ROUBINI ON FINANCIAL REFORM

Bill Breakstone, July 14, 2010


INTRODUCTION

The New York Times carried a featured article by Louis Uchitelle in the Sunday Business Section on July 10th about former Fed Chairman Paul Volker and his views on the Financial Reform Bill currently before Congress. Volker, who is now Chairman of President Obama’s Economic Recovery Advisory Board, was the author of the so-called Volker Rule, which places limits on the activities of Wall Street commercial and investment banks. Though the restrictions were much watered down in the final version of the Bill, they are still endorsed by Volker, though less wholeheartedly than the original version.

Two additional articles appeared in the Times on Tuesday, July 13th, one by Andrew Ross Sorkin about former Treasury Secretary Hank Paulson’s views on the Financial Reform Bill now before the Senate, and assured of passage after Monday’s decision by three Republican senators to vote in favor of the legislation; the other about the EU Central Bank’s new restrictions on executive compensation, a measure that should be mirrored here in the U.S., but has not even been proposed at this point and with the power of the banking lobby, would have little chance of even making it onto the table.

A quite famous economist has recently written extensively on economic crises in an excellent new book entitled Crisis Economics: A Crash Course in the Future of Finance. Its author is Nouriel Roubini, often referred to as “Dr. Doom” for his dire predictions leading up to the present crisis; its co-author is Stephen Mihm, a professor of history at the University of Georgia. Roubini is a professor of economics at New York University’s Stern School of Business. He is a frequent guest on cable network business programs, and I find him extremely difficult to follow. His speech is so rapid fire and his foreign accent so marked that in person he is nearly unintelligible. However, Roubini is absolutely brilliant, and his thoughts shine in print like the brightest searchlight on a sea of turmoil.

Crisis Economics is indeed a crash course on our economic troubles, the past history of economic crises, and a detailed examination of today’s world economy. With the economic news coming in rapid fire succession these days, especially that pertaining to reform legislation as noted above, an examination of Roubini’s work is particularly pertinent.

Chapter 8 is the heart of this study, and contains “First Steps” that should be considered to prevent a recurrence of the disaster. What follows is an overview of its contents.


COMPENSATION REFORM

“The biggest problem with compensation is not the amount of money involved; it’s the way this compensation is structured and delivered. Absent any direct or indirect oversight from shareholders, traders and bankers have every incentive to do crazy things that maximize their short-term profits and bonuses (like rustling up a bunch of toxic CDOs [credit default obligations] and leaving them hanging on the bank’s balance sheet). By the time the bank blows up, the traders and bankers have already spent the money on fast cars and that summer place in the Hamptons. And if recent history is a guide, it’s easier to get money back from Bernie Madoff than it is to claw back a trader’s bonus.”

New Restrictions on Stock Bonuses
“When employees are compensated with restricted stock, provisions should be put in place that force them to hold these shares for an even longer time than is now customary. Currently, many vesting periods are limited to a few years; they should be extended. Employees should be restricted from selling the stock until their retirement, or at the very least, for well over a decade.”

Change the Bonus Culture
“The bigger issue is the bonus culture of Wall Street, in which employees are compensated when their bets pay off, but are not penalized when those bets cost the firm money. This system encourages risk taking that generates oversize ‘alpha’ returns in the short term, with little consideration of long-term consequences.”

“One way to fix this mess would be to create bonus pools that aren’t calculated on short-term returns but are based on a longer time horizon—say, three years or so. Instead of rewarding its employees for making their particularly canny bets, a firm averages their performance over the course of several years.

Compensate With the Products They Create and Sell
“The problem of compensation has a more diabolical solution: to compensate traders and bankers not with money or with stock but with the very same esoteric securities that they’re cooking up in their laboratories. Traders and bankers would get bonuses, but in a very specific form: a little slice of, say, that CDO that they had a hand in making. If traders cook up toxic securities, they get paid with the same. The thinking here is that if traders know that the proverbial chickens will come home to roost in their bonus package, they may be a little bit more careful about the eggs they lay.”

Across-the-Board Implementation
“Whatever change in compensation is ultimately adopted should be implemented across the board. If one major financial firm adopts some version of compensation reform but no one else does, employees from the more prudent firm will likely flock to high-rolling firms, where they’ll be better compensated.”

