It has been a year since the Federal government absorbed Fannie and Freddie and crossed, however unknowingly, the Rubicon of nationalizing the consequences of private risk-taking. A few weeks later we had Lehman, and then immediately the drunken fire brigade: Reserve Fund, AIG, the conversion of Goldman and Morgan Stanley, and TARP and its variants.
Now that the dust has settled somewhat, let’s pretend we have a plan. In fact, let’s make one.
The good news is that a bunch of smart people have been thinking about this very topic. Simon Johnson and James Kwak at Baseline, Mike Konczal at Rortybomb, Elizabeth Warren, Jeremey Bulow, Willem Buiter. Even the brilliant, charming, and witty Taunter has weighed in. The bad news is that no one in power is paying attention.
Part of the challenge – and it is the same challenge we find in health care – is that a solution does not lend itself to incremental changes. There is an entire Washington Consensus of incrementalism – David Brooks embodies this belief – that believes we are either so perfect or so conservative that we cannot possibly make major changes in the way we do business. This is wrong historically; within a hundred days of taking office, FDR jammed through the Emergency Banking Act, creating a bank holiday and then reopening shuttered banks, took the US off the gold standard we had followed since inception, passed the Agricultural Adjustment Act, launched the Tennessee Valley Authority, and for good measure repealed Prohibition. More to the point, moderation only works to the extent that the solutions allow for an intermediate position. If you are alarmed by the prospect of flying hundreds of miles per hour in an airplane, slowing the airplane to walking pace induces a stall, not greater safety.
The New Deal balkanized American finance; between Glass-Steagall and the McFadden Act, we had something like 150 parallel financial systems: state-limited insurance, commercial banks, and investment banks. The intermediate solution was to creat a 151st: the nationally chartered bank. Eventually Phil Gramm came along and tore down most of these walls. In the meantime, the enormous growth of the pension/retirement scheme/endowment business worldwide (both private and public sector) created a parallel version of the entire regulated financial sector as giant institutions with very long-duration liabilities tried to find some method of matching these obligations; the Jimmy Stewart banking world, after all, presumed that banks borrow short and lend long. Throw in some globalization – Japan, the Gulf States, and then China all looking for places to put foreign earnings that, for a variety of political and economic reasons, had no productive use at home – and we found ourselves in a situation where a sleepy government agency that was supposed to bring stability to Middle America’s mortgage market could pull the global economy off a cliff.
Let’s go back and ask a question we haven’t heard much in the past year: what functions require government protection? I would make the argument that there are only two:
- Any depository or custodial activity;
- Any transaction with the great unwashed.
The New Dealers recognized the importance of deposit insurance. That is what brought us the FDIC. Various states have recognized – to different levels, roughly corresponding to the degree of incompetence of their regulators – that insurance is simply the mirror image; instead of handing over the principal and receiving periodic payments, the customer makes periodic payments and receives the principal. So there is a patchwork of insurance regulation. Larger institutions…well, one of the chief problems that became apparent during the Lehman failure was what happens when a prime broker or custodian goes down and interferes with access to securities held through it?
The other area whose failures have been illuminated by events of the past year is the broad ocean of retail financial transactions. I have generally been on the libertarian side of this debate; I would prefer high, legal interest rates to having individuals frozen out of the market and sent to the black market, and I can see reasons for most alternative mortgage structures. I also believe that when these structures fail, foreclosure should be quick; we should not shy away from the consequences of risk. However, the repeated arguments of Konczal and Warren have had some effect, as has, oddly enough, repeated consideration of the challenges in health care; there really are enormous percentages of the population – almost certainly a majority, if not an overwhelming majority – who do not have the analytical abilities to consider the consequences of every esoteric product Wall Street can dream up, and allowing every instrument to come to market is probably a denial of human experience.
So I would propose, quite simply, to separate the entire financial universe into two groups, the Boring and the Exciting.
