Panel Discussion at Wharton

[Thoughtful Thug]

Got to kill off all those loans before a new bubble inflate to even a more oversized bubble.

My brother is a mortgage broker in Cleveland...

 

[Samson]

Interesting. My thoughts and questions, from a non-ecconomist non-american:

(Quotes from memory, so not litteral)

Lehman brothers should not have been allowed to go bankrupt. The crash may well have happened, but it would have happened later.

ISTM that it is the nature of bubbles that had it burst later it would have been bigger, and so the fallout would have been greater?

We could have let the shareholders (and a load of other groups the definition of whom I had no idea of) have nothing, but suppored the contractual obligations of the failing banks. This would have prevented the colapes spreading to the whole market.

If this approach had been taken to the whole of the bank bailout scheme, how much money would the (US or international) taxpayer have saved? Who would have lost money?

America has never experienced a drop in house prices (greater than 2 or 3%?).

Is this really true? Not even during the great depresion? The civil war?

Noone expected a drop in house prices

Is this really true? Surely the bubble nature of the property market was at least accepted as a possibility by anyone who was paid to analyze it?

How much did adjustable rate mortgages and balloon mortgages contribute to an unwillingness on the part of the Fed to raise rates in the face of the housing bubble? Since with ARMs and balloons any rate increase on the part of the Fed was certain to cause an increase in foreclosures.

Was the Fed, Greenspan and Bernanke, unwilling to call the bubble because the only tool they had to deal with it would have caused a collapse because of ARMs?

(Sorry if this is OT, I did not see discusion of it in the talk)

You do mean mortgages that are not fixed for decades, that are dependant on either central bank rates or some number that the mortgage company decides on (apparently off the top of their head, but probably a bit more thought out than that )? Like for example the whole world outside of america thinks of as normal.

Surely if the rest of the world manages to control their base rates with most people having ARMs then america must be able to?

Another related question, how does the ecconomics of these mortgages work in relation to the possibilityof sustained double digit interest rates? Are they underwritten by someone who is suitably hedged against that, or is that another "black swan" that is waiting to bring down the world ecconomy again?

 

[Cutlass]

Adjustable rate mortgages, and balloon payment mortgages, like Whomp said, were until not all that long ago something that was only available to high end and sophisticated borrowers. Not the general public. How an ARM works is that when the mortgage is first created, a low interest rate is locked in for a certain time period. After that time period expires, there is a formula which raises the rate if the prime rate is higher than it was when the mortgage was first created. Now the problems with that is that the weakening of lending standards and the price level do to the bubble resulted if far more people having mortgages that were at the limits of what they could afford to pay. So if the rate reset to something higher, they could no longer pay. It seems to me that that was common enough to be a contributing factor in the Federal Reserve's reluctance to use monetary tightening, which raises interest rates, when those rate increases were apparently overdue for other reasons. Now keep in mind that there will always eventually be a reason that the central bank has to raise interest rates. It is always simply a matter of time. Another problem was that people were frequently refinancing their mortgages. Particularly people with ARMS and balloons. And because each of those refinancings add costs, those people were deeper and deeper in a hole. A balloon loan offers a low payment up front, but the loan is relatively short term, and at the end of that term the entire balance of the loan must be paid off. Again, this requires refinancing. And probably at less favorable terms.

Now these helped fuel the bubble, and the instability of the financial markets, by helping to drive up home prices and making the loans riskier. And no one was looking at that risk. The loan originators bore none of the risk. They made money only on the quantity of loans they were making. So they made the loans that maximized the number of loans that they made. And the consumer, who should have been more sophisticated and avoided these traps, wasn't up to the job.

So the failures that led to this include the failure of the government to tell the market that these tools are illegal. And the failure of the consumer to understand the consequences for themselves. And the failure of the market to have any concept of how much risk they were taking. And that last part was fueled because the people who started it were selling off the risk, not keeping it on their own books. So they didn't care.