“That means government must be involved. In the United States, only the federal government has the power to reform the compensation system in comprehensive fashion. It has plenty of justification for doing so: the government—or more to the point, the taxpaying public—has effectively bailed out and backstopped the entire financial system and has a cogent interest in making sure it doesn’t have to do it again.”


REFORMING THE SECURITIZATION PROCESS

“Compensation is hardly the only problem that cries out for reform; the elaborate system of securitization that helped cause the recent crisis must be fixed as well. In the originate-and-distribute model of securitization, a potentially risky asset—a subprime mortgage, for example—was pooled with similar assets and turned into securities that would be sold to investors better able to tolerate the risk.”

“One obvious flaw with this system was that it reduced incentives for anyone to actually monitor the creditworthiness of the borrower. Instead, the various players in the securitization process pocketed a fee while transferring most, if not all, of the risk to someone else. Everyone was complicit in this chain: the mortgage broker who handled the initial loan; the home appraiser, who had every incentive to give inflated values; the bank that originated the mortgage and used it to make mortgage-backed securities; the investment bank that repackaged these securities into CDOs and far more esoteric investments; and the rating agencies that bestowed coveted AAA ratings along the way; and the monolines [insurers a la MBIA] that insured those toxic tranches.”

"Any solution to the problem of securitization must somehow force these different players to more carefully consider the risks involved. In other words, each player must somehow be encouraged to pay more attention to the quality of the underlying loans. One way to do so is to force intermediaries—the originating bank and the investment banks—to hold on to some of the MBSs [mortgage backed securities] or CDOs in question. Forcing them to retain some risk, the thinking goes, will induce them to de a better job of monitoring the creditworthiness of the original borrowers (and leaning on the mortgage brokers and others who serve the first link in the chain).”

"[But] forcing firms to retain risk won’t do much to resolve an even more pressing problem: the fact that securitization has, despite government subsidies, all but ceased. Securitization in the go-go years was a bit like sausage making before the creation of the Food and Drug Administration [FDA]: no one knew what went into the sausage, much less the quality of the meat. And so it remains today: financial institutions can still churn out the sausage, but given what we know might (or might not) go into these things, is it any surprise that investors have lost their appetites? What we need are reforms that deliver the peace of mind that the FDA did when it was created.”

Standardization
“At the present time, there is little standardization in the way asset-backed securities are put together. Information [deal structures and monthly service performance reports] should be standardized and pooled in one place. We must have some way to compare these different kinds of securities so that they can be accurately priced. Standardization, once achieved, would inevitably create more liquid and transparent markets for these securities. That’s well and good, but a few caveats also come to mind. First, bringing transparency to plain-vanilla asset-backed securities is relatively easy; it’s more difficult to do so with preposterously complicated securities like CDOs, much less chimerical creations like the CDO2 the CDO3.”

Regulating the CDO Market
“For that reason, securities like CDOs must be heavily regulated if not banned. In their present incarnation, they are too estranged from the assets that give them value and are next to impossible to standardize. Thanks in large part to their individual complexity, they don’t transfer risk so much as mask it under the cover of esoteric and ultimately misleading risk-management strategies.”

“The most important angle of securitization reform, then, is the quality of the ingredients. In the end, the problem with securitization is less that the ingredients were sliced and diced beyond recognition but that much that went into these securities was never very good in the first place. Put differently, the problem with originate-and-distribute lies less with the distribution than with the origination. What matters most is the creditworthiness of the loans issued in the first place. The existing regulations and guidelines must be beefed up and given real teeth to ensure that what ends up in the securitization pipeline isn’t toxic.”


REFORMING RATINGS

“In the United States, three major private rating agencies—Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings—wield remarkable power, slapping grades on everything from mortgages to corporate bonds to sovereign debt of entire nations. These grades reflect the likelihood that the borrower or borrowers will default on their debt, and they are central to how financial markets ascertain risk. In effect, ratings are a way to outsource due diligence.”