Boring status would be required for any company that:
- accepts retail deposits
- makes loans to retail customers, including mortgages
- provides retail insurance, including annuity products
- provides any custodial service beyond traditional settlement (ie if you hold something after T+3, you’re a custodian)
Since the failure of a Boring institution has negative externalities, the government needs to be involved in the supervision of these institutions. Historically, that has simply meant allowing regulators who demand access to have it. No more of that sort of negative obligation. These are positive actions:
- Boring institutions are licensed for nationwide operation.
- If you are Boring, you may have no non-Boring affiliates under common control. No universal institutions, no prop trading arm. However, a Boring institution may carry a full line of Boring products – deposit, mortgages, and insurance, for example.
- Every product offered for sale by a Boring institution needs to be approved for sale by the Consumer Financial Protection Agency. The CFPA will not regulate fees or rates. It will, however, regulate both the form of any transaction and the marketing claims of that transaction, and its categorization of rates and fees will control. For example, a payday loan with a high fee and moderate rate will have to be advertised at its effective APR.
- Boring institutions are forbidden from making or handling any contingent or delayed obligations except as part of approved insurance policies for which the insured party has an insurable interest. A Boring institution can write a homeowner’s insurance policy or a life insurance policy, but it cannot insure a mortgage portfolio in a manner where the insurance can be separated from ownership of the portfolio or enter into a derivative contract where further performance may be required.
- Boring institutions do not have the right to trade or invest for their own account, except to purchase government securities. Among other things, this forbids buying mortgage-backed securities.
- Maximum national market share in any one line of business (including deposits) is 5%.
- Boring institutions do not have the right to choose their own auditor. Instead, the government will appoint and compensate the auditor, and the institution will pay the government a regulatory fee that covers its market-share percentage of the overall supervisory and audit expense of Boring institutions. The government may use internal auditors (the GAO) or contract with external auditors, and may change auditors at its sole discretion.
- Boring institutions do not set the valuations of their assets or the model that determines this valuation. These valuations are determined by the regulator and auditor based on industry-wide models.
- Boring institutions must maintain a Tier 1 capital ratio of 10%. Any deviation below the 10% barrier will immediately cause a bondholder cramdown into common equity until such time as the Boring institution is either in compliance with the 10% ratio or has run out of risk capital to cram down. If at any point in time the Boring institution is not able to cure its deficiency its license to remain a Boring institution is void and the government may seize all of its assets to discharge its regulated liabilities.
The good news about Boring status is that it is a license to make nice, sleepy money. There is price competition – indeed, that is pretty much the only sort of competition, other than convenience – but given the capital requirements, what is really being marketed is cost of capital, and I would expect some level of harmonization. The bad news is that some of the attributes of an independent company – freedom to advertise your products as you wish, freedom to put forward financial statements without prior restraint – are gone, and replaced with the constant peril of immediate seizure. It isn’t a business model for everyone:
For the folks who find Boring institutions a bit too, well, Boring, there is plenty of opportunity at Exciting firms. An Exciting firm can do anything it damn well pleases, except anything that requires a Boring license. So an Exciting firm cannot accept deposits or issue retail loans or insurance. It cannot hold instruments or securities for someone else for longer than three days.
An Exciting firm can be a traditional investment bank, selling its advice, or a modern investment bank underwriting debt and equity transactions. It can be a hedge fund or a private equity fund or a venture capital fund. It can change between these forms at will. It does not need to maintain any specific capital ratio, or any capital at all.
Legend has it that when Cortez reached Veracruz he burned his ships, so that his men would know that retreat was impossible. It’s not exactly true – he scuttled the fleet instead of burning it, was concerned not with retreat but with word getting back to Cuba that he was conquering the mainland, and kept one ship safe to go to Spain for the King’s blessing – but it is instructive.
The key act in separating the Boring from the Exciting is this:
the government, including the Federal Reserve, is legally barred from financially supporting an Exciting firm.
Come Hell or high water, Exciting firms must be allowed to live or die on their own. It is a critical distinction, to be disclosed in every list of risk factors in every annual report or prospectus, to be clearly stated in any contract; the government is prevented from stepping in.
