On the eve of Barack Obama’s inauguration as president of the United States, Wharton finance professor Richard J. Herring discussed with Knowledge at Wharton some of the advice offered to the new chief executive by the Shadow Financial Regulatory Committee, a group of economists, former regulators and lawyers, of which Herring is a co-chair. In an open letter to Obama, the committee suggested that the government should quickly extract itself from the investments it made to rescue the financial system and devise a new regulatory framework for preventing future crises. Herring also assessed the deepening woes at Citigroup.
Knowledge at Wharton: Professor Herring, thank you for joining us today. Perhaps you could tell us just in a few short sentences what the Shadow Financial Regulatory Committee is and what it does.
Richard J. Herring: It’s a group of economists, former regulators and lawyers who meet quarterly in Washington to take a look at recent regulatory initiatives, or initiatives that ought to take place, and write press statements. Usually, we’ll have interviews that are strictly off the record with policy makers. And then we will issue press releases on the following [day at] noon.
It’s a group that has been together for a little more than 20 years. It has had, in some cases, some very important impacts on public policy. And so it has had a long history of looking at the very kind of problem that we’re confronted with today.
Knowledge at Wharton: Did the latest session of the Shadow Committee include briefings from the incoming administration?
Herring: Not yet. We’ve talked to some people who may be involved in the incoming administration. But typically, the briefings will be by current policy makers. They do so only on the grounds, of course, that we never repeat what they say. But it does help us keep in touch with what’s [happening] on the inside, as well as what we know from our own research and simply keeping abreast of the news.
Knowledge at Wharton: Based on its most recent meeting, the committee has produced an open letter to President Obama about the nation’s response to the financial crisis. Have you seen anything about the Obama plan that gives cheer to the Shadow Committee?
Herring: It’s really very early to say. They obviously have made some very good choices for people who are involved. Although, even the structure of how things will be formulated is unclear. There are some doubts about who will be secretary of the Treasury. And exactly the role Paul Volker plays versus Larry Summers is not so clear, either. But Obama has certainly put together a credible team of experienced players.
Knowledge at Wharton: One of your committee’s recommendations is that the government should move as quickly as possible to remove itself from the banking system. Why is that so important?
Herring: Because the more deeply the government gets into actually owning and controlling the banking system, the closer we may come to a system of government-allocated credit. We know from literally hundreds of examples, that ends badly for overall long-term growth. It may be necessary for the government to temporarily intervene. They actually have a very good legislative framework for doing that with the banks called “bridge banks,” where they form a temporary charter. It’s usually for two years — renewable, I think, for another two years. And it gives them time to figure out the best disposition of the bank. It’s a much better way of proceeding than to have a shotgun merger over a weekend where nobody knows what exactly the banks are worth. Moreover, that kind of approach inevitably leads to a bigger and bigger banking system. A particularly bad example of this policy was the attempt to put Citi together with Wachovia. Wachovia was bankrupt — well, it was clearly headed for insolvency. And to find Citigroup as a rescuer suggests that the regulators really didn’t know much about the true value of Citigroup, even though they have been living inside them for literally decades.
Knowledge at Wharton: What does that say about our ability to regulate the banking industry?
Herring: I think it says that we need to rely a lot more on market discipline and a lot less on supervisory discipline. Because time and again, the supervisors have shown themselves incapable of preventing this sort of crisis. It also shows we need to re-think the fundamental regulatory framework. Another very good example of just how hard it is to do these things in a hurry was Morgan Stanley’s attempt to sell itself to Wachovia. Morgan Stanley is widely regarded as one of the premier institutions for valuing other institutions in the world. Yet it was trying to sell itself to a bankrupt institution two weeks before it went under — which suggests that we really do not have sufficient disclosure for outsiders to make intelligent guesses about what’s going on. Although certainly the markets have had much better information about this than one would glean from either the regulatory statements or from the ratings agencies, which inevitably lag.
Knowledge at Wharton: What was it about the regulatory framework that contributed to the current crisis?
Herring: There were obviously failures all around, not least of all in the private sector. But the government does deserve an enormous proportion of the blame, for which most people don’t really have a clear view. And it has to do with the perfectly laudable motive of creating more homeowners. But the wrong way to do that is to give greater leverage to people whose incomes are very volatile and uncertain in the first place. If you want to make stable homeowners, then you should give them grants that can be targeted, monitored and evaluated. Congress didn’t want to do that. And the failure goes all the way back to the Johnson administration. When President Johnson wanted to have both guns and butter during the Vietnam War, he spun off Fannie Mae as a quasi-private institution and Freddie Mac was created to have some quasi-competition between the two. Their role was to enable people to leverage up more to buy houses.
