Opinion

Felix Salmon

How to fix the US financial system

By Felix Salmon
November 10, 2009

I had a very interesting conversation with Bob Pozen yesterday evening; his new book is out now, and I highly recommend it. It’s the first crisis book to make a detailed series of specific recommendations about what needs to be done going forwards — or, in the words of the book’s subtitle, “how to fix the US financial system”.

These recommendations are sprinkled liberally throughout the book, and are helpfully presented in bold type. Whenever I came across one, I scribbled the page number on the back flap of my copy, in one of four columns. The first column was recommendations I agreed with, or which were at least a step in the right direction; the next two columns were for recommendations I thought didn’t make complete sense or were questionable, and the final column was for recommendations I thought were bad ideas. The final tally looked like this:

index.jpg As you can see, Pozen seems to be right (or at least in broad agreement with me) the overwhelming majority of the time. And as you can also see, he makes a lot of recommendations, on everything from accounting standards to insurance regulation. Tyler Cowen is quite right to give the book a rave review.

I’m not in agreement with Pozen on everything: he thinks, for instance, that it’s crucially important to get the securitization market up and running again — complete with tranche structures which require sophisticated modelling — while I think that securitization is inevitably going to be used to shove risk into tails and appeal to investors who don’t fully comprehend what they’re buying.

I’m also not fully convinced by one of Pozen’s big ideas, which is that banks should have small and professional super-boards which, rather than simply rubber-stamping the decisions of the CEO, take a much more active interest in the way the bank is run; Pozen has in mind here the governance structures at companies owned by private-equity shops. (Indeed, he wants to encourage more private equity companies to own and invest in banks.)

My view is that the rates of return targeted and required by private-equity investors are far too high for banking, which should be a boring industry, and that even if safeguards are put in place to stop PE-owned banks from lending to sister companies, management at such institutions will try as hard as they can to bend the rules to maximize leverage and profits. And that they will be positively encouraged to do so by their small super-boards.

Pozen, on the other hand, is fundamentally bearish on the business of banking, telling me that “if all you do is make traditional loans, you will lose money and you will go bankrupt”. I don’t think that’s true, but insofar as it is true of banks, it’s also true of investors who buy securitized loans originated by banks — so securitization is not really a solution to the problem. More generally, I don’t like the idea of creating a banking system where banks run around trying to make money on clever innovations because they’re losing money on their core loan products. It sounds like a recipe for disaster to me.

Some of Pozen’s other ideas are really good, though, like capping FDIC guarantees on bank debt at 90%. He also thinks that AIG Financial Products should declare bankruptcy, perhaps along with the parent company, which would give its counterparties a lot of incentive to settle their claims at say 70 or 80 cents on the dollar.

What’s pretty obvious though is that most of Pozen’s recommendations will not be enacted. Which raises the obvious question: if we don’t do this, what’s going to happen to the financial system and the economy? Pozen’s answer: we will have more crises, they will be increasingly severe, and they will be increasingly frequent. I agree.

One of the tragedies of the current crisis is that far too many people consider it to be an anomaly, a once-in-a-century event. It isn’t. The recipe for this crisis — a complex global financial system with large imbalances and inadequate controls — remains in place today. And financial crises are common things: even if you exclude emerging markets, there’s generally one somewhere in the world every year or two.

We can’t afford the trillions of dollars it would cost to rescue the world from the next crisis — yet at the same time we’re doing very little to minimize its effects or the probability of it happening. It’s a very risky game that we’re playing, and it’s liable to end in tears. Which is one reason why I’m so keen on Paul Volcker’s idea that we should eliminate the tax-deductibility of debt interest. That’s a big one: so big, indeed, that Pozen doesn’t dare even consider it in his book. But that’s the kind of ambition that we need to have if we’re going to seriously curtail crisis risk in the global economy.

Update: Pozen writes to say that he thinks some of his proposals — like regulating hedge funds and derivatives, as well as reforming loan securitization — will indeed happen. He also adds:

I was exaggerating when I said that traditional commercial loans would lead to bankruptcy as a way to driving home my point that traditional unsecured loans have a terrible risk-return relationship — with no upside and a lot of downside.