We have an alphabet soup of regulatory agencies that deal with finance today, and most of them are a sort of governmental appendix, a vestigal body with no function and the occasional ability to cause life-threatening harm. There are two different facets of a Boring institution that need to be regulated:
- The products it sells;
- The way it operates
Essentially, we are talking Outside and Inside. Outside regulation is the business of the CFPA, or whatever organization already exists and decides it wants to morph into the CFPA. This agency is a clone of the FDA; it exists solely to ensure that products put into the market by Boring institutions are understandable by the laymen to whom they are sold, and perhaps more importantly, do what their issuers think they do. Originally, the agency will be fought tooth and nail by Borings; in time, they will come to love it, as big pharma loves the FDA and airlines miss the Civil Aeronautics Board, for it defines a common set of ground rules. Compliance with CFPA will also serve as an affirmative defense against the occasional class action suit alleging predatory behavior, which should let legal counsels sleep a bit more soundly.
Inside regulation is equivalent to a greatly enlarged FDIC, and since Sheila Blair has all but gone on American Idol in her quest to lobby every live microphone for more FDIC power, she can have it. It will make her as popular as FEMA or the Centers for Disease Control; every quarter companies will complain about marks that were rejected, and should cramdowns begin, you can be sure there will be plenty of please for leniency.
The SEC and other, more peripheral agencies (eg CFTC) can focus on their core, Far Outside roles; virtually all of the products they touch will be traded among Exciting firms, and in that lightly regulated part of the world the rules that create some semblance of trading fairness are generally acceptable.
That leaves the elephant in the room: the Federal Reserve. While I could easily be convinced to give Inside or Outside responsibilities to other agencies, the one agency that cannot get either responsibility is the Fed. Indeed, one of the main goals of reform should be to strip any sort of oversight responsibility from the Fed. That is not to say that the Fed’s files should be deleted or its regulators sent to the gulag; they can easily regroup at Inside and carry on. But the Fed’s sole mission should be currency stability (yes, this means stripping employment targeting as well). Like Paul Volker, I have a difficult time understanding the logic behind a 2% inflation target as opposed to a 0% inflation target, but whatever the target, it needs to be the complete focus of the institution with control over the money supply. It is impossible to focus on this mission if the same agency is also supposed to be focusing on the welfare of financial institutions who may be harmed by policy actions taken in defense of the currency.
One of the major goals of this regulatory reform is to firewall the Boring institutions we need to defend from the dynamic world of equity investing. There is nothing wrong with deploying capital to maximum effect, and I support John Meriwether‘s right to come up with yet another harebrained scheme that will look great until it doesn’t.
Where I part company with the Exciting, however, is in its ability to infect the Boring. That is why it is so important that Boring institutions not only behave in a different fashion from the Exciting, but not invest in anything Exciting. The Midwest and Plains are full of sleepy little commercial banks whose managers pay themselves a king’s ransom and turn around and invest their capital in whatever idiotic derivative their Chicago coverage officer pitches. If the derivative issuer fails, not only does he make an Exciting hole in the ground, he also tears through all his Boring funding sources, and that naturally scares the government. So let’s remove that fear.
When we want companies to deploy massive amounts of capital in unproven ventures, we often agree to some sort of cost-plus pricing, where we absorb the risk. It might take $1bn to build a destroyer and it might take $2bn, and so one solution is simply to say spend what it takes, add 25% for yourself, and give me the destroyer. The civilian variant can be found in the power industry: we don’t want the lights to go out, so we tell the utility it can earn a certain return on its capital, so it should go ahead and build to its heart’s content and we will simply adjust rates to balance.
In some sense, the reverse can be accomplished if we do not want innovation. By regulating the form of contracts we make it difficult for Boring institutions to innovate and encourage them to compete on rate of return; essentially, we rent their balance sheets for the clearing price of capital. The innovation is channeled into mechanisms that drive down cost – for example, operating a more efficient (or a virtual) branch network – or improve customer service (First Republic versus the overall Bank of America experience).
