Summer Rerun: The Administration’s Cosmetic Credit Market Reform

This post first appeared on March 13, 2008

Never expect a group with members ideologically opposed to regulation to come up with a wide ranging reform program, no matter how badly one is needed. An individual can have a Nixon-goes-to-China moment, but not a committee.

Later today, no doubt with great fanfare, Hank Paulson will announce the plans devised by the President’s Working Group on Financial Markets to prevent the sort of credit mess we are in now from recurring. But these proposals are so toothless and narrowly conceived as to be close to useless.

Perhaps there will be more to these ideas than was pre-released to the Wall Street Journal, but the list is underwhelming. The biggest failing is that they do not address the lousy incentives that lead the many parties in the origination chain to conspire (whether consciously or not) against investors. Note than in any securities offering, there is always tension between how to balance the needs of the issuer and the investors. But this plan does virtually nothing to rein in the perps who created this mess.

Let’s go to key elements as reported in the Journal. No doubt anticipating Paulson’s speech, the article presents the program as comprehensive:

Their recommendations extend to nearly every niche in the credit markets — from mortgage brokers to the Wall Street firms that package home loans into securities, to the credit-rating firms that assess the risk of those securities, to the regulators who police the system.

It’s anything but that. First, the mortgage brokers:

The group will also recommend implementing what he termed “strong nationwide licensing standards” for mortgage brokers, a move that will probably require legislation.

Getting the mortgage brokers under some sort of regulatory umbrella is important. But what good is mere licensing? That assures perhaps a minimum standard of training, say getting education and sitting an exam. But any licensing proposal is useful only if there are also clear standards of conduct (particularly violations that would lead to liability) and enforcement. And which agency would be responsible for mortgage brokers? The OCC? HUD?

Without strong regulations (or legislation that defines conduct so that violations could be pursued in court) and an adequate enforcement budget, this initiative will accomplish nothing. Indeed, this Federal land-grab will prevent the states, who in many cases would be highly motivated to oversee brokers, given the damage falling housing prices have inflicted on local economies, from stepping to the fore. And even if the initial version of this regime were to have teeth, expect it to become hobbled quickly. The SEC’s enforcement efforts are woefully understaffed, and pro-consumer SEC commissioners like Arthur Levitt have been told by Congress to lay off or face deep funding cuts.

The other measures are equally dubious:

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.

The only bit that is novel and potentially useful in this list is forcing the ratings agencies to get more inquisitive about the quality of the borrower due diligence by the loan originators. But again, this could quickly devolve into a box-checking exercise. For this measure to be effective, the issuers and/or the rating agencies need to suffer financially if loan originators have lax procedures. That doesn’t appear to be under consideration.

The other two ideas are “horse has left the barn” measures. By now, anyone who reads the financial press knows ad nauseum that ratings for structured products are radically different than for, say, corporate issuers (it’s unheard of for a corporate borrower to go from AAA to junk in a single day, as has happened to a fair number of “mezz” CDOs). Similarly, rating agency conflicts have been widely discussed in the media. Is it really going to add anything to have a few paragraphs in an offering document detailing what the rating agency got paid by the issuer on this and other deals?

Back to the proposals:

Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about “the level and scope of due diligence” and about the underlying assets of the securities. The panel is also seeking disclosure of whether “issuers have shopped for ratings” — that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.

The first measure will probably be ineffective. The issuers will develop high level language describing their processes, which will probably be a bit more stringent given the need to restore credibility. The shopping the ratings provision sounds as if it could be useful, but in fact, the process of developing a structure is iterative, and (as I understand it) done with a chosen rating agency. So my impression is that a structure isn’t shopped very often; instead, a deal is massaged repeatedly until the rating agency signs off on it. So I have my doubts as to how often this provision will actually prove to be of use (as in how much rating shopping it will forestall).

Back to the WSJ:

And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.

So they are handing off a hot potato to “global bank regulators.” Clever.
More on regulation:

The recommendations call on bank supervisors to give much more scrutiny to the due diligence, risk management, and risk awareness policies at banks. Regulators will be pushed to work more closely with the Financial Accounting Standards Board to revisit accounting issues and make sure that exposures at financial companies are properly measured “across business lines.”

This would be useful, but I guarantee will not get adequate funding (more supervision means more bodies), and more important, the staff will not be upgraded to have adequate skills (there are going to be a lot of unemployed people on Wall Street soon, and a stint in DC is a good way to mark time. But I doubt enough of an effort will be made to bring in new blood with relevant skills).

The most revealing comments:

“We are going to be mindful when we implement it to not create a burden,” Mr. Paulson said. “But we think it’s very appropriate to lay out some of the causes and some of the steps that need to be taken…to minimize the likelihood of this happening again.”

We have a process that has destroyed what will probably be trillions of dollars before all is said and done, but Paulson nevertheless worried about not inconveniencing the perps.

And the last tidbit:

Mr. Paulson also is planning to encourage the development of a domestic market for “covered bonds,” bonds issued by banks that are secured by mortgages. Popular in Europe, these could be an alternative to securitization. When mortgages are securitized, they generally leave bank balance sheets and banks don’t hold capital against them; covered bonds remain on bank books, and banks must set aside capital to back them.

That’s a backhanded admission this program is likely to fail and as a result, securitization will not return to its former levels. Covered bonds, or any form of mortgage finance that requires a bank to use its balance sheet is inherently more costly than securitization and also requires banks to carry vastly more equity if they are to use this product on a large scale basis. Umm, banks are kind of short on capital as it is.

Time for a rousing chorus of the Titanic song (the version I learned had slightly different lyrics, but it’s wonderfully perverse, since the tune is quite peppy. Unfortunately, I an unable to find a good online rendition,).