PART of the New Deal was a new financial deal. The shameful shenanigans leading up to the 1929 stock market crash and the frightening wave of bank failures during the Depression led directly to the creation of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation.
As we emerge from this, the worst financial crisis since the 1930s, a New Financial Deal may follow. If so, what should some of the reforms be?
A warning to laissez-faire-minded readers: The following is mostly about the dreaded “R” word — regulation. But I’m afraid that we need more of that, starting in the mortgage market.
An inordinate share of the dodgiest mortgages granted in recent years originated outside the banking system. They were marketed aggressively, sometimes unscrupulously, by mortgage brokers who were effectively unregulated; we have now lived to regret that arrangement. The need for a federal mortgage regulator — including a suitability standard for mortgage brokers — is painfully obvious.
Next, we should resist calls to scrap the “originate to distribute” model, wherein banks originate mortgages, which are then packaged into mortgage pools and turned into mortgage-backed securities that are sold to investors around the world. This seemingly convoluted model has given the United States the world’s broadest, deepest, most liquid mortgage markets. And that, in turn, has meant lower mortgage interest rates and more homeownership. These are gains worth preserving.
But the model needs some nips and tucks. A far less radical, though still regulatory, approach would require both originating banks and securitizers to retain some fractional ownership of each mortgage pool. Keeping some “skin in the game” should accomplish two things: make the banks and securitizers more attentive to the creditworthiness of the underlying mortgages, and reduce the tendency to play “hot potato” with mortgage-backed securities.
And while we’re on the subject of M.B.S., we must end the regulatory fiction that off-balance-sheet entities like conduits and S.I.V.’s are unrelated to their parent banks. (S.I.V. stands for structured investment vehicle, if you must know, but please don’t ask me the difference between it and a conduit.) Since last summer, we have seen one financial giant after another brought to its knees by losses that originated off balance sheet.
What’s the solution? Take Shakespeare’s advice and kill all the S.I.V.’s? Probably not, though many will die of natural causes. These financial oddities were invented to exploit the regulatory fiction just mentioned. If you buy the premise that assets held off balance sheet pose no risks to their parent companies, then banks should not be forced to hold capital against them. But if you buy that, you may also be interested in a famous bridge connecting Brooklyn to Manhattan. The remedy here is simple: Apply appropriate capital charges to off-balance-sheet assets.
That brings us to leverage. After all, high leverage means owning a lot of assets with only a little capital. This is where something fundamental changed on March 16. Before that day, only banks had access to the Fed’s discount window; broker-dealers took large risks without a safety net. But everything changed when the Federal Reserve became the lender of last resort to selected securities dealers. Because securities firms are now under the Fed’s protective umbrella, they must start operating as safely and soundly as banks. That means both closer supervision and less leverage.
How much less? You may recall that Bear Stearns ended its life with leverage of around 33 to 1, meaning that just 3 cents of capital stood behind each dollar of assets. That won’t do any longer. Leverage of 10 or 12 to 1 is more typical for a bank. We should all take a deep breath here, because sharply reducing the leverage of securities firms, to bring it close to that of banks, will be a major change in the financial landscape. It will, for example, substantially reduce the profitability of investment houses and, therefore, reduce their scale. But that’s the price you pay for access to a publicly financed safety net.
Next come ratings agencies, whose recent performance has drawn criticism. The good news is that they are making good-faith efforts at change. They are improving their analytics, and guarding against conflicts of interest by hiring ombudsmen and submitting to independent third-party reviews. We should applaud and encourage all that. The bad news is that they face an acute incentive problem when they get paid by the issuers of the very securities they rate.
What to do? The third-party reviews should help. My Princeton colleague Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Robert Pozen, head of MFS Investment Management, wants independent investors in the conduits to hire the agencies instead. Another idea would have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers. If you have a better idea, write your legislators.
LAST, but certainly not least, is something that the United States cannot do on its own. Everyone knows we live in a world of giant multinational financial institutions, huge cross-border flows of capital and increasingly globalized markets. Such an environment demands ever closer international cooperation and coordination among the world’s major financial regulators. But today’s level of international cooperation is wholly inadequate to the need. Perhaps the current worldwide financial crisis will finally persuade the world’s financial regulators that lip service is not enough. At least we can hope.
Finally, let’s be clear about the purposes of all these New Financial Deal reforms. They would not banish speculative bubbles from the planet. After all, there have been bubbles for as long as there have been speculative markets. But with each bursting bubble, new flaws in the system are exposed. Like a good roofer after a soaking rainstorm, we should patch the leaks we see now, knowing full well that more leaks will spring up in the future.