Reader Scott asks:
With 20/20 hindsight now available what is the one, easiest, thing to have avoided the current crisis in the banking system.
Outlaw any financial transaction more complicated than a simple equity purchase. This, however, would have created more problems than it would have solved.
As I've said elsewhere, I can think of a lot of very complicated and extremely socially costly ways to have avoided the current crisis, but I'm not sure there is a simple solution--higher capital requirements are probably the best bet, but it's not clear how much this would have helped, since we still don't know whether Bear was insolvent or merely illiquid. They wouldn't even have helped us, the taxpayer, since JP Morgan bought them out at fire sale prices. There's a lot of talk about forcing originators to keep a portion of their securities, but from what I understand some of the toxic instruments on the books at Merrill and Bear were in fact originated in-house.
Probably the best way to avoid the problem is to keep financial professionals in the game longer. The money and stress of banking means that its titans tend to retire early. Bubbles seem to be a natural feature of asset markets, from tulips to houses, and the only known cure is repeated experience of them. Having more guys around in their sixties and seventies who remember the last few disasters would probably do a lot to mitigate the phenomenon. Unfortunately, I don't see any way to legislate this--and even then, if the current crop of elder statesmen actually did manage to mitigate bubbles, they would only create a future class of elder statesmen who have never seen them, and are thus even more vulnerable to their seductions.
The fact that there is a problem does not always imply that there is a solution. I think there are a number of sensible regulations being proposed right now: giving mortgage brokers fiduciary obligations to buyers rather than sellers; stiffer capital requirements; having originators keep a portion of their loans. I'm just not very confident that this would have actually prevented the current problems.
Well, I can think of one change that I think would help significantly:
Make mark-to-model values public and common (vs proprietary), and require that counterparties use the same one for any given security.
What about better risk management? What about the greed factor? That's what it boils down to. Greed. Many people saw the housing bubble coming. No one wanted to listen to them because of greed.
SamChevre:
Mark-to-model is partially what got us into this mess in the first place. When you mark stuff like that it is just asking for trouble. Make it Mark-to-market. Then companies would really know where they stand, and the merry go round would have stopped sooner, I am sure.
Thanks for picking the request thread.
Working in financial services I'd like to come up with Occcam's razor solutions but like Megan find it hard to come up a simple solution for the current crisis.
If I had two items, the first would be to head to a common regulatory framework - to have different rules on investment banks and commercial banks makes no real sense. As the big Investment Banks now have access to the Fed I think you will see this come to fruition, though with hindsight I think that absent the Bear Stearns meltdown no CEO of a major IB would have accepted this, though now they do realize there is a reason for it.
Second was the mispricing of liquidity risk. For example the SIV structures involved banks providing a liquidity line to the SIV for it to buy longer dated 'stuff'. From the regulatory capital perspective, this liquidity line was viewed as requiring no regulatory capital, hence this was essentially infinite return on capital - on a business that is capital intensive. Obviously over time banks realized they could take more risk and get even 'infinte-er' returns, creating more demand. I think that had regulators stepped in and said these types of lending commitments had some risk (maybe not 100%, but something material), maybe there would have been fewer creative structures invented and the banks would have more capital heading into a recession.
How about requiring the originating lender of mortgage to retain some fraction the loans they originate which represents the distribution of the loans they made.
It seems to me that a big chunk of the problem was that the people deciding what a good loan was ended up awfully far from the people who actually bore the risk for that loan.
"Make it Mark-to-market."
I don't see how this solves the problem when the market is in a bubble.
How about no Basel II? If the junk has to stay on the books, the last $400 to $800 billion doesn't flow into mortgages. The crunch comes sooner, when the bubble is less inflated, and nobody can hide & deny until it's too late.
How about margin limits for houses like we have for stocks. Make everybody put 20% down.
"It seems to me that a big chunk of the problem was that the people deciding what a good loan was ended up awfully far from the people who actually bore the risk for that loan."
Agreed. Moral hazard. At the lowest levels, originators were rewarded on quantity more than quality. At the highest, executives were rewarded for short term gains while the bondholders, taxpayers and savers (via inflation) held the long term risk.