Over time, they received more and more pressure to be involved in funding low-income housing. They also saw opportunities to make more money by actually directly holding mortgages. During the last five or six years, they got more and more pressure from congressional committees to be more involved in low income housing. And they negotiated a deal to satisfy that requirement by buying highly rated tranches of subprime mortgage securitizations. They ended up with about 50% of the market. That was an enormous stimulus to demand. It meant that investment banks that were creating these products had much stronger incentives … and I think it led to the deterioration of the credit standards all the way down the line. And of course it led to the collapse of Fannie and Freddie in the end.
Another huge failing was in 2004, when the SEC, in response to pressure from the Europeans, agreed to set up a voluntary regime in which they would be responsible for the oversight of the investment banks using Basel II-type rules, which meant they gave up their leverage requirements and based their requirements on risk-weighted assets. They judged that investment banks had very little risk attached to them. And so investment banks leveraged up. They were usually, most of them, about 30 to one. Now, if you’re leveraged 30 to one, you’ve got to have an almost perfect portfolio, there’s no scope for error. And when you get hit with the kind of shock that happened to housing markets, which should have been foreseeable … you’re finished. Any institution that is that highly leveraged is simply doomed. We chose to talk about it as a liquidity problem and wasted an entire year creating liquidity facilities that were simply forbearance and didn’t really accomplish any of the cleaning up that has to be done.
Knowledge at Wharton: The Shadow Committee’s report also urges the new administration to define its overall crisis management strategy. How can they do that in an environment in which the crisis has thrown so many curves at regulators already?
Herring: It’s very hard for the market to anticipate what the rules of the game are. Maybe the best example of that is the difference between the way they treated Bear Stearns and the way they treated Lehman Brothers. Bear Stearns was bailed out essentially through a shotgun marriage with JPMorgan Chase, where the regulators put in a $29 billion guarantee in the end. And it was done largely on the grounds that they feared the consequences that Bear’s collapse might have on the rest of the system. It’s very hard to argue the system was more vulnerable in March than it was in September. Bear was half the size of Lehman Brothers. It had half as big a dealer position. It had half as many assets. It was simply not nearly as big. And the market foresaw that coming, if you look at the spreads, which are the markets’ measure of how likely a bank is to default.
In about the same way, they saw a collapse at Lehman Brothers. But at Lehman Brothers, they suddenly decided that they were going to try to end the moral hazard they had created with Bear Stearns and with Fanny and Freddy to some extent by simply stepping aside and letting it go through bankruptcy. It may have been that they believed that they understood enough about Lehman Brothers, because they had been looking at it in a way they had not been able to look at Bear Stearns for a long time. It may have been they were very annoyed with the management that lost opportunities to recapitalize. But it’s also probably true that they thought they could handle the spillover consequences. They thought the spillover consequences would be in the credit default swap markets and in the repo markets. And they set up facilities to handle those.
But it turned out the really big hits were on the money market funds, which are the very lifeblood of financing corporate America because they hold commercial paper and they’re usually considered to be nearly as safe as guaranteed bank deposits and almost as safe as treasury bills. So it caused them to have to, without any planning at all, put forward a full guarantee for money market mutual funds. It’s just a very slippery slope. Moreover, the failure to deal with Lehman in an orderly way, because a bankruptcy was completely unplanned, led to a situation where they hadn’t really thought through the international consequences. Lehman had something like 40 subsidiaries in 20 different countries. And each of these countries had a different way of dealing with insolvent institutions. It turns out in the UK — where a huge amount of the activity had gone, especially the prime brokerage activity — the funds of hedge funds were actually mingled with the firms’ own funds. Those may be tied up for a decade or more as the administrators try to figure out what’s going to happen. So, the hedge funds were forced into hurried sales of their other assets, which depressed markets that were already illiquid. We had a virtual meltdown of the system.
It was such an excruciating experience that the group of seven met early in October and one of the headlines out of the meeting was, “Never Another Lehman Brothers.” Now, I’m not suggesting that Lehman Brothers should necessarily have been saved. What I am suggesting is there was surely a more orderly way to deal with it. A bridge bank would have been a possibility if they had sought permission to do that earlier. But maybe even more importantly, it would have been better not to save Bear and set up the expectations that Lehman was too big.
Knowledge at Wharton: Are there parallels in that chain of events to what’s happening with Citigroup right now?
Herring: Citigroup is the horror show of all failures because Citigroup is in nearly 100 countries, if not more. It has 2,500 majority-owned subsidiaries, and that’s not counting all of the off balance sheet, special purpose vehicles that have caused so much loss. It is unclear that they could even map Citi’s activities into the entities that would have to be taken through bankruptcy if they went into it. The regulators have simply permitted these institutions to adopt corporate complexity that defies resolution. The top 16 financial institutions have two and a half times as many majority owned subsidiaries as the top 16 corporations. And that’s entirely due to regulation, or getting around regulation more particularly.