Still, if that’s true of the loans, it’s true of the securities made from them, too. So it’s hard to see how securitization is the great solution that Pozen thinks it is.

Comments
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“My view is that the rates of return targeted and required by private-equity investors are far too high for banking, which should be a boring industry”

I think you miss an important point here. If his proposal should make any sense, those on that board would be those who took home the lions share of the bonuses to their PE. That way ownership and competence would once again be presumed to be on one hand instead of split between owners who knows nothing and managers who takes the lions share.

Posted by Gaute | Report as abusive
 

That’s a lot of bandaids.

 

“…also thinks that AIG Financial Products should declare bankruptcy, perhaps along with the parent company, which would give its counterparties a lot of incentive to settle their claims at say 70 or 80 cents on the dollar.”

That would have been a great idea, about a year ago. Before the government stepped in and paid off hundreds of billions of dollars in claims, at 100 cents on the dollar. Now that the government owns 80% of AIG, how would that help recoup the money it gave to companies like Goldman Sachs?

Pozen also says ““if all you do is make traditional loans, you will lose money and you will go bankrupt”. How did banks exist for centuries doing just that? They borrow money at 3% (or even less, now thath govt provides capital for almost free) and lend it out at 5%. They increase their profits by making larger loans, and doing a good job of picking out borrowers that won’t default. Or is Pozen implying that it’s impossible for anybody now to make loans without less than 1% of them defaulting with no recourse? If banks required 20% down on mortgages, they wouldn’t have lost anywhere near as much as they have in the last few years.

“What’s pretty obvious though is that most of Pozen’s recommendations will not be enacted. Which raises the obvious question: if we don’t do this, what’s going to happen to the financial system and the economy? Pozen’s answer: we will have more crises, they will be increasingly severe, and they will be increasingly frequent. I agree.”

It’s guaranteed. The financial system has way too many positive feedback loops, which ultimately lead to instability. There is more money in the economic system then ever before, which means the magnitude of corrections will be greater, and since communication is virtually instant, the time between cause and effect, and the second order response, is almost instant, which increases the frequency of spikes and noise.

“We can’t afford the trillions of dollars it would cost to rescue the world from the next crisis”. Well, since money is just printed up by all of the major economies, we (the world) can actually afford every crisis. All it does it revalue currencies and assets. People with assets won’t like it, but those without assets aren’t going to be as affected by it. Which is the way it should work, as the problems are mostly caused by the people with assets, who are constantly playing games (they call it financial innovation) to get more assets.

I haven’t read the book, and probably won’t. It doesn’t matter, even if Pozen is 100% right, his suggestions would never get implemented by Congress. Congress doesn’t really care about solving problems, they only care about appearing to trying to solve problems, so they can brag about it when running for re-election. And you want to eliminate crisis risk? What politician would want to do that? Crisis’s give them their reason for existence.

 

I am a little confused by your use of the term “securitization.” Could you please define it?

And explain how securitization differs in substance from loan “participation?” In both cases the original lender sells off parts of a loan to others, thus recouping their capital so as to make more loans. What’s wrong with that?

As well you seem to imply that securitized loans are not collateralized? Do I read you correctly? But isn’t it true that the problems in securitized loans are in real estate, which by its nature is collateralized. The only question is whether the collateral is correctly valued.

My own take is that securitization in theory simply broadens the ability of people, who are (we hope) skilled in judging risk, to make loans. It would seem that if “lenders” were forced to keep significant skin in the game by limiting their ability to sell loan packages to, say, 95% of the loan, then that would limit the risk to the buyers of that securitized loan.

Felix, you have written before with great doubt about securitization and I hope you will expand on your concerns. It is a very interesting subject. FHA and VA, for example, have securitized loans for the past 60 years and I think that the default rate has been very low. So what’s wrong _in theory_ with securitization?

 

Obama he promised to straighten Bush’s mess out Two Wrongs don’t make a right, By the way I found a website that give you prizes for your opinions and 4 play games here is a topic about this:
http://opinion.ezwingame.com/topics/who- do-you-blame-for-the-economic-crisis1

Posted by paty_cool | Report as abusive
 

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