I don't understand your comment about exchange rates. Did you mean to say interest rates?

 

[Samson]

To clarrify, I live in the UK and AFAIAA there is no such thing as a mortgage fixed for the life of the loan, the longest you can get a fixed rate mortgage for is around 5 years. I was quite supprised to hear that you can get 30 year fixed rate mortgages in the US. I suspect the situation in the UK is more common that the situation in the US, but I could very easily be wrong.

(Snip good description of ARMs)

Now these helped fuel the bubble, and the instability of the financial markets, by helping to drive up home prices and making the loans riskier. And no one was looking at that risk. The loan originators bore none of the risk. They made money only on the quantity of loans they were making. So they made the loans that maximized the number of loans that they made. And the consumer, who should have been more sophisticated and avoided these traps, wasn't up to the job.

So the failures that led to this include the failure of the government to tell the market that these tools are illegal.

I would find it very strange if the loan that just about everyone in the world outside america took out was illegal in the land of the free (market), but I really think there is something I am missing here.

And the failure of the consumer to understand the consequences for themselves. And the failure of the market to have any concept of how much risk they were taking. And that last part was fueled because the people who started it were selling off the risk, not keeping it on their own books. So they didn't care.

According to John Thain the problem for him was the people who made these complicated securities (Merrill Lynch) kept them on the books rather than selling them off.

I don't understand your comment about exchange rates. Did you mean to say interest rates?

Yes, sorry. I mean central bank interest rates (I will edit my post). The point being if a bank lends at 5% for 30 years and then central bank interest rates go to say 15% (about what Maggie had them at here for 2 or 3 years) how is the difference made up?

 

[Cutlass]

To clarrify, I live in the UK and AFAIAA there is no such thing as a mortgage fixed for the life of the loan, the longest you can get a fixed rate mortgage for is around 5 years. I was quite supprised to hear that you can get 30 year fixed rate mortgages in the US. I suspect the situation in the UK is more common that the situation in the US, but I could very easily be wrong.

I don't know about that. The 30 year fixed in the US has been the most common mortgage probably for 1/2 century or more.

I would find it very strange if the loan that just about everyone in the world outside america took out was illegal in the land of the free (market), but I really think there is something I am missing here.

If it is common, as you say, then there is a piece of information neither you nor I have. It could be that the down payments requirements are different. If someone put down a very large amount at the front of the loan, then the loan inherently becomes safer. One aspect of loans in the US over the past 10-15 years is that the amount of down payment required has substantially been reduced. So all low down payment loans are riskier, and there are more loans like that.

According to John Thain the problem for him was the people who made these complicated securities (Merrill Lynch) kept them on the books rather than selling them off.

I think you missed the levels of the market structure. Mortgage loan originators only created the loans. And then sold them. So they were uncaring about the level of the risk on the loans. Securities firms like Merrill do not create mortgages. What they do is buy mortgages from the originators and create the derivatives from them. As these derivatives became more complex they also kept more on their books. So it is the mortgage originators that made the riskier and more fraudulent mortgages. But it is the investment banks that made the more complex derivatives, Mortgage Backed Securities, Credit Default Swaps, and other financial instruments that were ultimately backed by the risky and fraudulent mortgages.

Yes, sorry. I mean central bank interest rates (I will edit my post). The point being if a bank lends at 5% for 30 years and then central bank interest rates go to say 15% (about what Maggie had them at here for 2 or 3 years) how is the difference made up?

Long term loans are made with a rate that takes into account the expectations and projections of inflation over the course of the loan. So for example if the projection is that inflation over a 30 year period of time would be 2%, and the rate of return that the banks need to earn is 2%, then any rate charged over 4% can be justified. As the expectation of inflation in the long run goes up, so does the rate charged. Now within that 30 year time period there will most likely be inflation which is both higher and lower. It's the 30 year average that is being targeted. Now a high central bank interest rate at some point in the middle doesn't really factor into that.