JK Conscience,
I agree that mark-to-market should be used in preference to mark-to-model; the problem is that in many cases there is no market to mark against, so mark-to-model is the best available method. My rule is intended to make mark-to-model more like mark-to-market--everyone uses the same value for the same security, even if that value comes from a model rather than a market.
Currently, the buyer has a model, and the seller has a model--and there's no rule saying the results must match. So I can sell complicated guarantee X, and account for the risk as $100--and you can buy it, and account for the value as $500. In my system, we'd have to use the same number.
How about the low-hanging fruit for the libertarian – government intervention? Given that Fannie Mae and Freddie Mac were involved in 40% of all mortgages, and that they were much likely to be subprime ones, it looks like that would be a good place to start...
I would agree that problems do happen. You can only dodge so many bugs before some end up on the windshield. People get greedy, mistakes will occurr, people will risk and lose.
I would say this about our economic system as a whole we need, and I mean NEED, to get back to a sustainable, low-debt, daily lifestyle. I mean on paper, as a people, we look like kids with their first credit card!!
There's a lot of talk about forcing originators to keep a portion of their securities, ...
Let me just point out that this would not work as a disincentive to originating toxic loans if the originators can short any of the tranches of the deal backed by the rest of the mortgages. The onus of inspecting the collateral lies with the people who are ultimately significantly long the MBSs. The best the government can do is to improve disclosure.
There's a lot of talk about forcing originators to keep a portion of their securities, ...
Let me just point out that this would not work as a disincentive to originating toxic loans if the originators can short any of the tranches of the deal backed by the rest of the mortgages. The onus of inspecting the collateral lies with the people who are ultimately significantly long the MBSs. The best the government can do is to improve disclosure.
I would say this about our economic system as a whole we need, and I mean NEED, to get back to a sustainable, low-debt, daily lifestyle.
"All I really gotta do is live and die." -Alabama
Ah, isn't the market solving the problem now?
There is only one answer (nothing to do with M-T-M
KEEP SOME SKIN IN THE GAME
Homeowners - at least 10% down (and NOT mon & dad's "gift"))
Mortgage Broker/Officer - deferred compensation
Mortgage Banker - bigger haircuts on warehouse lines + holdbacks on performance (if you sell bad loans to banks/securitizers they will put them back to you and you will either buy them or lose your holdback)
Bank - Hold a significant first-loss piece on any securitization or off-balance sheet vehicle (SIV, etc.)
Broker dealers - more capital and mandatory positing of collateral on any derivative, not just the derivs that are in a liability position
For those of you who understand finance, this is obviously the only solution. Nobody has any shin in the game, make 'em put some money (or collateral) on the table.
There is only one answer (nothing to do with M-T-M
KEEP SOME SKIN IN THE GAME
Homeowners - at least 10% down (and NOT mon & dad's "gift"))
Mortgage Broker/Officer - deferred compensation
Mortgage Banker - bigger haircuts on warehouse lines + holdbacks on performance (if you sell bad loans to banks/securitizers they will put them back to you and you will either buy them or lose your holdback)
Bank - Hold a significant first-loss piece on any securitization or off-balance sheet vehicle (SIV, etc.)
Broker dealers - more capital and mandatory positing of collateral on any derivative, not just the derivs that are in a liability position
For those of you who understand finance, this is obviously the only solution. Nobody has any shin in the game, make 'em put some money (or collateral) on the table.
There is only one answer (nothing to do with M-T-M
KEEP SOME SKIN IN THE GAME
Homeowners - at least 10% down (and NOT mon & dad's "gift"))
Mortgage Broker/Officer - deferred compensation
Mortgage Banker - bigger haircuts on warehouse lines + holdbacks on performance (if you sell bad loans to banks/securitizers they will put them back to you and you will either buy them or lose your holdback)
Bank - Hold a significant first-loss piece on any securitization or off-balance sheet vehicle (SIV, etc.)
Broker dealers - more capital and mandatory positing of collateral on any derivative, not just the derivs that are in a liability position
For those of you who understand finance, this is obviously the only solution. Nobody has any shin in the game, make 'em put some money (or collateral) on the table.
