By Jon Hainer
It doesn’t take a Sherlock Holmes to deduce that our lawmakers are focused on the wrong element of the housing crisis. Congress has just created a massive bailout package the details of which are still fuzzy. If only it had included the right provisions. Instead, it did nothing for the consumer, nothing for the individual homeowner, and it did nothing to put a floor under the value of homes which continue to drop nationwide. The bailout package focused on the concerns of those with the most political leverage that have precious little to do with the national emergency as it effects most of us. Rather than worrying about whether top financial executives have earned their golden parachutes, or whether Nancy Pelosi was right about the role of deregulation in this crisis, the Congress, the Administration, and the Fed should have spent time and energy worrying about the little guy. Here’s one modest proposal they could have considered.
Let’s make it a condition of any financial institution accepting government assistance with their illiquid mortgages, or mortgage-backed securities (“MBS”), that it will be required to lower the rates on all of its mortgages to not more than 6% and to fix them there. The problems that individual borrowers have with rates resetting at unaffordable levels would be considerably reduced. For the family with a $300 thousand mortgage that faced a rate-reset to, say 10%, the savings would make a world of difference. The principal and interest portion of their payment would be reduced by $834.06 per month. If their percentage of take-home pay were 50% with the 10% mortgage, it would drop to a much more manageable 34% with the 6% mortgage. Let’s call it the 6% solution.
Not only would this idea help the little guy, it would have a beneficial impact on the entire residential real estate market. Prices would tend to stabilize. Defaults would tend to decline. The supply of new homes coming on to the market through foreclosure would tend to drop. Illiquid MBS do not now trade because no one knows what the flow of funds into the mortgage pools will be will. As the 6% solution stabilizes the payment streams at known levels, those MBS will become increasingly saleable, and the banking system increasingly liquid. The 6% solution would not be a panacea, but it could make a considerable difference just at the cusp, or tipping point, at which I suspect we now find ourselves.
Interestingly, the cost of this little guy bailout would probably be about what the cost of the big bailout that is underway. Bank of America / Countrywide just announced a $8.5 billion dollar package for 400 thousand homeowners. If the bailout were for 40 million homeowners at the same rate the cost would be $850 billion – or almost exactly what the bailout we got is projected to cost. In addition, the Bank of America plan would lower borrower rates to as low as 2.5% and provides assistance to those who are going to loose their homes no matter what the rate.
There are problems with this 6% solution, of course. Owning an undivided interest in a pool of mortgages (i.e. owning part of an issue of a MBS) is not the same as controlling the terms of each individual mortgage. This proposal would tend to hurt holders of the lower-rated MBS disproportionately as less money would come into the mortgage pools. Moral hazard – rewarding risky behavior with public funds – exists with this idea. But isn’t that why we pay those guys in Washington, to figure out the details to such things and craft a workable solution? Tell your Congressman to stop worrying about political posturing and limiting the payout to a handful and to start worrying about putting a hand out to help millions. Even Dr. Watson could recognize this as a more promising avenue of investigation. Can’t anyone think outside of the box anymore? Sherlock, are you there?
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Jon Hainer is a principal with Stern & Associates, a bank compliance firm, and co-author of the book Commercial Loan Review and Audit Manual published by Sheshunoff. He also heads the Economic Strategy Group at the downtown LA law firm of Hicks Park LLP. He may be reached at jhainer@sternassociatesllc.com
Wednesday, July 15, 2009
What is to blame for the mortgage crisis?
By Jon Hainer
Good question.
As a student of economics, I was taught to be very careful when designing incentives to affect any element of human behavior because you tend to get more of the behavior that you actually reward. This is often not the same thing as the behavior that you intended to reward. Unfortunately in real life, there is no professor standing on the sidelines ringing a bell and intoning “beware the incentives” at the crucial moment.
Two dozen years ago, I was involved in one of the first securitizations of retail automotive receivables cutely called CARS for collateralized automotive receivables. (Loans grouped to provide the security for a bond are said to be “securitized”). It was perhaps the very first securitization effort that targeted “B” and “C” borrowers (car buyers). “A” borrowers were the people with good credit and/or large down payments. The transaction involved multiple originators (automobile dealerships), a loan broker, a loan servicing company, and an investment bank. My commercial bank provided the funding to accumulate the loans into a large enough pool to be efficiently securitized.
Auto dealers had difficulty selling cars to people with uneven or bad credit histories because few lenders wanted to hold such loans. By gathering these loans into pools and securitizing them, we provided funding for an under-served market. CARS helped struggling borrowers to finance the cars they needed to get to work and promoted the sales of cars for auto dealers. It transferred risk to those who were willing to bear those higher risks in exchange for stellar returns and an absence of paperwork. Everyone benefited.
Can you hear a bell ringing? Perhaps you can if you have been paying attention to the mortgage crisis of the last year or two.
