Tag: regulation

Does Size Matter?

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

Big and Small

Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

  1. Increased power and regulatory centralization to deal with the problem of systemic risk
  2. Increased protections for consumers and investors buying financial products
  3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
  4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk – the topic he focused on yesterday – I kept thinking it had been too long since he read Frog and Toad to his children.

Continue reading “Big and Small” →

Frog, Toad, Cookies, and Financial Regulation

My two-year-old daughter loves Frog and Toad.

There is a Frog and Toad story called “Cookies.” It is the only Frog and Toad story I remember from my childhood. Toad bakes some cookies and takes them to Frog’s house. They are very good. Frog and Toad eat many cookies, one after another. They try very hard to stop eating cookies, but as long as the cookies are in front of them, they cannot help themselves.

So Frog puts the cookies in a box. Toad points out that they can open the box. Frog ties some string around the box. Toad points out that they can cut the string. Frog gets a ladder and puts the box on a high shelf. Toad points out .  . .

Finally Frog takes down the box, cuts the string, opens the box, and gives all the cookies to the birds.

“Read more, Daddy,” my daughter says.

“One moment, I have to tell all the nice people the moral to the story.”

Continue reading “Frog, Toad, Cookies, and Financial Regulation” →

What’s Plan B?

One of the determinants of how you feel about the Geithner Plan is what you think will happen if it fails. By “fails,” I mean that the buyers’ bids are lower than the sellers’ reserve prices, so the toxic assets don’t actually get sold.

Brad Delong, for example, is moderately in favor of the plan, even though he thinks it is insufficient. In his words, “I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul [Krugman] thinks that the longer Obama delays proposing bank nationalization the lower it’s chances become.” (“Voinovich” is DeLong’s hypothetical 60th senator, whose vote would be needed in the Senate.) In other words, DeLong thinks that if this plan fails, the administration will be more likely and able to go forward with nationalization.

Paul Krugman, by contrast, is strongly against the plan, first because he thinks it has no chance of succeeding, and second because he thinks there is no Plan B. “I’m afraid that this will be the administration’s only shot — that if the first bank plan is an abject failure, it won’t have the political capital for a second.”

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Modifying Securitized Mortgages

Amidst the gallons of ink spilt, here and elsewhere, over the nationalization debate, the AIG collateral payments, and the AIG bonuses, I neglected to comment on the details of the new housing plan, which were released on March 4. When the initial plan was announced in February, I was concerned about the seeming lack of any provision that would enable servicers of securitized mortgages to modify those mortgages without being sued by the investors who bought the securities. (In brief, the problem is that the pooling and servicing agreements (PSAs) that govern those securitizations may not allow loan modifications, or may require the servicer to gain the consent of all of the investors, which is practically impossible.) People who know housing better than I said there was something in there.

If it is, I still can’t find it in the March 4 documents (fact sheet, guidelines, modification guidelines). In any case, an important question is whether the plan will do enough to encourage servicers to modify securitized mortgages, as opposed to mortgages they own. “A New Proposal for Loan Modifications,” a short (13-page) paper by Christopher Mayer, Edward Morrison, and Tomasz Piskorski that will appear in the next issue of the Yale Journal on Regulation, describes the problem clearly and makes three proposals to solve it. (A longer version with appendices is available here.)

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Bernie Madoff Day

As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.

A little late to close the barn door.

While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people – investors and officials alike – to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.

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Regulatory Arbitrage in Action

From the Washington Post:

[Scott] Polakoff [acting director of the Office of Thrift Supervision] acknowledged that his agency technically was charged with overseeing AIG and its troublesome Financial Products unit. AIG bought a savings and loan in 1999, and subsequently was able to select the OTS its primary regulator. But that left the small agency with the enormous job of overseeing a sprawling company that operated in 130 countries.

Is there another side to this story or is it really as simple as that?

Update: ProPublica had a good story on this back in November. Here’s one short excerpt:

Examiners mostly concurred with the company’s repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG’s huge capital base . . . and because securities underlying the swaps had top credit ratings.

Was It The Hedge Funds? (Diane Rehm Show at 11am)

Hedge funds have been nominated as a prime culprit in the current financial disaster.  European governments, in particular, seem keen to impose greater regulation on hedge funds, including more transparency and compliance requirements.  In fact, this is will be one of the main deliverables they seek at the G20 summit on April 2nd.

I’m not opposed to stronger regulation, and hedge funds have obviously disappointed investors – especially with their illiquidity under pressure.  But are hedge funds really responsible for the depth of the crisis?  They were present at the scene of the crime, in terms of buying and trading what we now call “toxic assets,” but surely their role was minor relative to supposedly “regulated” US and European banks. Continue reading “Was It The Hedge Funds? (Diane Rehm Show at 11am)” →

YLS Conference on the Financial Crisis

If you are a true crisis junkie (or you are having trouble falling asleep tonight and need more to read), my own Yale Law School held a conference on the financial crisis, its causes, and potential solutions (including better regulation) on Friday. There were a number of famous names present, including Lucian Bebchuk, Christopher Mayer (of the Hubbard-Mayer proposal), Anil Kashyap, and others. You can look at the agenda or check out the readings for sessions one, two, three, and four (each includes links to PDFs of the papers).

And where was I during all of this? I was home with my daughter.

(Let me know if you find something particularly important that I should read – I’m finding it impossible to keep up.)

The Importance of Accounting

Or, as I thought of titling this post, SEC does something useful!

Accounting can seem a dreadfully boring subject to some, but it gets its moment in the sun whenever there is a financial crisis . . . remember Enron? This time around is no exception. During the panic of September, some people were calling for a suspension of mark-to-market accounting, and while they did not get what they wanted, they succeeded in inserting a provision in the first big bailout bill to study the relationship between mark-to-market accounting and the financial crisis.