 

[Cutlass]

I think these other questions are addressed to Whomp, but there's a couple of points I'd like to make.

ISTM that it is the nature of bubbles that had it burst later it would have been bigger, and so the fallout would have been greater?

The problems is that we are not dealing exclusively, or even mostly, with the bursting of a financial bubble. The bigger part of the problem is a liquidity crisis. The bursting of a bubble destroys a lot of wealth and causes a lot of business failures, bank failures, loan defaults. But it does not by itself undermine the system as a whole.

A liquidity crisis does undermine the system as a whole. What a liquidity crisis is is a situation where the financial markets as a whole have been so destabilized that no one is willing to make any loans because they lack the information necessary to evaluate the likelihood of the loans being repaid. And that can cause the entire financial sector of the economy to seize up. And because the rest of the economy requires the financial sector on a day to day basis, a seized up financial sector causes a complete economic seizure.

Many feel that the failure of Lehman, and the failure to properly manage the failure of Lehman, added so much uncertainty to the financial sector as a whole that it brought the economy to the brink of a liquidity crisis.

So instead of simply the bursting of a major bubble, we had a crisis an order of magnitude more severe.

If this approach had been taken to the whole of the bank bailout scheme, how much money would the (US or international) taxpayer have saved? Who would have lost money?

Is this really true? Not even during the great depresion? The civil war?

Is this really true? Surely the bubble nature of the property market was at least accepted as a possibility by anyone who was paid to analyze it?

Some people did say that there was a bubble in housing prices. But far too many people either did not know that, or did not accept it. Certainly no one acted on it.

 

[Samson]

I don't know about that. The 30 year fixed in the US has been the most common mortgage probably for 1/2 century or more.



If it is common, as you say, then there is a piece of information neither you nor I have. It could be that the down payments requirements are different. If someone put down a very large amount at the front of the loan, then the loan inherently becomes safer. One aspect of loans in the US over the past 10-15 years is that the amount of down payment required has substantially been reduced. So all low down payment loans are riskier, and there are more loans like that.

I could be reading you wrong, but you seem to be somewhat sceptical about my claim that you canot get a 30 year fixed rate in the UK. I can get something more definative, but here is the information page on fixed rate mortgages from what I believe s that largest lender in the UK, the HSBC. Note it only gives 2, 3 and 5 year fixed rate:

http://www.hsbc.co.uk/1/2/personal/mortgages/first-time-buyer/fixed-rate

What peice of information am I missing? I know before all this current problems hit you could get a >100% mortgage, now you need a signifigant deposit (recently you needed 25%, but it seems some including HSBC are now offering better, like 10% down).

I think you missed the levels of the market structure. Mortgage loan originators only created the loans. And then sold them. So they were uncaring about the level of the risk on the loans. Securities firms like Merrill do not create mortgages. What they do is buy mortgages from the originators and create the derivatives from them. As these derivatives became more complex they also kept more on their books. So it is the mortgage originators that made the riskier and more fraudulent mortgages. But it is the investment banks that made the more complex derivatives, Mortgage Backed Securities, Credit Default Swaps, and other financial instruments that were ultimately backed by the risky and fraudulent mortgages.

The best evidence of this was that some of the Wall Street firms -- including Merrill Lynch, which created a lot of these things when it became more and more difficult to sell them -- thought it would be just perfectly okay to pile them up on their balance sheet.

Does that not sound like Merrill Lynch actually created them?

Long term loans are made with a rate that takes into account the expectations and projections of inflation over the course of the loan. So for example if the projection is that inflation over a 30 year period of time would be 2%, and the rate of return that the banks need to earn is 2%, then any rate charged over 4% can be justified. As the expectation of inflation in the long run goes up, so does the rate charged. Now within that 30 year time period there will most likely be inflation which is both higher and lower. It's the 30 year average that is being targeted. Now a high central bank interest rate at some point in the middle doesn't really factor into that.

I am still not sure you understand me, or I understand you, so I shall lay it out in more expansive terms.