With CARS we created some perverse incentives. The auto dealer did not have to be as careful as it once was in arranging financing for marginal buyers because it no longer had a meaningful stake in whether the loan was repaid. The loan broker did not worry because it would only be holding the loans for a matter of days. The loan servicing company did not worry because its fees were paid from the very first dollars coming from borrower payments into the loan pool. The commercial banker did not worry because the exposure was short term and hedged. The investment banker (think bond salesman) did not worry because it never owned the loans but rather packaged them for the end-buyers. The end-buyers made the relatively subtle error of assuming that things were staying the same, and that they were buying into a pool of collateralized loans underwritten to very exacting specifications – high risk, but high return and carefully scrutinized. They should have worried.
The truth was that no one was carefully watching. By changing the system from a one-step process (borrower and lender) to a five-step process, lines became blurred, responsibilities vague, and self-interest paramount. Borrowers promised more than they could deliver. Auto dealers generated worse and worse quality loans because that meant they could sell more and more cars. The rest of us just passed on whatever came through the pipeline blithely unconcerned because we were not bearing the ultimate risk. The system did not reward being careful; it rewarded volume with large short-term profits. So we generated fleets of loans. Before long, however, there were too many defaults and too many repossessed cars gathering dust in a lot in the desert. Does any of this sound familiar?
The underwrite-to-hold model (traditional lending) is successful precisely because it requires the financial entity generating a loan to depend upon its repayment. The underwrite-to-sell model (securitization) is not only successful, but superior in many ways because, if everything is done right, everyone benefits. But with underwrite-to-sell, moral hazard is built-in. Without very careful financial engineering, perverse incentives will undermine even those with the noblest of motives, much less the characters (like me and you) who operate out of strict self-interest.
As the current mortgage crisis developed, it looked quite familiar to those who remembered the ill-fated CARS. The moral hazard of the underwrite-to-sell system wreaked its havoc as it is wont to do. To solve the current financial crisis, we have to realign the system’s incentives so that all participants are rewarded for success at every stage and all are punished for failure at any stage. It is easier said than done; but in the end, it is just a question of creating proper incentives. Economics 101.
Good question.
As a student of economics, I was taught to be very careful when designing incentives to affect any element of human behavior because you tend to get more of the behavior that you actually reward. This is often not the same thing as the behavior that you intended to reward. Unfortunately in real life, there is no professor standing on the sidelines ringing a bell and intoning “beware the incentives” at the crucial moment.
Two dozen years ago, I was involved in one of the first securitizations of retail automotive receivables cutely called CARS for collateralized automotive receivables. (Loans grouped to provide the security for a bond are said to be “securitized”). It was perhaps the very first securitization effort that targeted “B” and “C” borrowers (car buyers). “A” borrowers were the people with good credit and/or large down payments. The transaction involved multiple originators (automobile dealerships), a loan broker, a loan servicing company, and an investment bank. My commercial bank provided the funding to accumulate the loans into a large enough pool to be efficiently securitized.
Auto dealers had difficulty selling cars to people with uneven or bad credit histories because few lenders wanted to hold such loans. By gathering these loans into pools and securitizing them, we provided funding for an under-served market. CARS helped struggling borrowers to finance the cars they needed to get to work and promoted the sales of cars for auto dealers. It transferred risk to those who were willing to bear those higher risks in exchange for stellar returns and an absence of paperwork. Everyone benefited.
Can you hear a bell ringing? Perhaps you can if you have been paying attention to the mortgage crisis of the last year or two.
With CARS we created some perverse incentives. The auto dealer did not have to be as careful as it once was in arranging financing for marginal buyers because it no longer had a meaningful stake in whether the loan was repaid. The loan broker did not worry because it would only be holding the loans for a matter of days. The loan servicing company did not worry because its fees were paid from the very first dollars coming from borrower payments into the loan pool. The commercial banker did not worry because the exposure was short term and hedged. The investment banker (think bond salesman) did not worry because it never owned the loans but rather packaged them for the end-buyers. The end-buyers made the relatively subtle error of assuming that things were staying the same, and that they were buying into a pool of collateralized loans underwritten to very exacting specifications – high risk, but high return and carefully scrutinized. They should have worried.
The truth was that no one was carefully watching. By changing the system from a one-step process (borrower and lender) to a five-step process, lines became blurred, responsibilities vague, and self-interest paramount. Borrowers promised more than they could deliver. Auto dealers generated worse and worse quality loans because that meant they could sell more and more cars. The rest of us just passed on whatever came through the pipeline blithely unconcerned because we were not bearing the ultimate risk. The system did not reward being careful; it rewarded volume with large short-term profits. So we generated fleets of loans. Before long, however, there were too many defaults and too many repossessed cars gathering dust in a lot in the desert. Does any of this sound familiar?
The underwrite-to-hold model (traditional lending) is successful precisely because it requires the financial entity generating a loan to depend upon its repayment. The underwrite-to-sell model (securitization) is not only successful, but superior in many ways because, if everything is done right, everyone benefits. But with underwrite-to-sell, moral hazard is built-in. Without very careful financial engineering, perverse incentives will undermine even those with the noblest of motives, much less the characters (like me and you) who operate out of strict self-interest.
