Policy Makers Miss the Mark

It was nice to see FDIC Chairwoman Sheila Bair endorse the Financial Services Oversight Council (FSOC) as the systemic regulator and also endorse as its head an independent director with long-term appointment. Readers might want to review my June 19th post on this matter, which can be found here.

The recent report of third-quarter GDP increasing 3.5% was initially met with bullish enthusiasm . . . for one day. But when the number was analyzed further, it became clear that almost all of the increase was due to one-time adjustments in large part the resulting from government programs and stimulus.

As Barron's reports this week:

[T]he estimable John Williams, proprietor of Shadow Government Statistics, reckons that a full 92% of the apparent 3.5% growth in the third quarter's GDP came from one-time stimulants, mostly courtesy, directly or indirectly, of Uncle Sam. Here's how he breaks down those nonrecurring contributions: 1.7% from auto sales (goosed by "cash for clunkers"); 0.6% from new residential construction (the rush of first-time home buyers to get in under the fast-approaching deadline on the $8,000 tax credit) and a 0.9% gain from a largely involuntary inventory buildup.

Something isn't working as government expected. The recession remains stubbornly alive, despite a one-quarter rise in GDP as employment continues to decline, bank lending contracts at 15% annual rate, and capital expenditures by business declined for a fifth-straight quarter. [information from Dave Rosenberg]

What is not working?

The economy is not working because policy makers have elected to commit taxpayer funds to address painful symptoms instead of the disease afflicting the financial system.

In a three-part series of posts last winter on The Transparency Wars, my blog (Red Wine and Beer Diet) described the central problem of the credit crisis in terms of a war over transparency in structured finance. The buy side decided to walk away from structured finance because investors recognized that they were unable to credibly value and price securitized assets. They were unable to perform this most basic investment function because Wall Street and its allies successfully prevented the disclosure of standardized, daily cash flow data as to the assets underlying the securities.

While preventing the disclosure of this information through its lobbying arms, Wall Street firms found ways to develop better and more timely access to detailed cash flow information. That is the lesson from a November 9, 2007 Heard on the Street column that described one Wall Street firm's venture to obtain better information than the industry standard monthly remittance report that the buy side utilized.

This confluence of events, the opacity of structured finance securities (due not to their complexity, but to the lack of timely, standardized data) and the information advantage enjoyed by Wall Street firms set up a classic Stiglitz problem, identified as such last summer by Richard Field in an article for the Financial Times. The buy side sustained enormous losses while being on the short end of what was quickly becoming recognized as an asymmetrical information disadvantage.

Thus, investors walked away from the entire arena of structured finance, causing a massive dislocation in the availability of credit. As I wrote a year ago,

There isn't enough balance sheet across the world to float the global economy 2007 levels. The credit contraction means a contraction in GDP and all that entails for employment.

The many attempts at restarting securitization have failed to date, as recently admitted by Federal Reserve Governor Tarullo and the International Monetary Fund. They have failed because policy makers in the U.S. failed to recognize that the core problem is the inability to obtain sufficient information for investors to credibly value and price structured finance securities.

In essence, we are experiencing a painful affirmation of Joseph Stiglitz' Nobel prize work on a major effect of asymmetrical information.

What needs to be done to overcome the Stiglitz problem and restart securitization?

First, as Phillip Swagel testified before Congress on Thursday, the government must create a centralized database that standardizes cash flow information and disseminates it across the world so that investors can, as the Financial Times' Aline van Duyn recently stated, use the information to credibly value and price the securities.

Mr. Swagel did not specifically state the need for daily information. However, when one considers Wall Street's ability to purchase companies with access to billing and collection systems that contain daily cash flow information, it should become clear that leveling the playing field will be a precondition to restarting the securitization market and solving the Stiglitz Problem of a substantial asymmetrical information advantage. Indeed, that appears to be the lesson from a McKinsey & Co. survey of the buy side released in December 2008.

The only way to level the playing field is for the government to require the information on a daily basis to be electronically delivered to a centralized database administered by an independent third party. I've described this in previous posts as The Transparency Database.

Mr. Richard Field described this transparency database in an April 2008 article in Total Securitization. You can review a copy of the article at his site. While there, take a look at his White Paper and note that by Fall 2007, he was describing the downward spiral we would have unless greater transparency into structured finance was implemented.

The Transparency Database could be the foundation of the Financial Services Oversight Council as I described in a previous post. Very clearly, regulators need better information than they already have and simply collecting available data from different regulators is insufficient to restart securitization or to identify incipient systemic risk as the regulators do not require standardized, daily cash flow data as to the trillions in dollars of structured finance securities held by financial companies.

When one thinks about that, it isn't surprising that regulators were unable to identify and stop the current crisis. A discernible lack of reliable information was at the core of the problem.

The Transparency Database is essential to restarting securitization and solving the credit crisis. Even adherents of XBRL have to admit that the business tagging protocol requires a centralized database first and foremost.

Yes, the almost monstrous combination of taxpayer stimulus funds and taxpayers taking on enormous liabilities in the banking system has for the moment halted the downward spiral. Yet, a sustainable recovery is doubtful without investors returning to the securitization market.

That is the Stiglitz Problem.

As yet, policy makers have not addressed the central issue of transparency.

As yet, policy makers have only treated the symptoms of the crisis.

As the numbers of unemployed continue to mount as credit continues to be difficult to access for small to medium size businesses so that they cannot fulfill their normal role of creating jobs coming out of a recession, the importance of solving the Stiglitz Problem by ending Wall Street's information advantage will become paramount.

We've already wasted 2-1/2 years with painful results. Wall Street's desire to wait for "collective amnesia" to settle in has failed. The buyers still remember and they remain on strike. The government's desire that the end of the recession and an increase in stock prices in part caused by massive liquidity would unleash "animal spirits" and restart securitization and the credit markets has also failed because it has not addressed the Stiglitz Problem.

More bubbles may be forming though.

Isn't it time to address the problem instead of the symptoms?

Comments

[Kimball Corson:]

I cannot agree that the economy is not working well because of a lack of financial transparency. The economy is not working well and we are in a recession because we have a huge trade deficits problem, a badly skewed distribution of income problem that seriously lowers the marginal propensity to consume, a problem with employment in our manufacturing sector, and a dysfunctional banking system where the money centered banks should be put in FDIC insolvency proceedings and where new financial regulation is needed, transparency being almost the least of it.

Nov 02 05:00 AM

[Tadit Anderson:]

While identifying the asymmetric nature of the availability is rather polite way of identifying the core issue, the core problem with the application of the securitization process may have more to do with the amount of dys-information being used to advance various ponzi-ed mechanisms. By the multiple varieties of fraud that have been perpetrated in various layers of the process it seems doubtful that full disclosure will result in re-validating the process, this includes a current class action suit alleging that lenders have destroyed the documents necessary to validate basic contract law. It would seem that Dr. Frankenstein's monster is stitched together such that it is dependent for its survival upon the opacity of the process. If for instance due process and due diligence were to be applied with full transparency the net yield and "advantage" of the process might be vastly reduced. The SEC has unmistakenly been captured and the FBI lacks the capacity to enforce against the destabilization efforts (nod to Hyman MInsky here) which became the basis of paper profits. The basic identity and contribution of speculative finance will need to be redefined once the barriers to transparency are removed. www.economics.arawakci...

Nov 02 05:28 AM