In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks. Seriously, how many times have you read that more capital will save the banks from another Armageddon? Even the banks point to capital as a reason to have faith. “Financial institutions have also been working alongside regulators to make themselves and the financial system stronger, more transparent, more resilient and more accountable,” wrote Rob Nichols of the Financial Services Forum, which is made up of the chief executive officers of 19 big U.S. financial institutions. “Specifically, capital, which protects banks from unexpected losses, has doubled since 2009.” If you were a cynic — who, me? — you might say that the mere fact that the banks are pointing to capital is proof that capital is not all that.
Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct. On his Interfluidity blog (which I found courtesy of Naked Capitalism), Steve Waldman writes, “Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital,’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank.” In other words, even if you give bankers credit for good intentions, the accounting that would truly capture “capital” may not exist. Or as Waldman writes, “Bank capital cannot be measured.” Layer in some real world realities. The next time things get tough, will regulators once again practice forbearance and allow firms to overstate their capital, which has the perverse effect of making no one trust reported capital? Let’s not forget Lehman, which according to Lehman had a very healthy Tier 1 ratio of 10.7 percent on May 31, 2008 and a total capital ratio of 16.1 percent. This didn’t matter, because no one believed Lehman’s capital was real.
On the list of cures for the sick financial system, the concept of “risk retention” ranks right behind capital — but there are a couple of neat little twists here. The narrative of the crisis is that because mortgages could be sold off to banks, who would turn them into securities and sell those on to investors, who thought they were buying triple-A paper courtesy of the rating agencies — well, no one had any incentive to care about credit quality. In a piece in the Wall Street Journal entitled “How to Create Another Housing Crisis,” MFS Investment Management’s former chairman Robert Pozen writes, “With ‘no skin in the game,’ the originators had little incentive to determine whether the borrower was likely to default.” As a result, one provision of Dodd-Frank requires securitizers of any asset, not just mortgages, to retain 5 percent of the risk of loss. Barney Frank has said that the risk retention rules are the “most important aspect” of the legislation that bears his name.
The first twist is how risk retention became risk liberation. The housing-industrial complex went to work. Into Dodd-Frank went a provision that certain “safe” mortgages, called qualified residential mortgages, or QRMs, would be exempt from the risk retention requirement. “Safe” was left to the regulators to define. Cue more lobbying. The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement. In other words, the very asset that most people believed led to the credit crisis is also the asset that is pretty much exempt from the new rules! Classic. In the joint announcement on August 28, the regulators wrote, “The Commission acknowledges that QM does not fully address the loan underwriting features that are most likely to result in a lower risk of default. However, the agencies have considered the entire regulatory environment, including regulatory consistency and the possible effects on the housing finance market.” (That last bit is super scary.)
That said, the real twist here is that risk retention is no silver bullet. After all, firms like Countrywide, Washington Mutual, Merrill Lynch, AIG and Citigroup went under or almost went under precisely because they retained so much risk on their own balance sheets. Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.