As the current mortgage crisis developed, it looked quite familiar to those who remembered the ill-fated CARS. The moral hazard of the underwrite-to-sell system wreaked its havoc as it is wont to do. To solve the current financial crisis, we have to realign the system’s incentives so that all participants are rewarded for success at every stage and all are punished for failure at any stage. It is easier said than done; but in the end, it is just a question of creating proper incentives. Economics 101.
Buying Back Public Confidence - What Will It Take?
By Jon Hainer
On the one hand, the Treasury Department’s so-called economic “Bailout” plan is on the wrong track. On the other hand, Shiela Bair, Chairman of the Federal Deposit Insurance Corporation (the FDIC that insurance bank deposits) is on the right track. Yes, it is the Main Street v. Wall Street argument that is raging right now, with an added consideration, the increase in public confidence that would attend to a focus on the needs of American taxpayers.
It is clear that, in general, the public does not understand the difference between commercial banks and so-called “investment banks” i.e. Wall Street brokerage houses. As a result, banks in general are getting a bad rap which erodes public confidence in our financial institutions. At the same time, giving financial giants billions of dollars without conditions is a big factor in the erosion of public confidence: billions in government funds used to acquire “failing banks” and create bigger monopolies with which community banks have to compete; the multi-billion dollar tax breaks provided to the financial giants acquiring failing institutions; few caps on multi-million dollar salaries and bonuses to executives of the corporate giants receiving bailout money. How about the story in the Wall Street Journal of the $7+ billion purchase by Citi of a toll road in Europe? Banks should get “capital injections” not only when withholding help from them would create havoc on Main Street – but also as a reward for direct assistance to homeowners. Further, there should be a mandate that “Bailout” money be used to ease the credit crunch by increasing the availability of credit.
The current economic crisis was driven by a growing number of foreclosures at the bottom of the economic structure and the primary solution should start there. Subprime borrowers (those with poor credit) got subprime loans - higher points, fees and interest to offset the added risk of making such loans. Consequently, subprime borrowers who could least afford a high-priced loan got the least affordable mortgages. Most home loans had been fixed-rate mortgages, but most subprime loans were “non-traditional,” something that unsophisticated subprime borrowers often failed to understand. Examples were adjustable rate mortgages (low interest to start, but periodically resetting to higher interest and higher monthly payments). Hybrid mortgages (starting with a fixed rate and switching to an ARM loan after a couple of years), loans with payments of “interest only” that later converted to payments of principal and interest, often doubling or tripling the monthly payments, etc. The resulting monthly payments were unaffordable and triggered defaults and foreclosures, which created a backlog of unsold homes that caused home values to plummet. The public in general is unaware that lenders who are basically unregulated by any governmental authority, state or federal, such as loan brokers and mortgage companies, were responsible for originating a large percentage of the subprime loans that were sold to banks and subsequently pooled and resold to Wall Street.
When a home is worth less than the principal amount owed on a promissory note representing the mortgage loan, discouraged homeowners often hand the bank the keys and walk away. In the foreclosure process, the borrowers lose their homes and, on average, the lender loses 40% of the outstanding balance owed on the note. The FDIC Chair, Sheila Bair leans toward restructuring all viable loans. One option to help homeowners currently struggling to stay in their homes and cut losses by banks, would be for:
¨ The bank (or other regulated lender) to reduce the balance owed by the homeowner to the current value of the residential property, but not more (for example) than 20%.
¨ Treasury to reimburse the lender for half of the reduction on the homeowner’s promissory note, and also to guarantee repayment of the note as reward for the lender’s portion of the reduction.
¨ Treasury to place a lien on the property in the amount of its reimbursement to the lender (paperwork to be handled by the lender.)
¨ Loan terms to be extended up to 40 years and interest to be fixed at 6-7% as required to keep monthly payments under 35% of the homeowner’s gross monthly income.
¨ Treasury’s lien to reimburse the federal government (and the taxpayers) upon the sale of the property.
Some side issues would have to be considered: The lender would have to provide proof of the reduction in the amount owed by a homeowner, and 50% would have to be reimbursed to the lender by an authorized government agency (possibly the IRS with a temporary extension of manpower – which would help unemployment). However, collection on the government’s lien should be relatively automatic and should not require much, if any, paperwork.
How such a program could apply to mortgages that were pooled as the underlying collateral for “mortgage-backed securities” is unclear. The fact that writing down the principal owed on a mortgage affects the interests of those who invested in mortgage-backed securities is something that must be resolved at the federal level, perhaps by the Justice Department. However, the government has never insured stocks, bonds and similar investments, and investors should readily recognize that a small loss is better than a big loss.
On the one hand, the Treasury Department’s so-called economic “Bailout” plan is on the wrong track. On the other hand, Shiela Bair, Chairman of the Federal Deposit Insurance Corporation (the FDIC that insurance bank deposits) is on the right track. Yes, it is the Main Street v. Wall Street argument that is raging right now, with an added consideration, the increase in public confidence that would attend to a focus on the needs of American taxpayers.
