Not everyone in finance works for a Too Big To Fail institution. Many saw the crisis coming, more are disappointed with the lack of real reform, and many more would be more than happy to tell you how we can actually fix the financial markets. The room where the hearing is being held has cleared out (and somehow gotten colder) after the morning fireworks with the CEOs of the largest firms, which is a shame, since the second panel had three people who have worked closely within the financial sector: Michael Mayo, Managing Director of Calyon Securities, Kyl Bass, Managing Partner of Hayman Advisors, and Peter J. Solomon, Founder and Chairman of Peter J. Solomon Company. Anyone who is serious about learning about financial reform should stream the video themselves, but if you don't have the chance here are the highlights.
In the first panel the tone between the committee and the those being interviewed was curt and practiced and always hedged, with the exception of a few moments where Chairman Angelides tore into Goldman Sachs CEO Lloyd Blankfein. The opening testimony of this panel started with Mayo stating "The ABCs of Reform": A is for accountancy, B is for bankruptcy, and C is for capital and capitalism. There's a new lack of accountancy in the financial markets Mayo stated and new bankruptcy laws are needed for large financial firms that fall outside of FDIC. For the letter "C" he pointed out that capital to markets is like water to a house; if you turn on the faucet and there isn't anything pouring out there's a panic, and so must we must regulate these institutions like a utility. Capitalism is the other part of "C", and the actual idea of good information used for decision making from markets has disappeared from the way our current financial markets works to keep prices and information opaque from people and investors.
It's very hard to imagine the Bank CEOs talking this way. Their testimony had a sense of "let's keep our heads down and this too will pass"; in this panel the participants were taking on what is going wrong with the financial markets and recommending bold and clear action in response. Bass directly called for derivatives to be regulated, stating that 90% of them could be put into a clearinghouse and that a center data repository could be created to give this information to everyone, preventing another AIG. Though the bank CEO's danced around this issue during their entire testimony, this was straight in Bass' opening testimony.
Peter Solomon talked about starting his career in finance during the early 1960s, when the post-Pecora regulatory structure of the New Deal from the 1930s was still in place. Solomon talked about how the newest capital markets allowed investment banks to move from their traditional lines of business to newer, riskier proprietary trading operations. This combined with all kinds of other changes in the financial markets from the 1980s and 1990s - junk bonds, globalization, mathematical modeling, increases in leverage, deregulation, and large over-the-counter derivatives markets - turned the largest investment banks into something completely different.
He pointed out that that this all came to a head in the years 1998 and 1999. That's when you have the collapse of the Long Term Capital Management, a small hedge fund that got itself so interconnected that it was too systematically risky to let fail and had to be bailed out. It's also when Gramm-Leach-Bliley Act passed, repealing the Glass-Steagall regulation from the New Deal. Goldman Sachs went public, and Citi had a large merger. It set up the entire stage for all that would come in the next decade.
'Christianity without Hell'
So where do we go from here? The three panelists gave very specific ideas about where reform needs to take place to get our financial sector back on track. The first key is bank leverage, how much money they lend for how much they keep in pocket. The higher this ratio, the more risky their firm is.
Right now you can qualify as minimally leveraged at 25-to-1, which means you lend out $25 for every $1 you actually own, which is unmanageable according to the participants. These ratios need to come down for the largest firms. Fannie-Freddie are even worse; the participants claimed that they had a 95-to-1 leverage at one point (just 18 basis points of capital), a monstrously risky number for any firm, much less a large one.
What about Glass-Steagall, the New Deal law that split up investment banking from commerical banking? There was disagreement among the participants, with a general agreement that it should be updated for the capital markets of the 21st century. Banks that are diversified with both commercial and investment wings survived better than normal investment banks, an argument that the deregulation was successful. However this leaves a situation where the Federal Discount window, the safety net the Federal Reserve provides banks to avoid disastrous bank runs, is being used to fund high-risk hedge fund like proprietary trading operations. So the suggestion is to update Glass-Steagall for the 21st century where risky operations are silo'ed away from normal operations.