Inherent Conflicts of Interests
Originally, rating agencies were paid by investors, who paid them to evaluate potential investments. That was too easy for investors to get around, so the agencies business model changed. By the 1980s, the issuers of debt had assumed the responsibility of paying the agencies for the rating of the debt they were issuing. Now the agencies were insured against losing revenue when investors “cheated the system.”

“This arrangement, however, created a massive conflict of interest. Banks looking to float some securities could shop around the agencies to find the best rating. A rating agency that looked at a proposed offering and slapped a subprime rating on it risked losing business. Increasingly, the rating agencies had an interest in giving the customers what they wanted—and if a customer wanted a AAA rating for an MBS made up of subprime mortgages, there’s a good chance that’s what it got.”

“As if that weren’t bad enough, the rating agencies started to generate revenue from other, equally problematic sources. A bank putting together a structured financial product would go to one of the rating agencies and pay for advice on how to engineer that product to attract the best possible rating from the very agency the bank would ultimately pay to rate its securities. This service was described as “consulting” or “modeling.” Perhaps. In fact, it was a bit like a professor’s accepting a fee in exchange for telling students how to get an A on an exam. That’s not kosher.”

Possible Solutions
First, “agencies must be forbidden to offer any consulting or modeling services. They should exist for one purpose: to assign a rating to a debt instrument. That’s it; anything more introduces a possible conflict of interest.” This prohibition should be strictly enforced by the SEC.

Second, “it also makes sense to open up the competition in this privileged realm. Unfortunately, the SEC makes it very difficult for new companies to obtain that coveted NRSRO” [Nationally Recognized Statistical Rating Organization] designation, which is required for rating agencies to operate. In one of the many paradoxes often found in the regulatory world, to achieve that designation requires a certain level of experience enumerated in years of practice. Yet without the designation, new entries can not obtain that experience. Thus, “the SEC needs to lower the barriers to entry, so that more competition—free market competition, if you will—enters into this vitally important industry.”

Third, “and more radical still would be to take away the semiofficial role that the rating agencies now enjoy. Everything from SEC regulations to world-wide capital requirements governed by international financial agreements [Basel I and II] formally recognize the NRSROs [those rating agencies carrying the imprimatur of the NRSRO] as the only place from which ratings can be obtained. That recognition invests them with disproportionately, if not excessive, power. Taking that power away would be another way of opening up competition.”

Fourth, “an even more comprehensive reform would be to force the rating agencies to return to their original business model, in which investors in debt—not the issuers of it—pay for the ratings."


DEALING WITH DERIVATIVES

Warren Buffett, in 2002, refereed to derivatives as “financial weapons of mass destruction.” He warned: “They carry dangers that, while now latent, are potentially lethal.” He forecast “the derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.” How right he was!

Now back to Roubini’s text:

“A derivative is simply a bet on the outcome of some future event: a movement in interest rates, oil prices, corn prices, currency values, or any number of other variables. They go by various names—swaps, options, futures—and they’ve worked just fine for decades, enabling people to “hedge” against risk.”

The Credit Default Swap Market
“But in recent years derivatives have grown into something altogether different, thanks to the rise of several new varieties, such as the credit default swap (CDS). It superficially resembled insurance in that it allowed a buyer to purchase protection in the event that a debtor defaulted on his obligations. If that happened, the seller of the “insurance” would be on the hook to help the buyer recoup his losses. However, unlike an insurance contract, the purchaser of a CDS didn’t have to actually own a chunk of the asset that was the subject of the bet. Worse, anyone who had placed a bet that someone would default had every incentive to make this happen. In these cases, purchasing a CDS was akin to buying homeowner’s insurance on a house that you didn’t actually own—and then trying to set fire to it.”

“The CDS market grew from next to nothing to astonishingly large. By the time the crisis broke in 2008, the notational value of CDSs (the amounts of money being insured) topped out at $60 trillion.”

When Brooksley Born, head of the Commodities Futures Trading Commission (CFTC) attempted to regulate the CDS market back in 1998, the financial powers in Washington and on Wall Street read her the riot act. Worse, the Congress passed the Commodity Futures Modernization Act that exempted CDSs and other over-the-counter (OTC) derivatives from regulation by the CFTC! Thus, the stage was set for the enormous expansion of the derivatives market, exactly what Born was warning against.