It is clear that, in general, the public does not understand the difference between commercial banks and so-called “investment banks” i.e. Wall Street brokerage houses. As a result, banks in general are getting a bad rap which erodes public confidence in our financial institutions. At the same time, giving financial giants billions of dollars without conditions is a big factor in the erosion of public confidence: billions in government funds used to acquire “failing banks” and create bigger monopolies with which community banks have to compete; the multi-billion dollar tax breaks provided to the financial giants acquiring failing institutions; few caps on multi-million dollar salaries and bonuses to executives of the corporate giants receiving bailout money. How about the story in the Wall Street Journal of the $7+ billion purchase by Citi of a toll road in Europe? Banks should get “capital injections” not only when withholding help from them would create havoc on Main Street – but also as a reward for direct assistance to homeowners. Further, there should be a mandate that “Bailout” money be used to ease the credit crunch by increasing the availability of credit.
The current economic crisis was driven by a growing number of foreclosures at the bottom of the economic structure and the primary solution should start there. Subprime borrowers (those with poor credit) got subprime loans - higher points, fees and interest to offset the added risk of making such loans. Consequently, subprime borrowers who could least afford a high-priced loan got the least affordable mortgages. Most home loans had been fixed-rate mortgages, but most subprime loans were “non-traditional,” something that unsophisticated subprime borrowers often failed to understand. Examples were adjustable rate mortgages (low interest to start, but periodically resetting to higher interest and higher monthly payments). Hybrid mortgages (starting with a fixed rate and switching to an ARM loan after a couple of years), loans with payments of “interest only” that later converted to payments of principal and interest, often doubling or tripling the monthly payments, etc. The resulting monthly payments were unaffordable and triggered defaults and foreclosures, which created a backlog of unsold homes that caused home values to plummet. The public in general is unaware that lenders who are basically unregulated by any governmental authority, state or federal, such as loan brokers and mortgage companies, were responsible for originating a large percentage of the subprime loans that were sold to banks and subsequently pooled and resold to Wall Street.
When a home is worth less than the principal amount owed on a promissory note representing the mortgage loan, discouraged homeowners often hand the bank the keys and walk away. In the foreclosure process, the borrowers lose their homes and, on average, the lender loses 40% of the outstanding balance owed on the note. The FDIC Chair, Sheila Bair leans toward restructuring all viable loans. One option to help homeowners currently struggling to stay in their homes and cut losses by banks, would be for:
¨ The bank (or other regulated lender) to reduce the balance owed by the homeowner to the current value of the residential property, but not more (for example) than 20%.
¨ Treasury to reimburse the lender for half of the reduction on the homeowner’s promissory note, and also to guarantee repayment of the note as reward for the lender’s portion of the reduction.
¨ Treasury to place a lien on the property in the amount of its reimbursement to the lender (paperwork to be handled by the lender.)
¨ Loan terms to be extended up to 40 years and interest to be fixed at 6-7% as required to keep monthly payments under 35% of the homeowner’s gross monthly income.
¨ Treasury’s lien to reimburse the federal government (and the taxpayers) upon the sale of the property.
Some side issues would have to be considered: The lender would have to provide proof of the reduction in the amount owed by a homeowner, and 50% would have to be reimbursed to the lender by an authorized government agency (possibly the IRS with a temporary extension of manpower – which would help unemployment). However, collection on the government’s lien should be relatively automatic and should not require much, if any, paperwork.
How such a program could apply to mortgages that were pooled as the underlying collateral for “mortgage-backed securities” is unclear. The fact that writing down the principal owed on a mortgage affects the interests of those who invested in mortgage-backed securities is something that must be resolved at the federal level, perhaps by the Justice Department. However, the government has never insured stocks, bonds and similar investments, and investors should readily recognize that a small loss is better than a big loss.
How Did It All Happen
By Jon Hainer
In the financial industry, the word “bank” is generally used to refer to a “commercial bank,” a financial institution chartered by state or federal government that accepts deposits and makes a lot of different kinds of loans to consumers and businesses. Savings and loans, now called savings banks, accept deposits but focus primarily on making residential loans. Both kinds of “banks” are subject to stringent regulatory supervision by federal agencies; their examiners visit, audit and rate these banks on a regular basis. However, the media often uses the word “bank” to refer to financial entities that don’t accept deposits and are subject to very little government regulation or oversight. These include mortgages companies and brokers that make home loans and finance companies, as well as Wall Street’s investment banks which are primarily in the business of buying and selling stocks and bonds. Wall Street banks created and “mortgage-backed-securities” (MBS) that were backed by sub-prime home loans; they were snapped up worldwide by small investors and corporate investors including banks, mutual funds, retirement funds, etc. Defaults on sub-prime mortgages and a growing flood of foreclosures, followed by a sharp decline in home prices, caused huge losses slashed the value of MBS supported by sub-prime mortgages. Losses suffered by investors and banks around the globe triggered the current worldwide financial crisis.
