April 26, 2010

The Python and the Mongoose: it helps if you know the rules of engagement

NYT suggests that the SEC changes mentioned yesterday are approved:

The proposed changes, approved in a 5-0 vote despite misgivings expressed by two commissioners, now enter a 90-day period for public comment before coming back to the commission for revision and final approval.

but more importantly,

The bond issuers would also be required to keep a chunk of the securities in their own portfolios so that they retain some of the bonds’ risk, under the S.E.C.’s plan. ... The changes would “represent a fundamental revision to the way in which the asset-backed securities market would be regulated,” the S.E.C.’s chairwoman, Mary L. Schapiro, said. “I think changes are both necessary and critical components of restoring investor confidence.”

Aha! Someone knows the definition of banking:

Banking is the borrowing of /demand deposits/ from the public, and the lending of those same deposits, /at term/ to the public.

Banking is special for one and only one reason. Because the funds are borrowed as deposits, they can be returned today, immediately. That's what "on demand" means, and also that's what deposits mean.

Yet the loans are "at term" or to be repaid in the future. 30 years away, in the case of modern western mortgages.

And that is the crux of banking. The loans out on houses can't be called in under normal circumstances, but the public can call in its deposits now, today. Ordinarily this would be called fraud, because the bank is entering into a contract that it knows it is impossible to guarantee. For this reason, a bank charter is like a specialised permission to undergo a certain sort of fraud, or more kindly, to turn this specialised contract into something that isn't a fraud.

This arrangement is delicate. Change one word above and it is no longer banking (and in this statement you can find much of the ills of modern banking). Which leads us to securitization.

Securitization is the process of creating the at-term loans, with demand deposits, and then packaging them and selling them onto the bond market. A bond issue might collectively handle thousands of similar properties, and gets sold into the market maybe 100 days after the mortgages are sold.

Securitization breaks banking. It breaks banking because the loans are no longer at term, or they are, but they are no longer in the hands of the banks, they are on the market! So the investors in the bond market are lending at term to the house owners, and the magic link of banking has been broken.

Regulators say the financial companies that created the bonds had little incentive to ensure that the bonds were backed by reliable loans. When large portions of the borrowers began to default on the loans, the holders of the securities had big losses.

Right, exactly. As, in theory the banks no longer owned the bonds, having sold them on the market, they no longer had an incentive to manage the loans. And this is the implicit, unwritten corollary in the definition of banking: in order to get the charter, you have to look after the loans for their entire term. That's what it means, to be a bank, guard the deposited funds, out on loan, for their entire life!

The proposed rules, which would affect a large portion of new offerings in the $9.5 trillion market for securities backed by consumer loans, would in many cases require financial companies to retain 5 percent of each offering, a move that Ms. Schapiro said would “better align” the interests of investors and the securities firms.

Financial reform bills winding their way through Congress contain similar requirements that financial companies “keep skin in the game,” as the commission put it. So does a proposal by the Federal Deposit Insurance Corporation, which regulates some asset-backed securities originated by banks.

Skin in the game! Which the Python can only shed, as it outgrows model after model, leaving investors more and more confused. Models can only approximate risks of defaulting borrowers, and aren't a substitute for attentive bankers.

The big message to take away is this: Securitization breaks the fundamental law of banking. Is this good or bad? We should probably know this, because practically everything is done with securitization these days. And why not? It is decidedly more efficient, saving the occasional global meltdown.

The answer is, that securitization is decidedly good, but it renders banking no longer "special." This has a lot of ramifications: it means we no longer need banks. But we've got banks, so there is going to be a huge hangover period while society shifts from banking to market-oriented facilitation. And likely a few more crises.

It also means we don't need central banks; or at least partly, we don't need that part which regulates the banks, because standard competition and exchange regulators should be able to do the job. It's all consumer products called bonds, after all.

Yeah, sure, I hear you say, "we don't need banks..." chortle chortle. Admittedly the hangover from the century of central banking will be with us for a long time, and we can only move forward slowly. But watch: slowly but surely the move will be to open the market for loans origination.

Under the new rules, bond underwriters would not be required to receive a credit rating; rather, the chief executive of the bond issuer would have to certify that the assets were likely to produce the expected cash flows. ... Moody’s, in a statement, said, “We believe the market benefits when ratings agencies compete on the basis of the quality of their credit analysis, and we have long supported the removal of ratings from regulation.”

Baby step by baby step, the business of banking is moving over to the marketplace.

Posted by iang at April 26, 2010 12:53 AM | TrackBack

Fall2008, testimony in congressional hearings looking into credit rating agencies was that unregulated loan originators were paying the rating agencies for triple-A ratings when both knew that they didn't deserve triple-A.

The comments that the seeds were sown for the "misaligned business process" and "conflict of interest" in the early 70s when they changed from buyers paying for the ratings to the sellers paying for the ratings.

then there is the "Man Who Beat The Shorts" (reference that the street was punishing him for the following observation)

from above:

Watsa's only sin was in being a little too early with his prediction that the era of credit expansion would end badly. This is what he said in Fairfax's 2003 annual report: "It seems to us that securitization eliminates the incentive for the originator of [a] loan to be credit sensitive. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care."

