‘Regulation-induced Innovation’: The Role of the Central Bank in the Subprime Crisis

When are investors like termites? When they are trying to avoid government rules.


And that is one reason new regulations won’t prevent another crisis like the subprime housing mess, Boston College finance professor Edward J. Kane said at the recent annual financial risk roundtable held by the Wharton Financial Institutions Center and the Oliver Wyman Institute. Writing new rules is tempting, but it leads to “regulation-induced innovation,” Kane said. “People being regulated are like termites. They go away from the poison and go after the wood. They’re intelligent.”


This year’s roundtable focused on the housing and banking crises. And while participants identified a host of problems that led to the bailout of Bear Stearns and capital crises at other banks, agreeing on solutions proved as challenging as destroying pesky bugs.


William C. Dudley, executive vice president of the Federal Reserve Bank of New York, kicked off an afternoon discussion on the role of central banks by explaining how the Fed analyzes market risks and how it developed some new responses to maintain liquidity in current markets.


Higher loan loss provisions and write-downs on security portfolios have pressured bank balance sheets and forced them to raise capital, Dudley said. This limits the Fed’s control over deteriorating markets. But the Fed can provide a way to financeless-liquid collateral on the balance sheets of banks and primary dealers, the banks and securities dealers allowed to trade directly with the Fed. By reducing this risk, the Fed can lessen the chance that forced asset sales at big discounts will destabilize markets.


During the recent crisis, Dudley added, the Fed created three new lending programs aimed at giving markets what they need most in times of crisis: confidence. By providing backup financing, the Fed hopes to reassure investors that banks and primary dealers won’t run out of cash.


One example of a new Fed program is the Primary Dealer Credit Facility, which operates in the tri-party repurchase, or repo, market. Repos are contracts in which a seller of securities agrees to buy them back at a specified time and price. In a tri-party repo, a custodian bank or international clearing organization acts as an intermediary. Many people believe the Fed rescued Bear Stearns because it was such a big player in the market for mortgage-backed securities, but Dudley said Bear’s role in the tri-party repo market also affected the decision.


‘Stopgap Measures’


Robert A. Eisenbeis, chief monetary economist for Cumberland Advisors and a former director of research at the Federal Reserve Bank of Atlanta, said the Fed’s efforts to deal with current market turmoil are “essentially stopgap measures and a form of forbearance to give large complicated financial institutions time to recover.”


But those institutions faltered because they had assets of questionable quality, including asset-backed commercial paper, on their balance sheets, not because markets did not have the funds necessary to trade. It’s like saying that what a sputtering car needs is not more oil, but a new engine. “I don’t really believe current problems were liquidity problems but solvency problems,” Eisenbeis said.


Meltdowns at Bear Stearns, Merrill Lynch, Citigroup and other companies resulted from their reliance on profits generated from issuing mortgage securities backed by subprime loans, he said. This means that new international capital requirements known as Basel 2, which focus on liquidity, “aren’t the answer.” Fed Chairman Ben Bernanke has said that “market participants themselves must address the fundamental sources of financial strains — through deleveraging, raising new capital, and improving risk management — and this process is likely to take some time.”


According to Eisenbeis, the Fed could make some structural changes to accelerate that process. For example, the Fed could “stand ready to buy and sell fed funds at the target rate all day rather than engaging in one transaction per day.” Fed (short for “federal”)funds are overnight borrowings between banks that the Federal Reserve facilitates to help maintain the flow of credit in the economy.


The Fed currently makes only one federal funds transaction a day. Trading fed funds all day could reduce uncertainties in the market and improve efficiency, Eisenbeis suggested, adding that the Fed also should consider expanding its pool of primary dealers to make markets more efficient in an increasingly global world. The Federal Reserve has less than 20 primary dealers as counterparties, while the European central bank has several hundred and the Bank of England has about 40, Eisenbeis said.


Boston College’s Kane argued that regulators identify problems too slowly and bail out foolish investors too quickly. This creates the well-known “moral hazard,” in which investors ignore risks in the belief that the government will come to their rescue when markets run amok. “This is a recipe for repeated bubbles and crises,” Kane said.


Regulators and others mistakenly focus on maintaining market liquidity, he noted, citing John Maynard Keynes: “There is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment … is to outwit the crowd, and to pass the bad, or depreciating half-crown to the other fellow.” In the cases of the current subprime crisis and the 1980s savings-and-loan mess, the “other fellow includes the taxpayer,” Kane said, “and that’s what pisses me off.”


Central bankers are rarely held accountable for “detecting the expansion of ruinous asset bubbles in a timely fashion,” he added. In both the tech stock and mortgage lending bubbles, the idea that new technologies and investment vehicles represent innovation provides political cover for allowing bubbles to continue to grow. “How many times did we hear Alan Greenspan say these new things are wonderful?” Kane asked.


‘Zombie Preservation’


The current regulatory structure encourages what Kane calls a “Bureaucracy of Zombie Preservation” that extends the life of dead companies. Regulators often try to act mercifully, as if they were “the Good Samaritan helping someone bleeding at the side of the road.” Regulators also suffer from “disaster myopia,” in which they underestimate the frequency of crises and the way that bailouts create long-term incentives to take on more risk, he added.


Instead, regulators should try to imitate private rescuers. Such an approach would include “adequate disclosure of continuing loss exposures and a formal claim to future profits. We need to change our contract with our regulators today to detect insolvencies early,” he said.


To fix the subprime crisis, authorities must explain how turning home loans into securities went wrong, Kane stated. He believes that securitization outsourced due diligence.The normal watchdogs — bank lending departments, credit-rating agencies and insurers — all failed to check out borrowers because each believed the risk had been transferred to another party. As a result, people got loans who could not repay them.


Federal policies aimed at encouraging homeownership by requiring banks to make someloans to risky borrowers at subsidized interest rates aggravated the problem, Kane said. Policies that require government officials to provide subsidized emergency loans and implied guarantees of repayment to depositors and other bank creditors also encourage risk-taking.


In addition, credit-rating agencies performed poorly, he noted, partly because they have a conflict of interest. They earn revenues when they rate structured securitizations, creating incentives for ratings agencies to be easy graders. In 2005, Kane said, more than 40% of Moody’s ratings revenue came from rating securitized debt.


He compared the financial engineering that allows subprime loans to be turned into securities rated as high-quality to a factory conveyor belt. Each work station on the belt manufactures a new risk. “The different stations produce contracts that create, disguise, assign or insure overleveraged risk exposures,” Kane said. “At each station, product-quality inspectors (supervisors) were apt to use their computers to entertain themselves rather than to inspect the quality of the work that was passing by.”


Credit-rating organizations, for example, said that loan pools qualified as sold when they were spun off the loan originator’s balance sheet into a separate vehicle. But the contracts for these vehicles were written so that investors sometimeshad recourse to the lender. This meant balance sheets were weaker than they appeared, forcing banks to liquidate assets and wreaking havoc on markets.


Simply rewriting regulations won’t help, Kane said, because investors find ways around new rules.


Instead, the United States should reform incentives for regulators. The root of the problem in many countries lies with politicians who require regulators and supervisors “to encourage lending to favor designated sectors of the economy,” according to Kane. This leads investors to believe that these loans will be “supervised with a lighter hand and willbe subsidized in times of banking turmoil.” A new system should ensure that supervisors, including regulators and firms involved in maintaining the credibility of the system, such as credit-rating agencies, are held accountable. Otherwise, “It’s a game where no one wants to catch or be caught.”

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