Over the past few months, while waiting for further regulatory developments in the securitization space, I have engaged in a self-taught course in finance and economics. Along with the plethora of tell-all's detailing the main players in and the course of the late great financial crisis, or the "Great Recession" as it seems to be called in some sectors, among the titles perused were The Origin of Financial Crises(Cooper), Zombie Banks (Onarin), How Markets Fail(Cassidy), Extreme Money (Das), The Black Swan (Taleb), The Myth of the Rational Market (Fox), Fault Lines (Rajan), This Time Is Different (Reinhart & Rogoff), Endgame(Mauldin and Tepper) and Freefall(Stiglitz). While this has (predictably) failed to result in the development of any sort of expertise on my part, the main conclusion that I managed to draw from this reading is that there was no single cause of the financial crisis; rather it resulted from the interaction of a multitude of interconnected factors the significance of which is yet to be fully understood. Nevertheless, I will venture a few observations:
- Financial crises and asset bubbles, far from being once-in-a-century, unpredictable catastrophes, in fact occur fairly frequently. Financial models based on market efficiency which exclude or minimize the likelihood of such events, and policies derived from such models, are of more than doubtful utility in any but the most benign environment. What this implies is not only that the crisis should have been expected and regulators should have been watching for signs of its approach and been ready with measures to address it, but more importantly, we should expect one again and there can be no excuse next time for any similar failure. (Regulators' notes to selves: next time, let them fail!)
- The 21st century real estate bubble was particularly pernicious due, I believe, to the identity of the parties who had an interest in pumping it up and riding it. Certainly, these included the usual suspects: originators, brokers and dealers who, perhaps under the influence of rather perverse incentives, concentrated on the quantity, without due regard to the quality, of assets. (It has become clear that incentives do matter and crucially so. Reputation, trust and even the financial health of one's customers, firm and country ultimately suffered as motivating factors in comparison to the lure of great personal wealth to be achieved at little or no personal risk.) But what made this bubble so huge was the co-opting of millions of mortgagors who had a direct and tangible interest in accelerating the housing market. Once the general public had bought in it would have taken a rare regulator or government to risk being identified as the one who "took away the punch bowl".
- The incentives which fueled the behavior which pumped the bubble were fostered in a relaxed regulatory and monetary environment highlighted by, among other things, (i) maintenance of artificially low interest rates, (ii) repeal of the Glass-Steagall Act which separated investment and commercial banks, (iii) relaxation of banks' leverage requirements and (iv) decisions not to regulate derivatives or predatory lending practices. The concurrent introduction and extensive utilization of extremely complex instruments to effect MBS transactions had the effect of both camouflaging and multiplying the risks inherent therein. The value of 'financial innovation' has been greatly exaggerated and oversold. According to Reinhart and Rogoff, financial innovation is a variant of the regulatory liberalization process which in turn often precedes banking crises by simultaneously facilitating banks' access to external credit and more risky lending practices at home: "indeed, it helped predict them".
- The most significant and damaging legacy of the crisis may be the resulting increased level of sovereign debt including but not limited to the cost of bailouts. Again, Reinhart and Rogoff: "Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked". Whether or not Keynesian stimulus spending to get out of a recession is the correct approach, the benefit of further stimulus spending when the economy is already over-leveraged surely merits further and perhaps different considerations.
The following is a quote from an article appearing in the January 19, 2007 edition of the London Times by Gerard Baker entitled "Welcome to the Great Moderation: Historians will marvel at the stability of our era":
Well, we all know now how that turned out and in the aftermath of the crisis it was no surprise that the global regulatory forces, until then in full retreat, would once again be feeling their oats. Although they have certainly taken their time getting there, the regulatory landscape will soon (a relative term) be significantly altered. In addition to the Dodd-Frank proposals and its equivalents in most jurisdictions in the G20, revised Basel III measures will affect the incentives for banks to hold securitizations including new capital, liquidity and leverage requirements. Just in the last month there have also been announcements from OSFI, CMHC, Mark Carney, the new chairman of the Financial Stability Board, the governor of the Federal Reserve System and the German Bundesbank which could be construed as being in support of the broad proposition that regulators need to forge a set of macro-prudential tools which will allow them to "take away the punchbowl" from overheated credit markets. As far as I can determine, there is little reason to believe that ongoing resistance from the financial community is going to have any more effect upon the rising tide of regulatory change than did Canute's command to the ocean.
One of the objections commonly raised by commentators on the proposed ABS rules, including myself, is that, by employing a one-size-fits all solution to problems that were associated with only certain sectors of the market, other sectors, specifically traditional ABS, have been unfairly caught in the net. In addition, the stigma which is still attached to the securitization industry generally is an ongoing impediment to the resuscitation of the market. Perhaps in recognition of the futility of attempting to stem the rising regulatory tide, certain industry participants appear to be trying a new tactic. A recent report on Reuters describes work by financial lobby groups on a new 'quality label' for certain high-quality ABS to be known as "Prime Collateralized Securities" or PCS. Apparently the idea is to "bring added quality, transparency and standardization to the market, with a goal of improving overall quality". Banks are also hoping to persuade European regulators to include PCS among the assets they can use in their liquidity buffers. Under the currently proposed rules, securitization bonds, even those with the highest qualifications or with sovereign guarantee, are considered a completely illiquid asset for the calculation of the liquidity coverage ratio. The report says that "the project inspires both enthusiasm and nervousness among observers. One banker, speaking anonymously, expressed concern that it could be abused by banks to disguise toxic assets." In order to address this concern, it is proposed that the PCS label would be granted by an "independent entity". (If this all sounds vaguely familiar, just substitute 'AAA' for 'PCS' and 'rating agencies' for 'independent entity' and it should start to clear up.) Whether or not traditional ABS can be rescued from the fate which seems to await MBS and synthetic products is still in doubt. Simply rebranding them as PCS will not avoid the substantive issue of how the integrity of the brand, and thus investors, are to be protected.