A bank lends in say 1980 at 6% for 30 years. It borrows on the short term money markets to do so. Interest rates then go up because the 80's is a boom time and by 1984 the base rate is up to 11.88, and is over 10% untill 1992 (surely this means the UK LIBOR is close to or over 10%?). How does the bank pay the higher short term obligations than the house buyer? Is it from reserves, by hedging the risk, or what?

 

[Cutlass]

No, I accept that you're right about the mortgages in the UK. But what of the rest of the world? Which way do they do it? But the rest of your explanation is so at odds to the way the US has always handled it that it seems to me that I'm not seeing whole picture.

Does that not sound like Merrill Lynch actually created them?

Merrill created the mortgage backed securities and derivatives. They did not create the mortgages in the first place. They purchased the mortgages, repackaged them as complicated securities, and then in last few years before the collapse had a harder and harder time selling them off. But it is the mortgage backed securities, not the mortgages themselves, that they created and then had trouble selling. Those companies that created the mortgages themselves sold them off just fine.

So there are two sources of risk: One, the mortgage originators, did not care about the risks of the mortgages, because they did not keep them. And then the upper level, the investment banks, also failed to understand the risks of what they were buying, but then added a great deal more risk through creation of overly complicated securities.

I am still not sure you understand me, or I understand you, so I shall lay it out in more expansive terms.

We aren't really understanding one another. And I'm not certain why. In the US, up until the 1990s, the majority of home mortgages were made by banks, or the near bank organizations we have called thrifts (savings and loans) and credit unions. The US had, at that time, some 16,000 banks. Most very small. For example I belong to a credit union with one office and only a few thousand customers. These banks, thrifts, and credit unions made mortgage loans from the money of their depositor customers. Not the short term money markets. So the fluctuation in base rate did not have the impact on the mortgage decisions that I think you would expect them to have. It is only over the past 10-20 years that most mortgages are not owned until the end of the term by the company that negotiated the loan with the home buyer. And that is the time period when the system as a whole became far more complex. A home buyer taking out a mortgage in the years when interest rates were high got a high rate fixed mortgage. But would often refinance the loan in a later low rate year.

As far as reconciling the difference between your system and ours, I don't know enough. I don't know why the banks over there decided to do it that way.

 

[otago]

Some of this I find confusing, people believing that land, housing stock has some special value, why ? a piece of land or a house is just another commodity that is only worth what some person is prepared to pay for it on the day that you need to sell it.

Mortgage backed securities ? if a house already has a mortgage on it of 80% of market value how can the same mortgage be used to back a security ?

Why should any bank shareholders be bailed out of the situation of their making ? should the free market not reign at all times regardless of how the cards will fall ?
Or should the free market rules only apply to small business ?

 

[Cutlass]

Some of this I find confusing, people believing that land, housing stock has some special value, why ? a piece of land or a house is just another commodity that is only worth what some person is prepared to pay for it on the day that you need to sell it.

There are a couple of factors. One is that it hadn't happened before that housing lost a large part of its value. So if it hadn't happened before, to many people think that it never can happen. Also, the national population keeps increasing, but the land area does not. So the perception was that there would be ever more demand for a finite resource. Other factors include a national psychology of the value of owning your own place. And the belief that people would do anything to avoid loosing their home, so defaults would always be a very low percentage of mortgages.

Mortgage backed securities ? if a house already has a mortgage on it of 80% of market value how can the same mortgage be used to back a security ?

Banks and mortgage originators sold the mortgages they made in order to raise money to make more mortgages. The finance companies that bought the mortgages packaged them together and sold them on the global capital markets to raise money to keep doing the same. That's what caused the US housing bubble to become a global problem. People and organizations around the world falsely saw these MBSs as safe.

Why should any bank shareholders be bailed out of the situation of their making ? should the free market not reign at all times regardless of how the cards will fall ?
Or should the free market rules only apply to small business ?