The problem arose when unregulated mortgage lenders made home loans to people with questionable credit at unfavorable terms meant to offset the added “risk” to the lender. Often, the loans were for more than the sub-prime borrowers could afford and the terms were “predatory” in that the amount of periodic “resets” to a interest rate resulted in an unexpected and excessive increase in monthly payments Unregulated mortgage lenders sometimes made huge profits for making risky loans which were immediately sold to banks that frequently failed to analyze the credit quality of the loans, which were immediately resold to greedy unregulated Wall Street investment banks. Wall Street created securities which were backed by “pools” of sub-prime mortgages on residential real estate - which was going up in value. The securities were sold to domestic and foreign consumers and investors.
When the value of residential real estate plummeted, the value of the mortgage-backed securities sold by Wall Street tanked. Big investors and ordinary people suffered enormous losses and stopped buying mortgage-backed securities, and Wall Street stopped buying loans from commercial banks. Commercial and savings banks lost one of their primary sources of income (used to make new loans) and had to limit the funds they lend. Naturally, they also stopped buying loans from mortgage lenders. At the same time, but to varying degrees, commercial banks suffered deepening losses from defaulting sub-prime loans, often forcing a foreclosure which usually caused banks to lose about 40% of their investment in the loan (asset). As the value of residential properties have fallen below the amount that homeowners owe on their mortgages, increasing numbers are returning house keys to lenders and “walking away.” More than a few are consumers who bought property to re-sell it at a profit but received terms less profitable to the bank by fraudulently claiming that they would be resident owners of the property. Developers, also, have walked away from unfinished projects. Consequently, the requirements for approval of both commercial and consumer loans are more rigorous and loans to residential real estate developers are scarce.
While the implementation processes relative to the current $700 billion “bailout” bill passed by Congress have yet to be clarified, it is clear that the government is funding Wall Street by buying their mortgage-backed securities at more than their current value on the theory that they will be re-sold at a profit at some future time to pay taxpayers back. Something further may have to be done to increase the liquidity of cash-poor commercial banks that are limited in the number of community-based loans they can make to consumers and small businesses.
In the financial industry, the word “bank” is generally used to refer to a “commercial bank,” a financial institution chartered by state or federal government that accepts deposits and makes a lot of different kinds of loans to consumers and businesses. Savings and loans, now called savings banks, accept deposits but focus primarily on making residential loans. Both kinds of “banks” are subject to stringent regulatory supervision by federal agencies; their examiners visit, audit and rate these banks on a regular basis. However, the media often uses the word “bank” to refer to financial entities that don’t accept deposits and are subject to very little government regulation or oversight. These include mortgages companies and brokers that make home loans and finance companies, as well as Wall Street’s investment banks which are primarily in the business of buying and selling stocks and bonds. Wall Street banks created and “mortgage-backed-securities” (MBS) that were backed by sub-prime home loans; they were snapped up worldwide by small investors and corporate investors including banks, mutual funds, retirement funds, etc. Defaults on sub-prime mortgages and a growing flood of foreclosures, followed by a sharp decline in home prices, caused huge losses slashed the value of MBS supported by sub-prime mortgages. Losses suffered by investors and banks around the globe triggered the current worldwide financial crisis.
The problem arose when unregulated mortgage lenders made home loans to people with questionable credit at unfavorable terms meant to offset the added “risk” to the lender. Often, the loans were for more than the sub-prime borrowers could afford and the terms were “predatory” in that the amount of periodic “resets” to a interest rate resulted in an unexpected and excessive increase in monthly payments Unregulated mortgage lenders sometimes made huge profits for making risky loans which were immediately sold to banks that frequently failed to analyze the credit quality of the loans, which were immediately resold to greedy unregulated Wall Street investment banks. Wall Street created securities which were backed by “pools” of sub-prime mortgages on residential real estate - which was going up in value. The securities were sold to domestic and foreign consumers and investors.
When the value of residential real estate plummeted, the value of the mortgage-backed securities sold by Wall Street tanked. Big investors and ordinary people suffered enormous losses and stopped buying mortgage-backed securities, and Wall Street stopped buying loans from commercial banks. Commercial and savings banks lost one of their primary sources of income (used to make new loans) and had to limit the funds they lend. Naturally, they also stopped buying loans from mortgage lenders. At the same time, but to varying degrees, commercial banks suffered deepening losses from defaulting sub-prime loans, often forcing a foreclosure which usually caused banks to lose about 40% of their investment in the loan (asset). As the value of residential properties have fallen below the amount that homeowners owe on their mortgages, increasing numbers are returning house keys to lenders and “walking away.” More than a few are consumers who bought property to re-sell it at a profit but received terms less profitable to the bank by fraudulently claiming that they would be resident owners of the property. Developers, also, have walked away from unfinished projects. Consequently, the requirements for approval of both commercial and consumer loans are more rigorous and loans to residential real estate developers are scarce.