The Toxicity within the CDS Market
Danger number one: CDSs traded on the OTC market. “The key phrase here is “over the counter.” It might seem to be the opposite of “under the table,” but in fact “under the table” is as good a definition as any of an OTC transaction. OTC transactions are ones in which the derivative contract is signed by two private parties—typically a “bilateral contract,” to which no one else is privy. The lack of transparency is complete: no one knows the extent of anyone else’s exposure, much less where it’s concentrated.” This was exactly what the CFTC was proposing to reform, then so brutally stopped in its tracks. It is also what the current financial reform legislation is attempting, finally, to create: transparency in the derivatives marketplace.

Danger number two: counterparty risk, the chance that the institutions that had sold this “insurance” would be unable to make good on their promises, particularly during a systemic financial crisis. Read AIG! Or, as Roubini writes, “In effect, counterparty risk created a financial system that was not only too big to fail, but too interconnected to fail.” AIG’s inability to make good on its derivative contracts threatened every counterparty it had, Goldman, Citi, Morgan, and right on down the line.

Derivatives have been at the epicenter of a number of other financial crises—the 1987 stock market crash; the 1994 collapse of the Orange County, CA pension fund; the 1998 failure and bailout of LTCM; and the boom and bust in oil prices in 2008.

“Given this rap sheet, banning derivatives may seem like a good idea. But it’s not: most derivatives operate without ill effect. What we need to do is control the excesses that certain derivatives can cause.”

Controlling Excesses in the Derivatives Market
“First we must correct the problem of transparency. True, some derivatives have long been traded over the counter without problems—like plain-vanilla interest rate swaps—and could reasonably remain that way. But CDSs are another story altogether. These must be brought into the light of day and subjected to rigorous regulation by the SEC and the CFTC.” Choices of action include (1) forcing credit derivatives onto the kind of central exchange similar to where simpler derivatives are bought and sold; (2) registering the more esoteric credit derivatives in a central clearinghouse and making certain that the parties to a derivatives contract have sufficient collateral to make good on their promises; (3) insuring that investors in CDS contracts have an “insurable interest”: a direct stake in the outcome; (4) banning insurance companies from selling these guarantees—the only ones trafficking in these instruments should be hedge funds and other high-risk players in the financial markets, and they should be subject to rigorous margin and collateral requirements via a clearinghouse; and, finally (5) changing the relative responsibilities of the SEC and CFTC. These agencies regulate different slices of the derivatives market, effectively dividing regulatory authority. Consolidating the responsibility for overseeing all derivatives within a single agency would permit a more systematic approach to regulating and supervising derivatives and, more important, reducing the potential threat they pose to the stability of the international financial system.”

“These suggestions are not a cure-all. Derivatives have gone from being a means of hedging risk to a purely speculative instrument that permits often naïve investors—pension fund managers, for example—to assume massive amounts of leverage and risk. Increasingly exotic, opaque, and impenetrable to non-specialists, they pose a very serious danger to the financial system that the foregoing reforms alone will not cure. For this reason, the new generation of derivatives should be the subject of far more systematic and ruthless scrutiny by regulators.”


THE BASEL ACCORDS

“The continued existence of derivative contracts, especially those of an exotic nature such as CDSs, pose a risk to global economic stability. That stability has to be shored up worldwide. That means examining some of the global guidelines that shape how banks do business. The quaint Swiss city of Basel is home to an important institution that plays a vital role in that regard: the Basel Committee on Banking Supervision. While its recommendations are nonbinding, it nonetheless carries a great deal of weight. Much of the financial system as it existed on the eve of the crisis was a creature of the Basel Committee’s guidelines.”

Basel I
“Those guidelines, or accords, have evolved over the years. The first accord, known as Basel I, asked banks to differentiate between the various classes of assets they held in order to better asses the relative risk posed by holding them. This risk assessment would affect how much capital a bank had to hold. Basel I had a few other stipulations. Banks that operated in multiple countries had to hold capital equivalent to 8 percent of their risk-weighted assets.”

