Fixing Finance: Three Simple Suggestions

Everyone nowadays seems to have a proposal to fix the financial system. Many, unfortunately, consist of self-congratulatory hogwash. (I recommend in particular ignoring any non-billionaire who starts his suggestion off with “as I had predicted years ago …”) But there are plenty of reasonable suggestions out there. I’ve come up with a few of my own, hereby tossed into the mix.

First, a quick observation: when it comes to patching up the banks, the Powell Doctrine is operative. The best proposals will have a simple, single objective. Part of the problem with the government’s involvement in the financial system so far has been the proliferation of “dual-mission” housing goals. For years, for instance, the purpose of the GSEs was to boost homeownership and create shareholder value. In the end, only one of those two goals was actually fulfilled. (And its fulfillment is a key reason the financial system is teetering on the brink in the first place.)

As regards its housing policy now, the government has a whole laundry list of (often-contradictory) goals. For example, it wants to (take a deep breath) prevent foreclosures, attract private capital, halt home price declines, enhance housing affordability, enhance the liquidity of the mortgage market, control executive compensation, and encourage lending. (Exhale.) These are all worthwhile aims, I suppose. But many are completely at odds with each other. You can try to halt the slide in home values, for instance, or you can try to make homes more affordable. But you can’t do both at once. No wonder the administration is pursuing a “leak-and-lurch” strategy to court public opinion.

In my view, any effort to fix the banks should have only one goal: the restoration of universal confidence in a sound, predominantly privately owned financial system. Once that happens, everything else will fall into place. There will be plenty of time for finger-pointing when the fire is out.

I don’t have a comprehensive plan for achieving this, but I do believe a workable solution should contain three simple ideas that aren’t getting adequate air time. Here goes:

1. Stop the cramdown silliness. President Obama says he supports the notion of giving bankruptcy judges the option of reducing the principal balance on first-mortgage loans, and this is reinforced in his new plan. This is a terrible idea that would make the situation much worse, and should – at the very least – be weakened much further.

The sheer awfulness of the cramdown scheme was brought home to me last week when I attended the annual American Securitization Forum conference (sorry, “junket”) in Las Vegas. This event brings together ABS investors, former ABS issuers, and regulators, for a series of panels, speeches, and general hobnobbing. If there were one broad takeaway from this year’s event, it was that the single most efficient way to further destabilize lending markets would be to enact a mortgage cramdown that would give broad latitude to judges to alter loan terms unilaterally.

Why? First off, as anyone who has experience in bankruptcy modeling will tell you, consumers can be expected to behave in highly rational ways, and consumer bankruptcy lawyers will be even more so. So if borrower-friendly loan-modification legislation does become law and borrowers get unfettered access to cramdown court, depend on the fact that filing volume will soar to much higher levels than is likely in anyone’s forecast. That’s what happened in 2005, ahead of the last round of bankruptcy law reform.

The numbers could be huge. Recall that roughly 20% of mortgage borrowers are underwater and, according to Wells Fargo (WFC), their marginal propensity to walk away from their properties is on the rise. Many of those upside-down borrowers are in such bastions of judicial rationality as California and Florida. If judges are given broad authority to essentially transfer wealth from lender to borrower via cramdown, the financial effect on the mortgage industry could be devastating.

The problems wouldn’t just stop with mortgage lenders, either. Rather, judicial cramdowns would likely create a rash of bad unintended consequences. For instance:

Losses on non-mortgage debt would balloon, as well. As it is, bankruptcy judges already have the power to change the terms of non-mortgage debt such as card and auto. Should bankruptcy filings surge following enactment of a cramdown bill (and they will, trust me), unsecured debts will not fare well behind the newly crammed--and secured--mortgage. As we saw in 2005, plenty of “marginal payers,” people who would have otherwise gotten through a period of debt to income stress, will now either be convinced or opportunistic enough to take their shot in court. The Obama Plan unveiled this week does not discourage this adequately, in my opinion.

Buyers of securitizations would go on strike. Numerous participants at AFS said that a cramdown law would kill investor interest in future consumer-debt securitizations, particularly for any longer-dated issuance. Why? The government will have shown it can and will change the rules in particularly radical ways. Investors hate uncertainty--particularly fixed income investors. At a minimum, they will demand much higher returns for the increased risk they will be taking. In a worst case, they will simply refuse to participate. Talk about a perverse effect. One goal of any bank-rescue plan, remember, is to revive the securitization markets—not kill them outright.

The cost of consumer credit would rise and its availability would fall. This is not simply a matter of faith or a scare tactic by credit providers. The price of consumer credit is set to rise in any event because of new regulatory and accounting issues facing the industry, from the effect of FAS 140 revisions on capital requirements to the Fed’s new rules restricting card repricing. There’s also uncertainly surrounding the economy generally. Cramdowns would be one more uncertainty that lenders would have to take into account--and price for. As it is, card lenders, particularly efficient responders to changes in the credit environment, have begun to step back. In December, their solicitation mailings were down 59% from last year, and 20% from November alone.