While the implementation processes relative to the current $700 billion “bailout” bill passed by Congress have yet to be clarified, it is clear that the government is funding Wall Street by buying their mortgage-backed securities at more than their current value on the theory that they will be re-sold at a profit at some future time to pay taxpayers back. Something further may have to be done to increase the liquidity of cash-poor commercial banks that are limited in the number of community-based loans they can make to consumers and small businesses.
Target practice: How much capital is enough?
Jul 9th 2009 From The Economist print edition
ASKING how tight gun-control laws would need to have been to have prevented any assassinations in Sarajevo in 1914 is not a rewarding exercise. For banks, however, looking at “what if” scenarios is more worthwhile. Most regulators now think that gradually building up capital buffers as the economy recovers is the best way to make banks safer. Britain’s Treasury was the latest to tread this line in a white paper unveiled on July 8th.
For a long time the amount of capital required to withstand a genuine meltdown has been a near-complete unknown. The minimum capital levels set by the Basel 1 accord in the late 1980s in effect endorsed the overall amount of capital in the system at that point. The crisis changes all that. Estimates of ultimate losses remain highly uncertain and the state of the economy is unclear. But regulators now have a real-life example of a systemic collapse with which to calibrate their new rules.
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So how much capital would the system have needed to have survived the crisis unscathed? It depends how you define “unscathed”. Assume, in an ideal world, that no bank should be in the position of having to raise equity once a crisis has begun. And assume, too, that at no point in the cycle should its level of core capital (basically, its common equity) drop below the minimum now demanded by the American and British governments of 4% of risk-weighted assets.
Based on the estimates used in the American government’s stress tests, the 19 firms involved collectively need to hold minimum core capital of $313 billion. Between the start of the crisis in mid-2007 and the end of 2010, these firms are expected to eat up about $317 billion of capital (with gross losses of almost a trillion dollars offset by core earnings). On this basis, they would need to have entered the crisis with $630 billion to have avoided breaching the floor. That is equivalent to 8.1% of their current risk-weighted assets. The American and European systems actually had a core-capital ratio of nearer 6% at the end of 2007, according to the Bank of England. The Basel rules allowed core-capital ratios to go as low as 2%.
If anything this calculation is generous. Using Bloomberg’s higher estimates of the losses recorded so far, a peak core-capital ratio of nearer 10% would have been needed for the big American banks. And of course losses are not evenly distributed across the system. Citigroup would have needed a starting core-capital ratio in the mid-teens. Using a similar methodology, Switzerland’s UBS would have needed a pre-crisis ratio of about 12% to have avoided hitting the floor of 4%. This is not far off the level it actually had. The fact it has still raised so much equity reflects a tough regulator and the perception that to command the confidence of its private-banking customers, its minimum core-capital must always be far above the 4% level.
That points to one problem with the exercise: a 4% minimum at the bottom of the cycle may be too low. There are others. Estimates of losses will be wrong. Bulls point to the recovery in the prices of risky assets such as leveraged loans. Bears worry that unemployment will rise above the level assumed in the stress tests. There is also a risk of double-counting. The adjustments used to calculate risk-weighted assets are becoming more conservative, as regulators seek to penalise certain types of activity, especially trading. That will also have the effect of building up capital, even if the minimum ratio remains unchanged.
Still, for all these caveats, the basic message seems pretty clear. Going into another crisis of this scale, absolute capital levels would need to be at least double the existing minimum level to avoid breaching that floor at the trough of the cycle. If regulators think the worst banks should set the benchmark for all in the future, the buffer could be even higher. For banks, that is bad news. Their best chance is to persuade regulators that a repeat is unlikely, but such pleading may fall on deaf ears. Right now, governments are interested in stitching taxpayers a bulletproof vest.
To read more: http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=348885&story_id=13998740
ASKING how tight gun-control laws would need to have been to have prevented any assassinations in Sarajevo in 1914 is not a rewarding exercise. For banks, however, looking at “what if” scenarios is more worthwhile. Most regulators now think that gradually building up capital buffers as the economy recovers is the best way to make banks safer. Britain’s Treasury was the latest to tread this line in a white paper unveiled on July 8th.
For a long time the amount of capital required to withstand a genuine meltdown has been a near-complete unknown. The minimum capital levels set by the Basel 1 accord in the late 1980s in effect endorsed the overall amount of capital in the system at that point. The crisis changes all that. Estimates of ultimate losses remain highly uncertain and the state of the economy is unclear. But regulators now have a real-life example of a systemic collapse with which to calibrate their new rules.
document.write('');
So how much capital would the system have needed to have survived the crisis unscathed? It depends how you define “unscathed”. Assume, in an ideal world, that no bank should be in the position of having to raise equity once a crisis has begun. And assume, too, that at no point in the cycle should its level of core capital (basically, its common equity) drop below the minimum now demanded by the American and British governments of 4% of risk-weighted assets.
