February 12, 2010
This is a post on a pretty specific point– a lesson from the troubled and troubling market in secondary mortgages in the U.S… but a post that’s hard (for me, anyway) to write without reference to the context that gives it significance…
On the heels of the 9-15-08 financial meltdown, everyone seems to agree that something needs to change. But what it is that needs to change, and how– on these details there’s no consensus at all.
A central point of “dissensus” goes to the regulation of financial players. There are nearly as many opinions and proposals as there are interested parties and observers; but one fundamental question seems to define what are two divergent camps: if we are to prevent the re-emergence of the conditions that brought the house down…
- Is it enough, as the financial community argues, simply to strengthen regulations (and enforcement), or
- Or, as past Federal Reserve Head Paul Volcker and others insist, should the financial industry also be fundamentally restructured?
More specifically– and emblematically–
- Is it enough simply to watch more closely the behemoth financial institutions that have arisen (and gotten even bigger in the wake of the crash)?
- Or do they need to be broken up, Glass-Steagall-like, to prevent the commercial banking that has become infrastructural to our economy from falling prey to speculative investment, and to prevent banks that are “too large to fail” from operating as an oligopoly with unfair advantage at the expense of other businesses, consumers, and taxpayers?
There are many, many reasons why I fall squarely into the Paul Volcker camp– “too big to fail” is just too big– and believe that reform will require both regulation and restructuring. The case is elegantly made by Simon Johnson and James Kwak in their forthcoming book, Thirteen Bankers, and in their blog Baseline Scenario, e.g., in this post.
Here I want to address just one of the arguments advanced by incumbents– the big banks– and other defenders of a status quo only lightly modified by regulation: the suggestion that the meltdown was a product of exotic derivatives and other “sci-fi” investment vehicles gone wrong. If we simply increase regulatory attention to those, the big banks argue, we’ll be fine.
All those second-mortgage-backed CDOs which have gone to zero, causing enormous losses? They’re in that tiny little purple wedge at the bottom. The overwhelming majority of second mortgages, it turns out, are held the old-fashioned way, on the books of banks, credit unions, and savings institutions.
Now this goes strongly against the dominant narrative of the subprime crisis, which is that the originate-to-distribute business model was largely responsible for the disastrous collapse in underwriting standards. Here, there was no originate-to-distribute business model, and clearly most of these seconds should never have been written — but they still were, and what’s more they were underwritten disproportionately by the big four commercial banks. (Actually, I’m not clear on if they were underwritten by the big four, or if the big four have just acquired them through the acquisition of companies like Countrywide (BAC) and Wachovia (WFC).)
What explains the commercial-bank loan officers taking toxic second mortgages onto their own books? I think it’s a combination of factors. Firstly, they believed the hype. Secondly, they were reaching for yield in the Great Moderation just like everybody else. And thirdly, the originate-to-distribute model still existed in a smaller form: the banks were acquiring these loans from mortgage brokers who got paid at close, whether or not the loan was a good one.
Salmon goes on to discuss what to do about the second-mortgage issue, and his thoughts are well worth reading.
But the point in this context is– surely obviously– that it wasn’t exotic instruments nor “weapons of mass financial destruction” that dug this ditch, it was “old fashioned” banking… gone horribly wrong.
Clearly, banks need to learn from this experience. And surely the smaller ones, feeling real pain, have. But the Big Four are “too big to fail”– and they know it. When we take away moral hazard, we eliminate the need to learn lessons like these– indeed, we create incentives not to learn them. If the Big Four make money, they keep it; if they get into trouble, they get bailed out.
So instead of figuring out how to prevent a recurrence of the mortgage disaster, the Big Four are blaming it on a few bad apples and a few bad instruments– nothing, they’d have us believe, that a little more scrutiny and self-regulation can’t handle.
History suggests that this simply isn’t true. And so we need to limit the size banks that enjoy a federal guarantee. There are other compelling reasons to limit the size of banks– the unfair advantage (in raising capital) that being “too big to fail” gives the giants viz their smaller, exposed competitors, the punitive behavior toward consumers that it allows (indeed, encourages). But even if we leave those aside, the need to protect the viability of the economy– the precautionary principle– makes the case for structural change. Otherwise, we are just asking for an amplified repeat of the boom-bust cycle the last wave of which nearly swamped our economy.
Still, the debate over approaches to financial reform rages even within the White House. Indeed, until recently Wall Street vets like Tim Geithner and Bob Rubin, along with Larry Summers, had been successfully arguing to protect the status quo. But after last month’s Democratic senatorial defeat in Massachusetts, there was a seeming about-face: the previously-marginalized Paul Volcker stood beside President Obama as the President declared himself the Reformer-in-Chief.
And not a moment too soon: a wave of financial turmoil has built in Europe, threatening economies around the globe (the currently-discussed “firewall bailout” notwithstanding)– reminding us that strengthening the foundations of U.S. capital markets is critically important– and terrifyingly timely.
Even so, only a month after the President’s adoption of Volcker’s line, the financial reform spotlight is shifting toward the Senate– and the encouragement generated by Obama’s epiphany is dissipating. The Senate always looked a harder slog for real reform than the closer-to-the-aggrieved-citizenry House… even before the Supreme Court encouraged corporations to dangle even tastier carrots and to wave even bigger sticks.
As it is, all we can do is plead with our elected representatives to represent us– to enact real structural reform. It’s that, or make sure that the lifeboats are well-stocked for the next financial catastrophe.