Most of the shareholders lost most of their value. But some retained some of their value because their no laws to close/dismantle/sell off the assets of these huge institutions. What laws did exist did not have a mechanism for handling the situation. So the Federal Reserve and the Treasury were largely making it up as they went along. And got some of it wrong.

 

[Whomp]

Samson--the loan you showed by HSBC is a fixed to adjustable rate loan. What I said earlier in this thread was considered a fairly sophisticated loan for most buyers to understand. This means that the loan is fixed rate for a period of time, say 5 years, then the rate will float off an index for the following 25 years (many times that floating rate is off LIBOR, say +2%, for 10, 15, 20 or 25 years depending on how the loan structured). The shorter the terms the lower the interest rate and the higher the payment.

Most home buyers can't afford to pay a loan that was short term the way you're discussing since the amortized payments would be gigantic.

Regarding Merrill Lynch, Stan O'Neil did buy a mortgage company that originated mortgages. Those mortgages would then be securitized and attempted to be resold to the market. The problem for investment banks, like Merrill Lynch at the time, is they are in the "moving business (sell, rinse and repeat)" and not intended to be in the "storage business' (hold inventory on the balance sheet as the owner). Problem is these investments they created couldn't be sold so the companies, like Merrill, Lehman and Bear Stearns in particular, become the "storage company" and the value had to be marked down on these securities (by way of mark to market accounting which requires the firm to put on the books at their worth) and, in turn, reduced their minimum capital requirements to stay in business. John Thain's comment about using a high speed computer that took three hours to value one of these securities shows how difficult it was to value these investments. That's why he feels these firms balance sheets should never be this complex.

As far as the other firms, like JP Morgan and Bank of America, they never had these problems on their balance sheet so they were picking up the valuable pieces of the other companies since these companies destroyed their balance sheet with these securities whereas their other operating businesses were very profitiable (IE wealth/asset management/forex trading etc).

 

[Samson]

We aren't really understanding one another. And I'm not certain why. In the US, up until the 1990s, the majority of home mortgages were made by banks, or the near bank organizations we have called thrifts (savings and loans) and credit unions. The US had, at that time, some 16,000 banks. Most very small. For example I belong to a credit union with one office and only a few thousand customers. These banks, thrifts, and credit unions made mortgage loans from the money of their depositor customers. Not the short term money markets. So the fluctuation in base rate did not have the impact on the mortgage decisions that I think you would expect them to have. It is only over the past 10-20 years that most mortgages are not owned until the end of the term by the company that negotiated the loan with the home buyer. And that is the time period when the system as a whole became far more complex. A home buyer taking out a mortgage in the years when interest rates were high got a high rate fixed mortgage. But would often refinance the loan in a later low rate year.

As far as reconciling the difference between your system and ours, I don't know enough. I don't know why the banks over there decided to do it that way.

Thanks, this really explains what I did not get.

 

[Samson]

Samson--the loan you showed by HSBC is a fixed to adjustable rate loan. What I said earlier in this thread was considered a fairly sophisticated loan for most buyers to understand. This means that the loan is fixed rate for a period of time, say 5 years, then the rate will float off an index for the following 25 years (many times that floating rate is off LIBOR, say +2%, for 10, 15, 20 or 25 years depending on how the loan structured). The shorter the terms the lower the interest rate and the higher the payment.

Most home buyers can't afford to pay a loan that was short term the way you're discussing since the amortized payments would be gigantic.

Did you notice this was the "fixed rate mortgage" option from the 3 sorts they offer. The others are "Life time tracker" which is fixed 2.45% above the bank of England base rate (sounds a lot to me) and the "Special" which as well as sounding dodgy is pretty much whatever HSBC wants it to be (currently 3.94%). This is the rate you go onto after the fixed rate period is up.

What do you mean by the last sentance? As I say, these are the basic options that you have over here, and many people manage to afford it.

