayer revenues. Ideally, the amount of the assessment should be proportionately bigger the larger and more risky the institution is, perhaps assessed based not on its assets, but on its liabilities. The Senate bill provides for a $50 billion fund. I don’t think that is close to being big enough, and would prefer to have it three or four times as big.
An Exchange of Derivatives
Derivatives, the financial weapons of mass destruction that Warren Buffett warned about, can have a useful place in the financial system, but they need to be much more transparent than they are now. The best way to do that is to bring them onto an exchange, the way that many normal derivatives are now traded, just about everything traded on the Chicago Board of Trade is a derivative — though not many people worry about frozen orange juice contracts bringing down the world economy.
The reason is that there is no counterparty risk. The counterparty for the buyer is not the seller, it is the exchange itself, ditto for the seller. Thus the buyer does not need to see the financial statements of, or worry about the solvency of, the seller of the option or future.
To do that, most of the derivatives will have to be standardized, and for the vast majority of them that should not be a problem. The big banks will tell you that it is. But that is because the more complex and opaque the instrument, the more money the big banks make off of it.
Curb Credit Default Swaps
Some derivatives, though, are inherently very dangerous and should be banned, or at least severely restricted. Credit default swaps top this list. Think of a CDS as a form of life insurance, but on a company not a real-life person. Instead of paying off when a person dies, it pays off if the company goes bankrupt.
Now, life insurance is a very useful product, and I have some of it myself. However, the key difference is that the life that I am insuring is my own. Aside from a few specific cases, such as a spouse or perhaps a business partner, I can’t take it out on anyone else. I certainly can’t wander around the halls of the nursing home looking for someone who looks likely to kick the bucket soon and take out policies on them. You wouldn’t want a cardiac surgeon to be able to take out a life insurance policy on you just before you went under his knife.
The same thing holds for property insurance. If people were allowed to take out insurance on other people’s houses, would it really shock you that there was an increase in arson cases?
However, those rules don’t apply to CDS’s. You can insure yourself so that if a bond does not pay off you will be made whole…even if you never own the bond. Worse, you can make that bet for many times as much as the actual amount of the bond outstanding.
This is simply financial arson waiting to happen, and it needs to be prohibited. The rule should be that you cannot hold a CDS unless you hold the underlying security, and the amount of the CDS pays out should not be more than the face amount of the bond.
Well, that is just a few of the main points of what needs to be included in real financial reform, not a complete list. The legislation under consideration generally moves things in the right direction, but is baby steps when we really need to be leaping. It is better than nothing, but I think that there are many areas where it needs to be strengthened.
Unfortunately the massive amount of lobbying is all pushing in the other direction, to either stop the bill or to make it simply a fig leaf, not serious reform. If either of those things happen, we will have another financial meltdown, just as bad if not worse than what we saw just 18 months ago. It might not happen this year, or even next, but eventually it will happen — probably within the next decade.
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