Once we can tell people that their deposits and their 401ks are held by well-capitalized institutions, we have the freedom to discipline the Exciting in ways we could not previously. The critical importance of not bailing out financial institutions has been well-noted; unfortunately, we threw up our hands when confronted with the simultaneous meltdown of money market and insurance markets, which had not been predicted in the Official Central Banker Handbook. Now it’s time to profit from the experience that these sorts of panics affect not only Third World countries with opaque, interest-group-driven politics but also First World countries with opaque, interest-group-driven politics. While the Boring institutions will undoubtedly do their best to capture their regulators, at least the regulators will be more constrained in the relief they are able to grant.
The Great Gatsby offers the following observation on human nature:
[w]hile he remained with Cody he was in turn steward, mate, skipper, secretary, and even jailor, for Dan Cody sober knew what lavish things Dan Cody drunk might soon be about…
Now that we know that we are liable to spend forty percent of our GDP in a month of panic, let’s make arrangements in the cold light of day to prevent recurrence of these events. Compared with attempts to change compensation or appeal to our better angels to operate with a conservatism diametrically opposed to the nature of the business, it is eminently more practical. It requires one major breakup and reorganization, but that is hardly unusual on Wall Street; virtually every major financial institution has gone through a transformation at least as large on a voluntary basis (BAC – rollup of Bank of America, NationsBank, Fleet, USTrust, MBNA, Merrill Lynch; JPM – formed from successive mergers of Manufacturers Hanover, Chemical, Chase, JPMorgan, and WaMu; C – merger of Citibank, Travelers, and Salomon; WFC – merger of Wells Fargo and Wachovia; GS – transformed from investment bank to bank holding company).
While we are at it, let’s shut down – or, more accurately, run off – Fannie and Freddie and the FHA. The goal should be to get the industry to internalize the costs of its operations, and we don’t help the process by refusing to take our hands off the scale.
Ultimately, this reform will lead to a better financial sector for all players. Boring institutions will continue to feel the real estate cycle, but as cycles heat up, there will be tremendous pressure from bondholders to tighten requirements lest bonds start getting crammed down. Exciting firms will burn bright and flame out, but when they do, the capital that they take with them will come exclusively from big boys. The market share caps will create some waste in the form of duplicative overhead, but that waste is compensated by making the cost of any failure more digestible by the government.
StatsGuy comments about the overwhelming temptation for the government to intervene in any financial meltdown, regardless the nature of the risk capital, because of the potential for loss of wealth and loss of jobs. I understand that, and as an empirical observation about postwar Western democracies, I agree.
However, it might be instructive to look at the other, literal example of contagion: wildfire. The American West has been subject to wildfire since before man set eyes on it. Settlers up to the past century feared it. Then all of a sudden several things came together: massive population growth, a strong central government, and mechanized firefighting tools. For decades the growing population demanded of its elected officials that they use the wealth of the nation to deploy state of the art firefighting tools.
The decades of fighting every fire, politically satisfying though they were, did not solve the problem of wildfire. Far from it. Without regular pruning by flame, western forests grew denser, and with time came lighting strikes and campfires and arsons that grew into fires so hot that even the tools of modern man were overwhelmed.
Ultimately we needed to make a political decision that we were not going to fight every fire. We would fight some fires, of course, and make every effort to protect human life. But one of the risks of building a subdivision amid isolated dry pines is that it cannot be protected at a reasonable cost, and people need to know going in that they in exchange for more affordable square footage and beautiful views and peaceful nights they have bedded down with a monster.
Memories are selective these days, but if true, this is a staggering quote from the European Central Bank administration of Jean-Claude Trichet:
It never occurred to us that the Americans would let Lehman fail.
Was the ECB unaware that Lehman was a private company? From June 1994 to June 2008, Lehman common stock had gone up ten times. Did Trichet think that it was an 18% government bond?
The reason it is so important to both wall off Exciting firms and abjure the right of intervention is precisely that we have such a history of intervention that only drastic measures have a hope of breaking through.