... snip ...

Posted by: Lynn Wheeler at April 26, 2010 08:59 AM

There was a new online computer services startup that I interviewed with in the late 60s ... but didn't join. They were starting to specialize in providing historical stock price and other financial information. In the early 70s, they bought the pricing service division from one of the rating agencies (about the same time that the rating agencies switched from buyers paying for the ratings to the sellers paying for the ratings).

Posted by: Lynn Wheeler at April 26, 2010 01:43 PM

related blog:

The Baseline Scenario; What happened to the global economy and what we can do about it; When Will Senator Dodd Start Taking Yes For An Answer?

comments in the above mentions breaking news item:

Berkshire-Backed Exemption Said to Be Cut From Bill

some of the blog entries also weigh in with references to Gramm & derivatives:

25 People to Blame for the Financial Crisis; Phil Gramm

from above:

He played a leading role in writing and pushing through Congress the 1999 repeal of the Depression-era Glass-Steagall Act, which separated commercial banks from Wall Street. He also inserted a key provision into the 2000 Commodity Futures Modernization Act that exempted over-the-counter derivatives like credit-default swaps from regulation by the Commodity Futures Trading Commission. Credit-default swaps took down AIG, which has cost the U.S. $150 billion thus far.

... snip ...

Gramm and the 'Enron Loophole'

from above:

Enron was a major contributor to Mr. Gramm's political campaigns, and Mr. Gramm's wife, Wendy, served on the Enron board, which she joined after stepping down as chairwoman of the Commodity Futures Trading Commission.

... snip ...

Phil Gramm's Enron Favor

from above:

A few days after she got the ball rolling on the exemption, Wendy Gramm resigned from the commission. Enron soon appointed her to its board of directors, where she served on the audit committee, which oversees the inner financial workings of the corporation. For this, the company paid her between $915,000 and $1.85 million in stocks and dividends, as much as $50,000 in annual salary, and $176,000 in attendance fees

... snip ...

Greenspan Slept as Off-Books Debt Escaped Scrutiny

from above:

That same year Greenspan, Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt opposed an attempt by Brooksley Born, head of the Commodity Futures Trading Commission, to study regulating over-the-counter derivatives. In 2000, Congress passed a law keeping them unregulated.

... snip ...

Wendy Gramm fairly quickly replaced Born before stepping down to join Enron's board.

Posted by: Lynn Wheeler at April 26, 2010 04:42 PM

What I find interesting is the NYT quote...

“Do very large institutional investors need investor protection from other financial institutions that sell them securities?” he asked, implying that the answer was no....

How dumb would that institution be buying a private placement bond without documentation of the underlying assets. Surely it's investors in very large institutions who need protection?

Posted by: Thomas Barker at April 26, 2010 06:11 PM

SOX supposedly gave SEC additional powers for throwing executives in jail for fraudulent reporting. However, possibly because SEC didn't appear to be doing anything, GAO started database of financial filings that appeared to be fraudulent.

'Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges'

from above:

While the average number of companies listed on NYSE, Nasdaq, and Amex decreased 20 percent from 9,275 in 1997 to 7,446 in 2002, the number of listed companies restating their financials increased from 83 in 1997 to a projected 220 in 2002 (a 165 percent increase) (table 1). Based on these projections, the proportion of listed companies restating on a yearly basis is expected to more than triple from 0.89 percent in 1997 to almost 3 percent by the end of 2002. In total, the number of restating companies is expected to represent about 10 percent of the average number of listed companies from 1997 to 2002.

... snip ...

along with

Financial Statement Restatement Database

and more recent update (2006)

Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities


Financial Restatement Database
and update (2006)

from above:

The database consists of two files: (1) a file that lists 1,390 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between July 1, 2002, and September 30, 2005, and (2) a file that lists 396 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between October 1, 2005, and June 30, 2006.

... snip ...

some possible spinning of gao reports:

1) sox audits have no effect on fraudulent filings
2) sox audits motivated public companies to increase fraudulent filings
3) if it hadn't been for sox audits, every public company would have been making fraudulent filings

SOX also supposedly had SEC to look at rating agencies ... but they don't appear to have done anything but:

Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets; As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002

This somewhat corresponds with comments by person testifying in congressional hearings into Madoff who had tried for a decade to get SEC to do something about Madoff.

Posted by: Lynn Wheeler at April 26, 2010 06:39 PM

I agree with your definition of banking and that's all I agree with. I don't think there is any evidence that securitization is more efficient. I do think there is evidence that it enhances liquidity but that is definitely not the same thing. I think the fundamental problem is that there is too much liquidity.

Money is both a store of value and a medium of exchange. We have completely abandoned the former in pursuit of the latter. Markets do a terrible job of assessing value in relatively illiquid goods such as housing. The fundamental truth is that no one knows what those assets are actually worth and the whole thing is an act of faith. Central banks are integral to that act of faith. They may be the financial equivalent of security theater but such financial theater shouldn't be underestimated.

Posted by: Daniel at April 26, 2010 07:35 PM
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