There is only one answer (nothing to do with M-T-M
KEEP SOME SKIN IN THE GAME
Homeowners - at least 10% down (and NOT mon & dad's "gift"))
Mortgage Broker/Officer - deferred compensation
Mortgage Banker - bigger haircuts on warehouse lines + holdbacks on performance (if you sell bad loans to banks/securitizers they will put them back to you and you will either buy them or lose your holdback)
Bank - Hold a significant first-loss piece on any securitization or off-balance sheet vehicle (SIV, etc.)
Broker dealers - more capital and mandatory positing of collateral on any derivative, not just the derivs that are in a liability position
For those of you who understand finance, this is obviously the only solution. Nobody has any shin in the game, make 'em put some money (or collateral) on the table.
Do we really have a problem? Yes, because many of the companies involved are "too big to fail".
Like many political arguments, a lot of the calls for regulation are, at base, an argument that people don't like huge corporations. And here we have an actual case where the size of the company in quesiton is a direct cause of the problem.
So... have smaller companies. Nobody would really care if a bunch of $100 million investment banks went broke over a 5 year period. It's having a multibillion dollar one go down that's the crisis.
How do we make companies smaller? How about a progresive company tax? 0% for companies under 5 million a year, growing up to 40% for companies pulling in a billion a year and up. (Numbers plucked out of the air.)
Of course, everyone will just restructure their businesses so that exactly the same job is done by 10 small corporate entities unstead of one large one. Which is exactly what we want.
Not all 100% loans are crap, guys. Some of us are good risks in that situation. Doctors in residency, for example, generally make less than $50k/yr but will soon be making quite a bit more.
Of course, I live in an area that didn't have a huge runup in prices, either; my wife and I have an 1800 sq ft house in a decent neighborhood that we bought for a shade under $200k. Then again, we don't have a traditional mortgage, so our bank still owns our loan. Make of it what you will.
Not an expert, but have been in a position to witness the meltdown closeup. Don't really know public debt, but the Term B Loan market was what drove the bank debt credit bubble. It serves a very useful purpose, but it was not working right last year, and I'm not sure that it's working right now. Josef may have part of the solution, but if a bank makes $400mil in fees on a deal, and is required to keep some fraction of the deal - say $2billion, then even if they later have to sell the paper for 90cents on the dollar, they've still broken even, and that's a bad case scenario.
Standard City of London line on this.
Everybody starts making the mistakes which will lead to the next crisis just as the last person who was around to clear up the last one retires.
Hi -
With 20/20 hindsight, the banks should have fought the legal requirement to provide subprimes at all. No subprimes, no subprime crisis.
Very simple.
Of course, activists like ACORN, who were the driving force in forcing banks to "lend to the community", with their lack of fundamental economics understanding, screwed it up for everyone else.
The simplest answer is this: raise interest rates. That's right, if Alan Greenspan hadn't cut interest rates to historically low levels in an attempt to spur us out of a recession (just in time for the election, who knew?) all that liquidity Bush was pumping into the market with deficit spending wouldn't have found housing such easy money. People wouldn't have started refinancing into lower interest rates. The refi boom started this mess. Then people saw that their cash out refis were turning into HELOCs and then second homes, investment properties, etc. I've said it before and I'll say it again: it is supply and demand. The demand for new homes shut down suddenly. One way we knew we were in a bubble was that it was a-historical. Usually when interest rates go up, the mortgage business goes down. But when Greenspan started ratcheting the rates back up mortgages continued to rise. We also know it was a bubble because of the steep price increases and the comparative cost savings of renting at the time.
There are pros and cons for any market interference. I am surprised that so many conservatives have such a blase attitude at the situation. Right now large banks are taking hits, and some of them for the first time ever. Isn't that a little disconcerting? Some of them are getting bailouts from the US government (Bear Sterns) and some are getting bailouts from foreign governments, from these soverign wealth funds. Neither is really attractive, but the market is as the market does.
This is a very easy problem to fix. Simply have GAAP changed to include counterparty risk totals on company balance sheet. That way, brokerage firms who show a trillion dollars of counterparty risk will be punished severely in the market.
Wouldn't that be the banning of "lo doc/no doc" loans?