The participants thought the current tax structure for debt and equity was fine, though hybrid instruments designed to mislead regulators should have sharp lines drawn to avoid confusion. Buying equity with taxpayer money "is an abomination to the taxpayer", and as such any money injected into institutions by taxpayers should be more senior than the most senior debt.
The old saying "capitalism without bankruptcy is like Christianity without Hell" was brought up by the participants, and it seemed very appropriate to the situation at hand. Systematically important institutions were thought to be identifiable by their lack of oversight, activities conducted and size. And any institution that can credibly claim to be so systematically risky that it can't be allowed to fail then it should have leverage ratios that run it like a public utility.
While discussing the over the counter derivatives market with Brooksley Born, it was clear that derivatives reform was one of the most necessary items. Derivatives need to clear on a central exchange, with a data repository. Solomon predicted the price of derivatives would fall quickly, in the same way that stock commissions fell back when regulation was brought to that market on the so-called "May Day." This is why banks, who keep this money from bespoke derivatives, want to derail this without getting too many fingerprints on it.
The committee ended with two interesting observations. The first was what problems were still out there? Mayo pointed out "4 d's": "deleveraging", especially as all the bad assets haven't been found yet. "De-risking", as both consumers and the government are going to have to roll over debt with higher risk, "deposit insurance", which is how are we going to pay for all the bank failures to come, and "deposit overdraft", which is the ways consumers are getting hit by their banks. They also clarified that unregulated over-the-counter derivatives was the single greatest threat facing the economy right now.
The last was an observation by Peter Solomon: rather than getting closer to the end of this crisis, he mentioned he felt like he was in the movie Groundhog Day, where it's just the same crisis with the same banks each and every day he wakes up. As a concerned citizen, I know all too well how he feels.
The regulators failed, and the devastation has been widespread. This was the depressing theme of the last three of the five panels that opened the Financial Crisis Inquiry Commission, and it made for a very depressing series of statements and questions Wednesday and Thursday in Washington DC.
The third panel featured C.R. Cloutier, a past chairman of the Independent Community Bankers Assocation, Dr. Rosen of Berkeley, Dr. Zandi of Moody's Economy.com, and Julia Gordon of the Center for Responsible Lending. They gave all the numbers that you would expect to hear of an economy at the tail end of a devastating housing bubble and with double-digit unemployment numbers. What was surprising was the human element we got in these panels. Gordon talked about how the Center for Responsible Lending wrote a paper in 2006 predicting that one out of five subprime loans would fail, and they were dismissed as pessimists. Sadly, that paper turned out to be optimistic when compared to what happened.
Gordon brought up testimony from the top four banks' CEOs at the first panel, the part where they mentioned how they had sleepless nights where they were worried about the health of their businesses. Gordon told the committee that currently six and a half million people are going sleepless from worrying about the late payment they made or the foreclosure process they've entered. Some statistics that were entered by Gordon into the record: as opposed to the massive numbers you often hear about, the average subprime loan was a little over $200,000. Rather than the result of government interference or community activists, 94% of subprime loans were not covered by the Community Reinvestment Act (CRA). Gordon concluded by mentioning how the crisis has widened a gap in assets and has wiped out entire neighborhoods of their life savings, events requiring the passage of a Consumer FInancial Protection Agency.
Panel Four was about as depressing as watching a late-era Beckett play: everyone sat around recounting their failures, with what seemed to be little hope on how to fix it. FDIC Chair Shelia Bair, Attorney General Eric Holder and others recounted all the ways regulators failed. SIVs and other off book balance sheet items? Not regulated. Ratings Agencies? Trusted too much even with their massive conflicts of interests. Shadow banks? Not regulated. Instruments that were took complex for anyone to understand? They turned out to be sitting time bombs. Over the counter derivatives market? Left unregulated. And one of the biggest problem, according to Shelia Bair, was the decision by the SEC to allow the increase in leverage of the largest banks.
Tune in tomorrow where we look into what went wrong with consumer lending in closer detail, and also talk about where the committee should go from here.