Based on the estimates used in the American government’s stress tests, the 19 firms involved collectively need to hold minimum core capital of $313 billion. Between the start of the crisis in mid-2007 and the end of 2010, these firms are expected to eat up about $317 billion of capital (with gross losses of almost a trillion dollars offset by core earnings). On this basis, they would need to have entered the crisis with $630 billion to have avoided breaching the floor. That is equivalent to 8.1% of their current risk-weighted assets. The American and European systems actually had a core-capital ratio of nearer 6% at the end of 2007, according to the Bank of England. The Basel rules allowed core-capital ratios to go as low as 2%.
If anything this calculation is generous. Using Bloomberg’s higher estimates of the losses recorded so far, a peak core-capital ratio of nearer 10% would have been needed for the big American banks. And of course losses are not evenly distributed across the system. Citigroup would have needed a starting core-capital ratio in the mid-teens. Using a similar methodology, Switzerland’s UBS would have needed a pre-crisis ratio of about 12% to have avoided hitting the floor of 4%. This is not far off the level it actually had. The fact it has still raised so much equity reflects a tough regulator and the perception that to command the confidence of its private-banking customers, its minimum core-capital must always be far above the 4% level.
That points to one problem with the exercise: a 4% minimum at the bottom of the cycle may be too low. There are others. Estimates of losses will be wrong. Bulls point to the recovery in the prices of risky assets such as leveraged loans. Bears worry that unemployment will rise above the level assumed in the stress tests. There is also a risk of double-counting. The adjustments used to calculate risk-weighted assets are becoming more conservative, as regulators seek to penalise certain types of activity, especially trading. That will also have the effect of building up capital, even if the minimum ratio remains unchanged.
Still, for all these caveats, the basic message seems pretty clear. Going into another crisis of this scale, absolute capital levels would need to be at least double the existing minimum level to avoid breaching that floor at the trough of the cycle. If regulators think the worst banks should set the benchmark for all in the future, the buffer could be even higher. For banks, that is bad news. Their best chance is to persuade regulators that a repeat is unlikely, but such pleading may fall on deaf ears. Right now, governments are interested in stitching taxpayers a bulletproof vest.
To read more: http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=348885&story_id=13998740
Appetite Suppressant: Capital rules now seem the only way to tame the banks. They will need to be tighter than in the past
Jul 9th 2009 From The Economist print edition
BANKS and free lunches traditionally go together. Lenders are run for private benefit, but taxpayers underwrite them if things go wrong. Yet the scale of support that has been extended in the current financial crisis is unprecedented: the entire system has been explicitly guaranteed. Even as unemployment soars, bankers are talking again of big bonuses and a “war for talent”. The woeful legacy of the crisis could be a supersized banking system gorging on the taxpayers’ tab.
Regulators want to prevent this, and their tool of choice now seems to be tighter capital-adequacy rules. This week Britain announced reforms that put a strong emphasis on capital (see article), and other countries are expected to do the same in the coming months. Even though banks have often found their way round such rules in the past, this approach probably makes sense for two reasons.
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First, it reflects the lack of alternatives. Governments have turned away from the really radical options for reform because there is no easy way to resolve society’s desire for cheap and efficiently delivered credit with its wish for stability. Breaking up the biggest banks might not make them safer, and politicians seem not to have the stomach for the fight it would entail. Taking the banks into public ownership, to be micromanaged by politicians, has obvious drawbacks too.
Second, capital, the buffer between banks’ assets and liabilities, is indeed at the heart of the problem. The bigger that buffer is, the safer a bank is likely to be. Low levels of capital ordinarily frighten off creditors but state guarantees give depositors and others every reason to keep financing the banks. If governments cannot retire these guarantees—and doing so is not credible given the crisis—they have to mandate higher capital.
Tougher, craftier and more creative
What should capital rules try to achieve? First, they can expand the system’s buffer to a level which protects taxpayers from losses. The existing Basel 2 rules proved to be too lenient. Regulators now have a better idea of how much capital is needed to survive a meltdown. Heading into the crisis, America’s banks would have needed at least double the present minimum core-capital ratio of 4% to have avoided raising equity or breaching that floor at the bottom of the cycle (see article). The broad outcome is clear: as the economy picks up, capital must be built up substantially from the low it is likely to hit in 2010. The rules must be global, ideally in the form of a new Basel regime, to prevent activity migrating to laxer countries.
Banks complain that equity is expensive and that they will have to raise the price of loans. By how much is unknown: even if banks’ borrowing costs are insensitive to their capital levels, shareholders may accept lower returns in exchange for the lower risk provided by a bigger equity base. But it is an illusion that taxpayers can avoid pain in a guaranteed system. They can either have cheap loans and pay for bail-outs, or pricier loans and bigger buffers. Society clearly prefers the latter.
Second, the new capital regime must be harder to game. Basel 2 failed not just because it set the level of capital too low, but also because the definition of capital was too lax: banks were allowed to include certain types of debt. To start with, the new regime must admit only pure equity as capital. Although there are novel proposals to use insurance policies and convertible debt as capital, the immediate priority should be simplicity.