 

[Whomp]

Did you notice this was the "fixed rate mortgage" option from the 3 sorts they offer. The others are "Life time tracker" which is fixed 2.45% above the bank of England base rate (sounds a lot to me) and the "Special" which as well as sounding dodgy is pretty much whatever HSBC wants it to be (currently 3.94%). This is the rate you go onto after the fixed rate period is up.

What do you mean by the last sentance? As I say, these are the basic options that you have over here, and many people manage to afford it.

Look closer because this is the same loan people in the US got themselves in trouble with. If you look closer at capital repayment plan it can be up to 30 years amortization. This is typical of a a fixed to adjustable rate loan anyone can find.

The problem US borrowers got into was when the "life tracker rate" skyrocketed after their fixed rate expired. Here you are subject to 2.45% above the Bank of England base rate and the "special rate" (which is a little more elusive to find on their site) but my guess is it's based on LIBOR plus a margin. In the US, LIBOR based loans can be had for ~2.25% right now (LIBOR plus 2). The problem with this rate is it assumes the rate doesn't move much and more importantly that you qualify. There's also the issue of prepayment and other fees (VAT) that HSBC charges which many loans don't do here. In fact, the more principal you pay the lower your payment becomes on interest only fixed to adjustable rate loans in the US because it reamortizes the loan. The good news is you can transfer that loan to someone else (IE if you sell the home) which can be attractive if the buyer wants to keep your terms. We haven't done for decades but I think we should.

I know this is a lot and probably why some people should understand the terms before entering the agreement.

 

[Cutlass]

I hate to let this thread die off. It's the most interesting here in the past few months.

So.... Opinions solicited on regulatory reform. There is a debate in public policy circles concerning the choice between regulation by executive agency, and regulation by independent regulatory commission. Now if any of you outside the US are reading this, you might not be familiar with the US version of independent regulatory commissions. So quick version: IRCs are intended as a "good government" reform. The way they work is that an agency tasked with regulating certain segments of the economy or being engaged in other tasks is set up as a commission of experts, rather than being run by the executive. They typically have a number of people on their board who are appointed for extended periods of time, longer than a presidential term, so that no one president can appoint all of the people on the board. That is to insulate the commission from political control and influence. The main criticism of IRCs is that they can become "captured", that is that they can become closer to the industry that they are supposed to regulate than they are to the public interest. And so collaborate with the very organizations that they are supposed to control. The alternative is regulation by executive agency. That means that as a part of the executive branch of the government, the president appoints the administrator, and that administrator answers to the president directly. The president can fire that person at will, where he cannot fire a member of a board of an IRC. The main criticism of regulation by executive agency is that you may get a president who, for whatever reason, disagrees with the goal of the agency and orders the administrator to simply not do any regulating.

The Treasury and Justice departments are examples of executive branch regulatory agencies. The Federal Reserve and the Securities and Exchange Commission are examples of IRCs (the Fed's organizational structure is actually more complex than that, but the description will do for this discussion).

In this crisis it's pretty clear that both types of regulatory agencies failed. President Bush told those members of the executive branch that answer to him to cease to regulate. Alan Greenspan, as chairman of the Federal Reserve, did pretty much the same thing. The Securities and Exchange Commission fell down on the job for lack of competence.

We discussed earlier, and it was part of the panel discussion, that the regulatory structure is very complex, with many different organizations having jurisdiction in different areas. So the system of regulation, as well as the agencies themselves, contributed to the overall failure.

So my question for anyone here is what type of structure do you think we should be looking at for regulatory reform?

 

[I'm Cleo!]

So my question for anyone here is what type of structure do you think we should be looking at for regulatory reform?

I feel like it should be something that changes the foundation of the market, rather than just regulation. I hate the idea of a cat-and-mouse situation where a regulatory body says "you may do A, B, and C, and you may not do X, Y, and Z," and then some firms come up with D-W and AA-ZZZZZZZ, which requires the agency to address them, and so on. I just don't like those systems, especially when the regulated will have lots more resources than the regulators.

