Sunday, April 05, 2009

Regulation and the origins of the financial mess

Perhaps the foremost ideological battle of the moment is that of the origins of the current financial crisis. In the narrative provided by President Obama and the Democratic party blame lies largely at the feet of a Bush Administration that -- marching to the pied piper of laissez faire -- worked feverishly to deregulate while ignoring rules and regulations already on the books. They effectively looked the other way while Wall St. engaged in its shenanigans. If the political left can make this story the defining history of the crisis it will undermine the very foundations of capitalism and pave the way for a greatly expanded government role in the economy.

This theory, however, suffers from both practical and theoretical shortcomings. Practically, we know that the Bush Administration added regulation -- most notably in the form of Sarbanes-Oxley -- while increasing funding for the Securities and Exchange Commission regulatory body. Blame has also been cast on the Gramm-Leach-Bliley Act that deregulated banks in the late 1990s under President Clinton but I have yet to see a real explanation of how this contributed to the current mess. From a theoretical perspective I still fail to understand how regulators are better positioned to expose weaknesses and failings in a system than those who actually participate in it and have their money on the line.

On the political right, meanwhile, are commentators who cite the Community Reinvestment Act, interventions in the mortgage market by Freddie Mac and Fannie Mae and a loose monetary environment -- government factors all -- as chief culprits. While I am sympathetic to this approach and think that all of these played a role to varying extents I find it unsatisfactory as a comprehensive explanation. After all, the CRA was a relatively minor piece of legislation, Freddie and Fannie played a significant but not decisive role in the mortgage market and a global savings glut -- particularly from China -- ensured that money was easy to come by regardless of Federal Reserve policy. This also explains why housing booms took place all over the world, including Spain, the UK and Australia.

In order to assess who is really to blame let's think about the housing boom and the financial crisis in very simple steps. First, we know that plenty of people opted to buy housing they otherwise couldn't afford because banks and mortgage institutions were willing to give them the money, often with no questions asked.

The reason the banks were able to do this is because they didn't hold on to the loans and consequently had less of an interest in whether they were actually repaid. Rather, the loans were sold to other financial institutions that repackaged them, turning them into securities that could be bought and traded. These loans, having been securitized, were then sold to various investors. Again, it makes perfect sense for the loans to be bought and securitized since these financial institutions weren't holding the bag if these loans turned out to be faulty -- the people who bought the securities were.

So then we have to wonder what the rationale was for people to buy such securitized loans? Well, these people weren't stupid. They knew that some of these securitized loans were risky, so they consulted rating agencies such as Standard & Poors that examined these securitized loans and placed grades on how risky they were. Here's where the system broke down. Many of these securitized loans that were highly rated later turned out to be near worthless. Why? Well, many of these rating agencies were paid fees by the same companies whose products they were supposed to be evaluating. You figure it out.

As this column says:
The predecessors to today’s rating agencies began over a century ago to offer research on the risks of railroads and other bonds, explains Richard Herring, Jacob Safra Professor of International Banking at the Wharton School at the University of Pennsylvania. That earlier system was less subject to conflicts of interest, since rating companies made money by selling their manuals to investors, who would buy more manuals if the credit assessments turned out to be accurate. However, the advent of the Xerox machine enabled other users to photocopy the manuals, compelling the rating firms to turn to issuers for compensation.

By the 1970’s, issuers, rather than investors, were funding the model.

...The pressures toward grade inflation are obvious, when companies are paying for their own bonds to be rated. To make matters worse, issuers pay maintenance fees for monitoring and re-rating, which clearly undermines any impetus to downgrade, and cloaks poor performance.

On October 22, 2008, the Congressional Committee on Oversight and Government Reform held a hearing on the role of the credit rating agencies in the Wall Street crisis. In his opening statement, Chairman Henry Waxman referenced an October 2007 presentation by Moody’s CEO, Ray McDaniel: “Analysts and MD’s are continually pitched by bankers, issuers and investors,” as McDaniel described in a confidential address to the Board of Directors, and admitted that sometimes we “drank the kool-aid.”

The problem is compounded when rating agencies are paid consulting fees to help to design the structured finance deals in the first place. “Everyone is sitting on the same side of the table at that point,” says Graham Henley, a director at LECG who formerly served as director of mortgage-backed securitization at Societe Generale. “The fox is in the henhouse!”
This then begs the question of why anyone paid attention to their ratings, given that some of them appeared to be bought and paid for. Well, would you believe that the government had a role in promoting the their trustworthiness?
The three primary rating agencies, Standard & Poor’s, Fitch and Moody’s belong to an exclusive club of NRSROs, or Nationally Recognized Statistical Rating Organization. The designation, first established in 1975 by the SEC, eventually widened to encompass ten firms, although the others have never gained competitive traction.

The marketplace continues to rely on the big three, as a result of culture, path dependency and investment guidelines. “The SEC unwittingly promoted an oligopoly, rather than designing a process of approval that would permit new entrants and more competition or alternative companies,” says Michael Youngblood, a principal at Five Bridges Capital in Bethesda, Maryland.

Both U.S. and foreign regulators further entrenched the agencies’ dominance, by baking ratings into their rules. The Basel II Standardized Approach measures the adequacy of a bank’s capital cushion. It assigns a capital charge to each asset, which is weighted according to its rating. “It’s ironic that, just as reforms were being proposed in 2008 to remove ratings from SEC regulations, the adoption of Basel II was pushing regulators in the opposite direction,” Herring comments.
These aren't the rantings of a single kook. Via Mark Perry I read a fascinating article today well worth a read about a bank that sat out the housing boom after 2004 and is now buying assets left and right in the current distressed environment. The founder of this rapidly growing bank had the following to say about who is responsible for the current mess:
...Beal points a finger at the government for giving its imprimatur to just a handful of credit rating agencies, then insisting that money market and pension funds buy only paper with top grades. He also blames government for luring people into debt by backing everything from bank deposits to Fannie and Freddie to student loans.
Beal also points out in the article that he was questioned by regulators during the housing boom for not being aggressive enough in his lending -- essentially he was too responsible -- and qualifies for little TARP money under the government's rules. Something to chew on for those who advocate more regulation and government involvement as the elixir to cure our current woes.

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