Third, regulators need to be craftier when estimating the hit that capital must absorb. Rather than “snapshots” of banks’ balance-sheets, which are riddled with accounting quirks, they should use rolling “stress tests” that try to capture losses over several years, taking into account off-balance-sheet activities as well as banks’ core profits. The results of these tests should be made public. If this requires teams of supervisors to camp inside banks, as is the case today in Spain, so be it.
Finally, national regulators need to be creative and use capital surcharges over and above the global minimum standard to “fine” banks that pose a bigger threat to taxpayers. There is a risk that the blunt tool of capital will be asked to do too much: fine-tuning pay policies, for example, and discouraging certain types of trading. But the broad objective must be gradually to prod banks to shrink and improve their liquidity.
Can banks be tamed by capital rules? Nobody really knows. But capital is the only civilised option left in the regulatory toolbox. If it cannot be used to protect taxpayers from losses, or it fails to persuade banks to reform themselves, there will be popular pressure for more violent forms of intervention. Banks greatly underestimate this risk. They are enjoying a free lunch—in the last chance saloon.
Read the whole article at: http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=348885&story_id=13988598
BANKS and free lunches traditionally go together. Lenders are run for private benefit, but taxpayers underwrite them if things go wrong. Yet the scale of support that has been extended in the current financial crisis is unprecedented: the entire system has been explicitly guaranteed. Even as unemployment soars, bankers are talking again of big bonuses and a “war for talent”. The woeful legacy of the crisis could be a supersized banking system gorging on the taxpayers’ tab.
Regulators want to prevent this, and their tool of choice now seems to be tighter capital-adequacy rules. This week Britain announced reforms that put a strong emphasis on capital (see article), and other countries are expected to do the same in the coming months. Even though banks have often found their way round such rules in the past, this approach probably makes sense for two reasons.
document.write('');
First, it reflects the lack of alternatives. Governments have turned away from the really radical options for reform because there is no easy way to resolve society’s desire for cheap and efficiently delivered credit with its wish for stability. Breaking up the biggest banks might not make them safer, and politicians seem not to have the stomach for the fight it would entail. Taking the banks into public ownership, to be micromanaged by politicians, has obvious drawbacks too.
Second, capital, the buffer between banks’ assets and liabilities, is indeed at the heart of the problem. The bigger that buffer is, the safer a bank is likely to be. Low levels of capital ordinarily frighten off creditors but state guarantees give depositors and others every reason to keep financing the banks. If governments cannot retire these guarantees—and doing so is not credible given the crisis—they have to mandate higher capital.
Tougher, craftier and more creative
What should capital rules try to achieve? First, they can expand the system’s buffer to a level which protects taxpayers from losses. The existing Basel 2 rules proved to be too lenient. Regulators now have a better idea of how much capital is needed to survive a meltdown. Heading into the crisis, America’s banks would have needed at least double the present minimum core-capital ratio of 4% to have avoided raising equity or breaching that floor at the bottom of the cycle (see article). The broad outcome is clear: as the economy picks up, capital must be built up substantially from the low it is likely to hit in 2010. The rules must be global, ideally in the form of a new Basel regime, to prevent activity migrating to laxer countries.
Banks complain that equity is expensive and that they will have to raise the price of loans. By how much is unknown: even if banks’ borrowing costs are insensitive to their capital levels, shareholders may accept lower returns in exchange for the lower risk provided by a bigger equity base. But it is an illusion that taxpayers can avoid pain in a guaranteed system. They can either have cheap loans and pay for bail-outs, or pricier loans and bigger buffers. Society clearly prefers the latter.
Second, the new capital regime must be harder to game. Basel 2 failed not just because it set the level of capital too low, but also because the definition of capital was too lax: banks were allowed to include certain types of debt. To start with, the new regime must admit only pure equity as capital. Although there are novel proposals to use insurance policies and convertible debt as capital, the immediate priority should be simplicity.
Third, regulators need to be craftier when estimating the hit that capital must absorb. Rather than “snapshots” of banks’ balance-sheets, which are riddled with accounting quirks, they should use rolling “stress tests” that try to capture losses over several years, taking into account off-balance-sheet activities as well as banks’ core profits. The results of these tests should be made public. If this requires teams of supervisors to camp inside banks, as is the case today in Spain, so be it.
Finally, national regulators need to be creative and use capital surcharges over and above the global minimum standard to “fine” banks that pose a bigger threat to taxpayers. There is a risk that the blunt tool of capital will be asked to do too much: fine-tuning pay policies, for example, and discouraging certain types of trading. But the broad objective must be gradually to prod banks to shrink and improve their liquidity.
Can banks be tamed by capital rules? Nobody really knows. But capital is the only civilised option left in the regulatory toolbox. If it cannot be used to protect taxpayers from losses, or it fails to persuade banks to reform themselves, there will be popular pressure for more violent forms of intervention. Banks greatly underestimate this risk. They are enjoying a free lunch—in the last chance saloon.
Read the whole article at: http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=348885&story_id=13988598
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