I read somewhere on the World Wide Web where someone suggested breaking up finance into two sections: (i) boring finance, like home loans, car loans, small business loans, bank accounts, &c., and (ii) exciting finance, like credit default swaps and derivatives and all that junk (pun intended). Each firm has to decide if it's a type (i) or type (ii) firm -- the former are backed by the government (through FDIC, say), and the latter aren't backed by anything (hardcore mode -- death is permanent). Naturally, there can't be any firms that are both, or have both parts within them. Just enforce the firm types, and there you go. (Of course, someone smart will probably come along here in a few posts and show how "just enforc[ing] the firm types" is incredibly hard, and awfully like the regulatory systems I detailed above.)

Cleo

 

[Cutlass]

Unfortunately, it was the exciting part of finance that did the most damage to the economy. And it was the collapse of Lehman, part of the exciting side, that is blamed for costing the economy trillions.

 

[Whomp]

I would propose a few things...
1. Disclosure--Standardize methods of disclosure. For instance, if an institutions CDR (Conditional Default Rate) ticked up X% how much risk it adds to capital. Key metrics should be disclosed more often to the regulators so instead of monthly it would seem weekly is wholly realistic. Companies know their VaR (value at risk) thirty minutes after markets close every day.

2. Create an overarching regulatory body--instead of the OCC, Fed, FDIC, SEC, CFTC, MSRB, NASD, and every exchange regulating various parts of the financial infrastructure they should be built like financial firms build their organizations. Have a divisions for banks, thrifts, insurance companies. investment banks, holding companies and hedge funds. Then breakdown even fruther all the activities these firms do and send it back up the channel. Break up the silos however self-interested politicians don't have the will to do it I'm afraid.

3. Size and complexity matters--Raise costs for bigger institutions and firms that have less liquid, higher risk assets on the books. IE Citicorp would pay more than JP Morgan for their complexity on the balance sheet.

 

[Cutlass]

I feel like it should be something that changes the foundation of the market, rather than just regulation. I hate the idea of a cat-and-mouse situation where a regulatory body says "you may do A, B, and C, and you may not do X, Y, and Z," and then some firms come up with D-W and AA-ZZZZZZZ, which requires the agency to address them, and so on. I just don't like those systems, especially when the regulated will have lots more resources than the regulators.

Cleo

Having given this some more thought, it is a problem that innovations are by default not regulated. The solution to that is to say that any innovation requires prior regulatory approval before it can be used. So, for example, instead of companies issuing Credit Default Swaps, something no sane an honest person would do, they would have to seek approval for it. They would have to prepare a proposal, submit it to the regulatory agency, have hearings, solicit public comments, and finally get a ruling. That could take a while. and reducing innovations would certainly draw some protests. However it would have stopped at least some of the worst aspects that caused the recent crisis.

@ Whomp, risk to an organization can be evaluated, but how do you evaluate systemic risk?

 

[Whomp]

@ Whomp, risk to an organization can be evaluated, but how do you evaluate systemic risk?

I think I've already suggested it. Consider how large of a percentage of GDP brokers dealers assets became by 2007. It was near 22% of GDP which is unprecedented versus just 4.5% 25 years ago.

So we need to revisit what's the trade off for guaranteeing deposits. Make the government guarantees explicit and financial institutions pay for them through more stringent regulation of those assets (IE tier 1 vs. 3) and cash. The objective would be to make the incentive to avoid becoming systemically important.

The problem here is how do you avoid regulatory arbitrage? If all nations aren't on board it makes for a tough sell. The other issue is who determines what systemic risk is if no governmental agency could figure it out in the first place? Steamlining authority and getting rid of silos makes much more sense to me.

Honestly, I'm not sure systemic risk in finance is where we need to be focused. There's a lot more governmental systemic risks that are not addressed than anything finance can muster at this point. From what I can tell FHA is simply repeating mistakes mortgage brokers were creating just 4 years ago. Entrenched incumbency is a greater systemic risk than anything finance can create post bubble.