Government-promulgated debt forgiveness sets a very bad example. Who knows what the longer-term psychological impact on borrowers would be of a no-strings-attached, government-sponsored forgiveness plan? For myself, I suspect it won’t do much to promote rugged individualism and self-reliance. The cramdown bill is essentially a recipe for moral hazard—possibly on a huge scale.

So, the introduction of relatively unfettered cramdowns would a) cause huge losses among mortgage lenders, b) bring about losses among non-mortgage consumer lenders, as well, c) re-freeze securitization markets, and d) set the stage for even worse credit problems next cycle. Let’s just says it’s a terrible idea, okay? President Obama says borrowers should be given access to cramdown court only as a last resort. Presumably that means his plan would put up a lot of roadblocks and force borrowers to jump through a lot of hoops before they became eligible to have their loans altered. That’s fine. Unfortunately, the history of these sorts of ideas shows that borrowers (helped by their lawyers) can find ways around the roadblocks and hoops without much trouble. Better to dump the cramdown idea altogether. Rather, let loan modifications happen outside the courts, whenever and wherever they make sense for the lender and servicer. If it is truly in their own best interest, let them handle it.

Which gets me to my next idea:

2. Incentivize private investment in banks. President Obama, Tim Geithner, and Sheila Bair have said that they want private capital in the banking system, pronto, and public capital out. Then everything else they say and do seems utterly art odds with this objective. Even the term “public-private partnership” is enough to give private investors the willies.

An anonymous Treasury aide told Bloomberg News last week, for instance, that “the Treasury wants to entice voluntary participation, using incentives of public financing and possibly public capital.” What the heck does that mean?

There have been all sorts of ideas floated that are designed to make banks more attractive investments. These involve, say, clarifying fair-value accounting, promoting balance-sheet transparency, ending the patchwork policy announcements, and so on. All very laudable. But in my view, the very best way to incentivize private investment in banks is to--hold on to your hat, this is going to sound radical--incentivize private investment in banks!

Like, for instance, the government might offer a simply structured tax break for investments in bank holding companies. It should make it dramatic and easy to understand. I, for one, suspect that 0% tax on gains earned on investments in bank holding companies made in the next six months would quickly draw new capital from out of the woodwork.

The government should also consider offering similar incentives for large-scale asset purchases from bank holding companies (such as securities portfolios, lines of business, and real estate) as a supplement or substitute for the “Bad Bank” or “toxic asset” funds.

Capital seeks a return. As we’ve seen with the TARP experience and the GSE conservatorships, a “partnership” with the government is really not a partnership at all. It’s a one-sided relationship that will likely end up being either unprofitable or confiscatory. This is not the sort of arrangement profit-seeking investors will be attracted to.

Plenty of money and liquidity is sitting on the sidelines or in alternative investments. If the government were serious about attracting that capital, rather than punishing the capital that’s already invested in the banking industry, it could attract it. Would a “tax holiday” for private investors in banks be politically popular? No, probably not. That’s where leadership comes in. President Obama should draw down some of his immense political capital, in order to draw in private capital.

This would have the added benefit of avoiding or mitigating government ownership of the banking system, which nobody seriously thinks is a good idea.

Finally:

3. Bank regulators should set and commit to public capital requirements for the next three years. This is no time to start changing the capital rules banks are supposed to live by. (And what the hell is a one-size-fits-all “stress test” supposed to achieve?) The government should reduce uncertainty by a) affirming a regulatory capital standard, and even more importantly b) committing to it for a fixed time period, say, through 2012. Stop changing the rules, and then provide assurance you won’t start trying to change them again any time soon.

Again, this is not a comprehensive plan, and I’m just one voice among many offering suggestions. But each of these ideas figures to be effective, simple to understand, and easy to implement—and fairest to all participants as well.

Comments

[Alan Young:]

True, if the goal is to fix the banking system, cramdowns make no sense. In fact, any problem can be solved if you don't care about the externalized consequences.

But as a society, we have to be concerned about more than just having a good banking system. Good banking does you no good if your neighborhood is deserted because of foreclosures, your city can't pay for basic services such as police and utilities, and you have no job (or own a business that has no customers).

The trick is to figure out a way to leverage the remaining assets we have as a society (i.e. the U.S.Treasury's credit rating, such as it is) so as to stop the bleeding--without over-allocating resources to one sector at the expense of others. I don't know the best solution, but looking at banks in isolation, as if housing and jobs don't matter, doesn't look like an effective way to compute it.

Feb 22 03:11 PM

[Briggsy:]

The author loves private banking too much. What is the best argument for private banking? Superior skill at allocating resources? Ha! An ongoing public lottery for loans (i.e. blind luck) would demonstrate better skill. While your waiting for your number to hit and your ration to be meted out, maybe you're saving a few quid of your own so you don't even need that loan.

Let us go to non-profit public banking ASAP, and let statutory cramdown authorization lead the way.

Feb 23 01:24 AM