“The first Basel accord went into effect in the 1980s, and by 1992 most of the G-10 had adopted its recommendations. Many emerging market economies voluntarily adopted these guidelines too, as a demonstration of financial stability and prudence. Unfortunately, standards that made sense for advanced industrial economies proved more difficult for emerging economies to maintain, particularly in times of crisis, and proved their undoing.”

“No less troubling, bankers had found ways to hide risk that Basel I did not anticipate—for example, by securitizing assets. These sleights of hand gave bank balance sheets the appearance but not the reality of stability. Bankers had obeyed the letter but not the spirit of the Basel I guidelines.”

Basel II
“These failures led to Basel II. While its predecessor had filled a mere 37 pages, the new accord was almost ten times as long. It gave much more precise technical guidelines on weighing the relative risk of various assets; suggested methods for making these calculations; expanded the definition of risk to encompass other perils; sought to close various loopholes by which banks had hidden risk; urged regulators to move more aggressively to monitor compliance with capital reserve requirements; and spelled out terms by which banks would make their financial condition public. Though many European nations wanted Basel II to apply to all banks, the United States, Canada, and the United Kingdom successfully argued that it should apply only to large international banks.”

G-10 member nations had hammered out a final version of Basel II in 2006 that went to the individual members for implementation when the crisis hit. It immediately became apparent that the new accord had serious flaws. “Simply stated, Basel II assumed that the world’s financial system was more stable that it actually was. This was a serious mistake.”

“The crisis underscored several realities. One, banks needed higher-quality capital and more of it. Two, the “Capital buffer” that many banks had established was nowhere near large enough to shelter them from the kind of shock delivered by the housing bust and the credit crisis. Three, the quality of capital as defined by Tier 1 and Tier 2 could deteriorate significantly in a time of crisis.”

Basel III
Roubini’s book went to press prior to the most recent round of conferences in Switzerland, which are being held on July 14th and 15th. Basel III attempts to address the flaws mentioned in the preceding analysis by the author. New guidelines will force banks to top up their capital and curb risks in order to avert a repeat of the financial crisis. They will also address such issues as accounting standards and globally agreed rules on how to measure the value of bank assets and liabilities. The new reserve requirements, as they now stand, are much higher than those contained in legislation already approved by the Obama administration and to be voted upon in the coming days, and bankers around the world are already up in arms, saying that they will choke off the economic recovery. The Bank of England Chief Cashier, Andrew Bailey, said Basel III must be a “robust standard” but the timing of implementation could be “handled quite sensibly. Achieving financial stability by killing the economy is not something we want to do.”


CONCLUSIONS

“Skeptics might reasonably point out that if investors want to pay through the nose for the privilege of alpha—or schmalpha—returns, that’s their business. But the rise of a small coterie of incredibly powerful, opaque financial firms has generated a far more unsettling problem. These firms now house a staggering assortment of financial functions: everything from securities origination and underwriting, market making and dealing, prop trading , private equity, hedge funds, and asset management to bread-and-butter banking. The interconnections among the handful of surviving firms, have created a system that is extraordinarily vulnerable to systemic risk.”

“Moving most trading from OTC markets that rely on market makers/dealers to exchanges would reduce these rent-extracting distortions but, more important, would radically reduce the counterparty risk that makes the financial institutions too interconnected to fail. Indeed, the more that transactions occur on exchanges, the less the system becomes interconnected as counterparty risk is significantly reduced.”

“Not only do we need to reduce the too big to fail problems by making each institution smaller, we also need to unbundled financial services within financial institutions to reduce the too-interconnected-to-fail problem: with exchanges, broker dealers would be involved only in the efficient execution of trades for clients, not in market making/dealing, which is rife with conflicts of interest, lack of price transparency, and large systemic counterparty risk. So we need to go back to Glass-Steagel, and even beyond it, to a financial system in which both institutions and their activities are unbundled to make them less too big to fail and too interconnected to fail.”

“In short, the concentration of financial power has created a system that is too interconnected to fail. The proposals outlined in this chapter represent the first steps toward curing these problems. But far more radical reforms must be implemented if the financial system is to achieve any semblance of stability in the coming years.”

That’s another chapter. You can read it on your own.