So, one of the things that they could do that regulators world-round should do is require every single institution to have a live bankruptcy plan that gets updated every quarter, in the same spirit they have business continuity plans. Because winding them down is just as important as keeping them going. Because, as we’ve seen, if you wind them down clumsily, you can have really serious systemic impact.
Knowledge at Wharton: The committee’s report also suggests that the government’s financial rescue efforts have created too much “moral hazard,” which occurs when investors take risks they would otherwise avoid because they think they’ll be bailed out if their investment goes bad.
Herring: The government has in virtually every case except Lehman hugely extended the problem by offering full guarantees. After the Lehman debacle, they increased deposit insurance with virtually no discussion — and more than doubled it. And they extended it even to creditors who were not even depositors. So that one source of discipline was lost.
There are multiple problems with this. One of the problems is, What’s your exit strategy? We know from literally dozens of studies of countries that have been through this before — and you know, we’ve had 138 such crises — that it’s enormously difficult to unwind these guarantees once you’ve offered them. There’s never a good time to take them away because somebody’s always depending on them. And it enormously increases the burden on supervisors because the market has no real incentive to discipline these institutions.
Knowledge at Wharton: An interesting suggestion in the committee’s letter deals with compensation, but not for executives. The letter proposes tying the compensation of regulators and supervisors to their performance in overseeing these institutions over a number of years. How would that work and what would the impact be?
Herring: One of the problems is we don’t pay supervisors nearly well enough and so we don’t have the pool of talent we need to oversee these very, very sophisticated institutions. But having said that, there’s almost no accountability for supervisors, partly because we’re very vague on what their objectives are. Supervisors get very heavily criticized when an institution goes under. But often that’s the very best thing that could happen. Probably the most flagrant abuse that we’ve seen recently is what happened with IndyMac. IndyMac was overseen by the office of Thrift Supervision. IndyMac should have been subject to prompt corrective action measures, it should have been closed when its equity-to-asset ratio reached 2%. In fact it had virtually $10 billion in losses before it was shut down. And it’s simply because the [regulators] were really trying to keep it going and were acting like social workers rather than simply implementing the law.
What’s the accountability for that? Not much. There may be some for the supervisor who allowed them to backdate some capital injections, but you really need a different kind of incentive system to make supervisors accountable for actually carrying out their responsibilities. But that involves being very clear in what their objectives are, having clear standards of measuring them and having some significant proportion of their pay, which should be higher, withheld for a long enough period so that you can tell that they performed well.
Knowledge at Wharton: A lot of what we’ve discussed here today seems to come back to the high level of complexity in regulatory systems and financial instruments. Is part of the answer here a simpler regulatory scheme that does not create incentives for designing such complex financial products?
Herring: The market is in some sense doing that on its own. You’re no longer going to be able to sell CDOs or CDO squareds or CDO cubes. SIVs are dead. There is an aversion to complexity at this point that exceeds anything the regulators were likely to have done, with good reason, because it simply became unclear. I think an enormous challenge is bringing securitization back. There is some level of securitization that is enormously beneficial. But it’s the very transparent kind where you can really easily judge what something’s worth. I hope that gets restored. But at this point that’s destroyed as well.
There are going to be enormous calls for simplifying the structure of the U.S. regulatory system. There is no denying that we have the most hideously complex, uncoordinated system in the world. However, it’s very hard to argue that it had a major role to play in our failure, because the streamlined system of single regulators and integrated regulators which now dominate in 36 other countries really didn’t do a better job. The FSA in London that is widely admired really screwed up in a significant way. Maybe the best example is Northern Rock, which was one of the first fatalities of the credit crunch. Its primary regulator, the FSA, permitted it to start Basel II — the new capital approach — using the advanced internal models approach, which reduced its capital requirement by nearly 30%. And they were permitted to pay that out as dividends to their shareholders something like six weeks before they collapsed. So there was utterly no sense of what the real risk exposures were or how they should be handled. Moreover, they really weren’t sharing information with the Bank of England or the treasury, which both have to be involved. And they tried to manage the crisis by committee, which lead to a series of market unsettling reversals and embarrassing 180-degree turns in policy statements that simply made things worse.
There will be a lot of attention to structure and we certainly could think of better structures for the U.S. It’s unlikely to happen, but this may be our best opportunity ever to clean up what is something that sort of grew historically and randomly. But there are so many entrenched interests in keeping the current structure alive, not least of all in Congress where various committees have oversight over various pieces of the system. And the regulatees are enormous sources of funding for the campaigns of these members of Congress. So I think it’s going to be very tough going even if the administration can make a very lucid argument, as I’m sure they can, for making these simpler, more straightforward structures that would be more comprehensive.
Knowledge at Wharton: Thank you very much.