A brief, high-level explanation of the dispute: Under mark-to-market accounting, assets on your balance sheet have to be valued at their current market values. So if you have $10 million worth of stock in Microsoft, but that stock falls to $5 million, you have to write it down on your balance sheet and take a $5 million loss on your income statement. The criticism was that mark-to-market was forcing financial institutions to take severe writedowns on assets whose market values had fallen precipitously, not because of their inherent value, but because nobody was buying these assets – think CDOs – and that banks were becoming insolvent because of an accounting technicality. Under this view, banks should be able to keep these assets at their “true” long-term values, instead of having to take writedowns due to short-term market fluctuations.

I am instinctively skeptical of this view, and in favor of mark-to-market accounting, because I believe that while market valuations may not be perfect, they are generally better than the alternative, which is allowing companies to estimate the values themselves, subject only to their auditors and regulators. But the issue is considerably  more complicated than either the simple criticism or my simple defense would imply.

Earlier this week, the SEC released its study of mark-to-market accounting as required by the bailout bill. Their conclusions are simple:

fair value [mark-to-market, as will be explained] accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.

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Managing Financial Innovation

Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.

Free Market Ideology, Epilogue

In the most recent post in the Causes series, I expressed a fair amount of agreement with Joseph Stiglitz’s criticism of an excess of faith in the free market and the lax regulation that results. With the Bernard Madoff scandal (New York Times; WSJ has more information but requires subscription), Felix Salmon is asking, where were the regulators?

(By the way, if you’re wondering how the Madoff fraud was possible, remember that a hedge fund is like a bank in the sense that you put your money in and you generally leave it there for a while, and although you may take some out now and then you may also put some more in now and then, and other people are putting it in, and so on. With a bank, not all depositors can get their money out at the same time because it is tied up in long-term loans that the bank can’t call in. With Madow’s fund, investors couldn’t get their money out because he had, effectively, burned it. They had been getting periodic paper statements showing returns, but there were no real returns, and hence no assets behind that paper.)

Causes: Free Market Ideology

Other posts in this occasional series.

Joseph Stiglitz, the 2001 Nobel Prize winner and the most cited economist in the world (according to Wikipedia) has an article aggressively titled “Capitalist Fools” in Vanity Fair that purports to identify five key decisions that produced the current economic crisis, but really lays out one more or less unified argument for what went wrong: free market ideology or, in his words, “a belief that markets are self-adjusting and that the role of government should be minimal.”

The five “decisions,” with Stiglitz’s commentary, are:

  1. Replacing Paul Volcker with Alan Greenspan, a free-market devotee of Ayn Rand, as Fed Chairman. (Incidentally, when I was in high school, I won $5,000 from an organization of Ayn Rand followers by writing an essay on The Fountainhead for a contest.) Stiglitz criticizes Greenspan for not using his powers to pop the high-tech and housing bubbles of the last ten years, and for helping to block regulation of new financial products.
  2. Deregulation, including the repeal of Glass-Steagall, the increase in leverage allowed to investment banks, and the failure to regulate derivatives (which Stiglitz accurately ascribes not only to Greenspan, but to Rubin and Summers as well).
  3. The Bush tax cuts. Stiglitz argues that the tax cuts, combined with the cost of the Iraq War and the increased cost of oil, forced the Fed to flood the market with cheap money in order to keep the economy growing.
  4. “Faking the numbers.” Here Stiglitz throws together the growth in the use of stock options – and the failure of regulators to do anything about it – and the distorted incentives of bond rating agencies – and the failure of regulators to do anything about it.
  5. The bailout itself. Stiglitz criticizes the government for a haphazard response to the crisis, a failure to stop the bleeding in the housing market, and failing to address “the underlying problems—the flawed incentive structures and the inadequate regulatory system.” (There’s regulation again.)

Continue reading “Causes: Free Market Ideology” →

How the SEC Could Have Regulated Subprime Mortgages

From a new paper (link below):

Kafka would have loved this story: According to our current understanding of U.S. law there is far better consumer protection for people who play the stock market than for people who are duped into buying a house with an exotically structured subprime mortgage, even when the mortgage instrument is immediately packaged and sold as part of a security.

The crux of the matter is that securities transactions – notably, the sale of a security to a customer by a broker – are governed by SEC regulations, which impose a fiduciary relationship on the broker, meaning, among other things, that the broker can only sell financial products that are suitable for that customer. However, no such rule governs the relationship of a homebuyer to a mortgage broker or company, meaning that behavior by the latter must be actually fraudulent before it can be sanctioned.

Jonathan Macey, Maureen O’Hara, and Gabe Rosenberg (two of whom are at my very own Yale Law School) have a new paper (abstract and download available) arguing not only that mortgage brokers should have a fiduciary responsibility to their customers, but that they already do under two reasonable interpretations of existing SEC regulations. (It has to do with whether a complex subprime mortgage is already a security or, failing that, whether it is related to a security transaction.) This means that the SEC could have been regulating these things all along.

Systemic Risk, Hedge Funds, and Financial Regulation

One of our readers recommended the Congressional testimony by Andrew Lo during last Thursday’s session on hedge funds. Lo is not only a professor at the MIT Sloan School of Management, but the Chief Scientific Officer of an asset management firm that manages, among other things, several hedge funds. He discusses a topic – systemic risk – that has been thrown around loosely by many people, including me, and tries to define it and suggest ways of measuring it. He recommends, among other things, that

  • large hedge funds should provided data to regulators so that they can measure systemic risk
  • the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
  • financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
  • a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
  • minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)

Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.

Continue reading “Systemic Risk, Hedge Funds, and Financial Regulation” →