How Consumer Finance Failed: Friday, 01/15/2010
The final panel of the first public hearing of the Financial Crisis Inquiry Commission brought testimony from the state regulators as to how so many subprime loans were able to be issued given the current regulation, which is important as these issues are part of the motivation for a Consumer Financial Protection Agency. The testimony of Attorney General Lisa Madigan of Illinois and John Suthers of Colorado is useful here.
So what went wrong? The failure appeared to be in two directions. One is that 'shadow banks' of subprime lenders started to appear, often as subsidiaries of the largest banks, which offered complicated loan products designed to balloon, weighed down with fees, and with special perverse incentives to originators to jack up the interest rate. The second is 'pre-emption', which meant that the federal government was actively working to undermine reform taking place at the state level.
So what was so bad about these loans? The one that jumped out at me most strongly was the issue of "Yield Spread Premiums": this is a form of broker compensation that has brokers paid more by the lenders for placing borrowers in riskier loans and with riskier features. A broker gets a piece of the interest rate as compensation; if the broker adds a prepayment penalty, often considered to be a trap to keep borrowers in loans that have gone sour, the broker gets more money. This gives him an incentive to find the craziest tricks and traps and get them into loans. The rest of the narrative follows accordingly. Lisa Madigan called for the banning of Yield Spread Premiums and similar forms of broker compensation, and it's hard to think of a way to defend these things. These compensation schemes make brokers less into honest brokers and more into front line deception agents of lenders.
So why didn't state regulators step up and fight predatory lending? One issue they had was pre-emption: federal regulators came in and tried to block efforts at the state's regulating the biggest national banks. I've discussed why pre-emption is important for consumer finance here, and it is interesting to hear live testimony about how much of an effort the federal efforts of The Office of the Comptroller of the Currency and the Office of Thrift Supervision put in to derail efforts by states to regulate the largest banks.
And regulating national banks at the state level for consumer finance would have been crucial: National banks funded 21 of the 25 largest subprime issuers doing business in the lead-up to the crisis. If the Obama administration is able to create a Consumer Financial Protection Agency, co-ordinated action on both these efforts, banning the most egregious practices that create the conditions for all the others, and letting state regulators supplement the federal mission, is essential.
Round 5: In Conclusion
So what did we learn?
Over the course of two days we learned that the largest bank CEOs don't feel a conflict between their underwriting and their trading process. There was a series of heated exchanges between Angelides, who has turned out to be an informed and effective chairman, and Goldman Sachs CEO Blankfield about whether or not Goldman was doing sufficient underwriting given their actions in betting against housing, and Blankfield thought there wasn't a problem. This may be reason to look into a 21st Century version of Glass-Steagall.
We learned some of the broad outlines of where reform needs to take place from the second panel: leverage requirements, derivatives reform and the silo-ing out of business lines. We also learned that regulators failed in large part because they became too trusting of business, too willing to look the other way and follow the advice of those they were regulating, in order to efficiently do their jobs.
So where to go from here?
Based on my own observation and talking to other panel watchers, it is very clear that some members are much stronger on the materials and the questions than others. Hopefully for the next panel those whose questions were vague or easily deflected by the witness will catch up, and those asking penetrating questions that were unearthing new information will be given more time. Luckily for the commission, both the Chairman and Vice-Chairman fall into the good category.
We need more effort and investigation into what specifically happened in the Fall of 2008. This panel gave us some broad outlines for what happened in 2000-2007 in terms of the housing bubble and the way regulators were asleep, but actually getting into the meat of the moments when the financial markets collapsed is essential. As a personal interest, I want to see expert lawyers and government agents discuss both (a) the options available to regulators in terms of bankruptcy for financial firms and (b) the decisions behind the way TARP money was distributed. Let's see Neel Kashkari, for instance, up on the stand.
Overall the committee was far more effective than I thought it would be. It did not break into partisan bickering as much as I was worried; even as the very political issues of mortgage fraud was dismissed by conservative members it did not bog down the proceedings. I am more optimistic that something useful will come out of this committee in 2010 than I was Tuesday night, and maybe we can actually get real financial reform passed during the Obama administration.
These posts originally appeared on New Deal 2.0
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