SeriousBull

An Open Letter to Congress on Financial Reform

Tags: Congress + Federal Reserve + FINRA + Ginnie Mae + GNMA + investing + SEC

Dear Members of Congress,

You are undertaking the task of studying the current financial crisis with the objectives of strengthening regulation of the US financial system to encourage capital formation and to increase efficiency and order.  Reportedly, first up is gathering facts and information to understand what happened in the

failure of Bear Stearns. Why didn’t the SEC see it coming and prevent it? How can such a loss be prevented in the future; or how can risk management be improved? Are there any powers lacking to improve regulatory oversight; or are there other powers that could be granted to the SEC to avert such a failure going forward? 

The outcome of this investigation will conclude that this was a “black swan” event. Bear Stearns was within regulatory limits until they failed and properly gave immediate notice when their net capital dropped below statutory levels. The system worked. It was an unprecedented market event associated with deleveraging that led to the credit market turmoil, that arose from a rise in mortgage defaults. 

Of course, this is accelerating what you must discover on your own. And it goes without saying that your thoroughness and hours of investigation will not be as concise, nor as direct. However an important point will almost certainly be missed, and it is that point which became the impetus for this letter.

You see the investigation likely stands to be derailed, by improper focus on the right questions. The question is not about Bear Stearns, or indeed just investment banks, or new regulation. The question is about the heart and soul of regulation. Regulators follow directions. They are not entrepreneurs driven by innovation and profit motive. They are administrators applying rules ignoring what-if questions by and large. If a bank or brokerage firm is properly accounting for and following statutes, they get an A. If the markets decline and they are marking their regulatory capital to the market and yet meet the Net Capital test, they are sound. It is not their venue (apparently) to question the future impact of making zero down payment loans. Or to question the propriety of mortgage origination if all the paperwork is in order. Their purview is not to think about the eventuality that it is likely that these loans could go bad. Nor is it apparently their forte to ponder what-if scenarios like for example, what-if these sub-prime loans that have been packaged and sold off have recourse, because they are insured by Ambac or MBIA, as the transactions were completed. Or more to the point to ask, what is the implied leverage ratio were an above-average default rate experienced?

The point is that Bear Stearns is simply the most notable casualty of a flawed regulatory system perhaps not capable of ever averting the kind of financial crisis we now have because of the inherent conflict between innovation and yesterday’s rulebook. In hindsight it should be obvious to most everyone that financial institutions should not have manufactured housing loans to the un-creditworthy. And it was not the job of regulators to assess creditworthiness of customers, only the creditworthiness of lenders whom they regulate. The innovation of banks and brokers was to offload risk to others to make it appear quite creditworthy and risk-free. Chairman Greenspan, as bright as he may be, argued this while ignoring the plausability of fraud–a minor detail somehow escaping all the regulatory bodies. Bear Stearns failed because it did not have access to the Fed’s Discount window when banks did. In other words, more than one bank would have preceded Bear, had it not been for the power of the Fed’s purse. And this point may easily be missed if the Federal Reserve is not likewise investigated. The problem therefore is that our regulatory system is not capable of innovation, perhaps by design and definition. For this reason the failure we are experiencing will happen again, as it did when Congress last investigated similar debacles with Ginnie Mae.  Indeed we have covered this ground many times before. The Glass-Steagall Act was the intelligent result. If the Congress wants to foster innovation while cultivating a climate of responsibility with less regulation, let it be done with private money, not the public money–or if a certain intervention is desired define its bounds and cap its costs.

So there is only one other point to make–perhaps the most important one. That is, who should pay for the losses we are piling up as a result of the housing crisis? The wrong was done by ‘innovators’ disguising risk. It would seem reasonable that the innovators should pay–their controlling shareholders, not the public shareholders unless the cost burden necessitates it. The tragedy of it all will be if the aforesaid ‘black swan event’ argument  wins the day with no recognition of what really occurred. To remedy this potential problem you, the Congress, must make them pay as a deterrant. Begin by asking what the tab has been to date. Ask, given current defaults, including the probabilities of future defaults arising from non-performing loans, what the Federal Reserve’s cost, combined with Fannie Mae, Freddie Mac and Ginnie Mae’s cost will be. Then complete your hearings with a vote to seek reimbursement for the loss from the ‘innovators’ who created this mess. (Please legislate it so the Supreme Court can not overturn it). Finally, separate risk money from public money. Go back to sound lending principles. And change more than just the chairs; direct that a change be made in the people sitting in them. This current incumbency of regulators at the Federal Reserve, Comptroller, and FDIC did neither increase bank reserve requirements, nor curtail stupid lending practices while almost a decade of unsound lending was practiced. Likewise do the same at the SEC and FINRA (formerly NASD Regulation) who failed to estimate recourse leverage for both groups appear to have a serious case of “status quo” bias as the quality of their judgment seems to lie solely on hard evidence as opposed to any intuition. Indeed, surely a computer program could have done what they did if you think about it had firms merely imputed their data.

Editor,
SeriousBull

PS. Look in depth into Ginnie Mae as it holds more sub-prime paper, and has sold even more than it holds, all with recourse to the US Treasury.  While your at it look into the how banks and brokerages are raising costs to customers. Not passing down interest rate cuts while lower deposit rates and raising credit card rates and other fees and charges. 

May 7, 2008 - Markets, Politics