Posted on 12/09/2009 3:48:19 PM PST by bigbob
An Action Plan for Economic Recovery
by Roger Thompson
Most books about the nation’s financial crisis tell us what happened. In his new book, HBS senior lecturer Robert Pozen tells us how to fix the system. A financial industry veteran and chairman of MFS Investment Management, a Boston firm that oversees more than $170 billion in pension and mutual funds, Pozen writes with authority and unusual clarity about complex issues in Too Big to Save? How to Fix the U.S. Financial System (Wiley).
Q: How does the government figure out which financial institutions are too big to fail?
There are two valid reasons for bailing out a financial institution. First is to protect the system for processing payments, like checks, because that system is critical to the operation of the U.S. economy. Second is to avoid a situation where the failure of one large, interconnected financial institution is likely to lead to the failure of many other large institutions.
Most of the 600 institutions recapitalized by the federal government over the last year do not satisfy either criterion. A lot of bailout decisions were made ad hoc without a clear rationale. For instance, the government bailed out Bear Stearns, but why not Lehman Brothers? Ironically, Congress in 1991 passed a statute establishing specific procedures (including stating a rationale) to be followed before a bank could be rescued and mandating an after-the-fact audit by the Comptroller General. But because Bear and AIG weren’t banks, no one had to explain what they were doing under the 1991 statute. To hold senior government officials accountable for all bailouts, Congress should extend the 1991 statute to any type of financial institution.
Q: How has Congress tried to restore confidence in credit rating agencies?
The first thing Congress did in 2006 was to boost competition. We now have nine approved rating agencies instead of three. However, if you are a bond issuer and you don’t like what one rating agency says, you can choose another. So now, you have tripled the number of choices. That doesn’t solve the problem of forum shopping. In fact, it makes it worse.
Q: What if rating agencies were paid by investors rather than by bond issuers? Wouldn’t that stop forum shopping?
In theory, yes. The people who are being served by the rating agencies, the investors, should pay for the service. But that’s not going to happen because the largest investors in bonds — banks, insurance companies, and mutual funds — aren’t willing to pay because they think they do a much better job than the rating agencies.
What I propose is a neutral third-party approach to ratings. The SEC would designate a knowledgeable person, independent of both issuers and rating agencies, to select a rating agency for the bond issuer and negotiate a rating fee. This would eliminate the two worst abuses: the issuer shopping for a higher rating, and the issuer paying inflated fees to get a higher rating. But the issuer would still pay for the fees of the rating agency after it was selected by the third party.
Q: You note in your book that loan securitization collapsed at the end of 2008. Has it revived yet, and why is it important for a healthy economy?
The monthly volume of securitization in 2007 was over $100 billion. Now, it’s $1 or $2 billion a month. So we’ve got a long way to go. And we need to get securitization going because that’s what drives loan volume.
Q: Why has loan securitization been slow to recover?
We had a terrible system of securitization where everything was off balance sheet, and we made believe that the sponsors, the biggest money center banks, had zero risk of loss. They did not fully disclose what was happening, and they did not put up enough capital to cover potential risks. Now, the FASB [Financial Accounting Standards Board] has overacted by adopting rules that effectively force all securitizations on the balance sheet. Since the new rules treat banks as if they have 100 percent of the risk of loss, they must put up capital as if that were true.
So we’ve gone from one extreme to another, with the reality lying somewhere in between. If we are going to resuscitate securitization, we should utilize off-balance-sheet entities but with a transparent process and capital charges that are based on actual risks. We want banks to disclose their potential liabilities to these entities and to put capital behind these risks. Unless we have that sort of transparent process backed by capital, we’re not going to revive securitization.
Q: Corporate boards have been criticized for being asleep at the wheel leading up to last year’s financial meltdown. Are boards at fault?
After Enron and WorldCom, Congress hastily passed Sarbanes-Oxley, basically a very elaborate set of procedures for boards to follow. But it’s very clear that the boards of megabanks — the nineteen banks with over $100 billion in assets — complied with Sarbanes-Oxley and somehow didn’t realize what huge risks they were taking.
Q: If boards don’t need more procedures, what do they need?
Some of the most effective boards are those at companies that are owned by private equity. They are composed of the CEO and six directors, all of whom have relevant industry expertise. The directors make the time commitment, spending several days each month at the company. And they all have significant stock incentives.
The question is, what can we learn from the private equity model? When it comes to megabanks, I’m in favor of a smaller board with deep financial expertise, substantial time commitments, and a different pay structure. We can try to be clever and add more procedures. But unless we rethink the board model in a very fundamental way, I believe we’re kidding ourselves. Is it likely that somebody who isn’t a financial expert can show up six times a year and really understand Citigroup?
Q: In an attempt to head off the next financial crisis, should Congress designate a systemic risk regulator? If so, who should that be?
The Treasury has proposed that systemic risks be monitored by a newly formed Financial Services Oversight Council, with the Fed becoming the primary regulator of all institutions posing such risks. I disagree with making the Fed the primary risk regulator.
First of all, the notion that the Fed could be the primary regulator of every systemically risky institution is just not practical. That means it would need to be an expert on money market funds, hedge funds, and life insurance companies as well as banks. Second, if you identify an institution as systemically risky, you’re creating moral hazard [implicit federal guarantees] by that very process. Third, you’re assuming that we can know in advance every institution that’s systemically risky, but I don’t think that’s possible. Finally, why do we assume that it’s just institutions? Sometimes rapidly growing new financial products are systemically risky, like credit default swaps.
Q: What would you do?
My proposal is just the opposite of the Treasury’s. I would put the Fed in charge of risk monitoring because that’s where it has the most expertise. When the Fed comes upon a systemic risk, it should turn to the relevant regulatory agency to resolve the problem. So you get the best of both worlds. The Fed does what it’s best at, macro risk monitoring. And the agencies with the deepest expertise in the relevant financial area would be in charge of problem resolution. Moreover, if the Fed assumed the role as primary regulator of all systemically risky institutions, it would jeopardize its political independence. And that would be a big mistake.
Want to bet the Obamanation listens?
common sense solution my ass, the only way to fix the problem is the Andrew Jackson Way.
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