Bull by the Horns

by Sheila Bair

  Megabanks’ international operations should also be simplified and sub-sidiarized so that major operations in each foreign country are housed in separate legal entities organized under the laws of that country. Some megabanks, notably Spain’s Santander and Britain’s HSBC, organize their operations in this way. It has not hurt their profitability and makes them much more resolvable.

  Creating a manageable number of distinct, stand-alone subsidiaries within the broader banking organization would make it much easier to break up and resolve the behemoths if they get into trouble. Requiring separate boards and management would also improve the quality of management as executives would have a smaller, more specialized entity to oversee. Finally, separate boards and managers would reduce the opportunity for conflicts of interest, particularly between megabanks’ securities activities and commercial banking operations. The megainstitutions, with their far-flung operations and diverse businesses, are simply too complex to manage centrally. Of course, a lot of people would prefer that the big banks be completely broken up, and that is an attractive option. However, I do not think the Fed and FDIC’s legal authority extends that far, and as previously indicated, I do not believe there is sufficient support in Congress for passing legislation to break them up. In any event, much the same result can be achieved through restructuring their different business lines into discrete, separately managed legal entities. This approach also preserves benefits associated with diversification and keeps the entire organization under government supervision. A disadvantage of some break-up proposals is that they would push nontraditional financial activities back into the “shadow system” where there is very little regulatory oversight. This is exactly the problem we had precrisis, with shadow banks like AIG, Bear Sterns, Lehman Bros, and others feeding the subprime crisis.

  Ironically, such a restructuring would not only help ensure that those institutions can be resolved in an orderly way if they get into trouble; it would also likely improve performance for shareholders. The megabanks have always performed more poorly than well-managed commercial banks that have stuck to the basic business of taking deposits and making loans. Even during the go-go years before the crisis, bread-and-butter commercial banks such as Wells Fargo and U.S. Bancorp consistently delivered better returns than Citi, Bank of America, and even JPMorgan Chase. Since the crisis, the megabanks’ share valuations have lagged the average performance of regional banks. Indeed, based on share prices at the beginning of 2012, the megabanks’ shares in relation to their tangible book value traded significantly lower than that of regional commercial banks. Management efficiency would be improved by creating legal entities that focused on specific business lines. It would also make it easier for shareholders themselves to break up the megabanks if they concluded better value could be realized through such a step.

  Megabanks argue that making them reorganize into smaller stand-alone units would impair their ability to meet the financial needs of big multinational corporations. But it’s not clear that multinationals find it advantageous to do business with a huge, complex financial titan. Dealing with smaller, focused entities would give them specialized expertise and less risk of conflicts. Conversely, even the megabanks don’t want to take all the risks of big deals for multinationals, which is why those deals are typically syndicated among multiple banks. If there was really that much value in megabanks’ services, presumably it would show up in shareholder returns. But it doesn’t.

  Megabanks also argue that their economies of scale can lower costs for customers, and that they will lose those economies if they have to manage each business line as a separate, stand-alone unit. Studies show that some economies of scale exist, but they are limited by management difficulties in overseeing many different business lines. So although average overhead costs go down, average revenues go down even more. In short, there are no clear market or shareholder benefits from having complex, multitrillion-dollar institutions and many disadvantages from a public policy standpoint. If the FDIC had to resolve one of the megabanks now, it could do so by seizing control of its holding company. However, it would take months if not years to untangle its complex legal structures, split them up, and return them to private-sector ownership. That means the resolution would be costlier than it needed to be for the shareholders and unsecured creditors who, under Dodd-Frank, must absorb the losses. Taking steps now to restructure the behemoths into a limited number of smaller specialized, stand-alone subsidiaries would be in the public interest and in the enlightened interest of their shareholders as well.

  Require Securitizers to Retain Risk

  My book has spent a lot of time explaining the mechanics and structure of the securitization market and the skewed economic incentives it created. Those skewed incentives not only led to the origination of millions of unaffordable mortgages but also created incentives for servicers and certain classes of investors to choose foreclosures over loan modifications. I firmly believe that the only way to correct those incentives is to align the interests of securitizers with those of investors as a whole. The best way to do that is with a simple rule that says that every time an investor takes a dollar of loss on his investment, the securitizer must absorb at least 5 cents of it, as provided by Dodd-Frank. If I had it my way, we would make it 10 cents.

  When I served as FDIC chairman, my home fax number somehow landed on a spam fax list used by a mortgage brokerage to advertise its mortgages. Each month I would get a fax advertising “adjustable fixed-rate loans,” prominently noting that I could qualify even if I had no income documentation and a bad credit score and had filed for bankruptcy! This sleazy ad used the confusing oxymoron of “adjustable fixed-rate” to describe the loans because the rate on them was “fixed” during a brief introductory period, with a steep payment reset once the introductory period expired. I received those faxes all through 2007 and a good part of 2008. Each month, the only thing that would change on the ad was the phone number. I took the ads into the office and asked the staff to try to track the firm down, but they were unable to do so. It moved around too quickly.

  Risk retention would put firms like those out of business. Why? Because they do not have a budget or financial resources to retain any of the financial risk. If securitizers have to retain 5 or 10 percent of the losses on securitized loans that go bad, they will want to have recourse against the broker who sold them the loans. If a broker cannot demonstrate the financial capability to make the securitizer whole, the securitizer will not buy loans from it. That would be a good result. A mortgage is by far the biggest financial obligation you and your family will ever undertake. We don’t want lightly regulated fly-by-nights originating your mortgage. We want an established, reputable firm originating it, one that has some financial interest in making sure it is affordable to you.

  Yet, as I write this, risk retention for securitizations is under assault in the Congress, and I regret to say that both Republicans and Democrats are succumbing to industry pressure. Unfortunately, some community groups are aligning with mortgage industry advocates. Here again, Washington needs a good dose of common sense from Main Street. If we are to keep the securitization-fed subprime debacle from happening again, it is essential that those who securitize mortgages keep some meaningful skin in the game.

  Require an Insurable Interest for Credit Default Swaps

  Congress made a huge mistake280 when it enacted legislation in 2000 that essentially insulated most financial derivatives from any regulation by state or federal regulators. Into that regulatory void, the credit default swaps (CDS) market exploded. By the end of 2007281, the CDS market had grown to $62 trillion, nearly twice the size of the mortgage market, U.S. stock market, and government securities market combined.

  As discussed in earlier chapters, CDSs are essentially a form of insurance protection that investors can buy to protect themselves against losses on debt securities they hold. Many investors in complex mortgage-backed securities—the CDOs discussed in chapter 5—bought CDS protection
against losses on those securities. The company that sold a major part of that protection was AIG. Because of the 2000 legislation, AIG’s CDS business was left unregulated. The standard tenets of insurance regulation—that insurance companies must charge premiums and hold capital and reserves that are adequate to cover losses on the risks they are insuring—did not apply to AIG’s CDS business. During the go-go years before the subprime crisis hit, AIG made a lot of money selling large volumes of CDS protection at relatively low prices. As a consequence, its financial resources to pay out on CDS claims were woefully inadequate when mortgage losses spiked in 2007 and 2008. The government ended up investing a whopping $180 billion in AIG. As of March, 2012, about $45 billion of the government’s investment had not been paid back.

  Dodd-Frank fixed some of that by giving both the SEC and the CFTC authority to regulate the derivatives market. Among other things, the legislation mandated that the SEC and CFTC, working with the banking regulators, set standards for the amount of capital and margin that sellers of CDSs must hold. But Dodd-Frank continues to insulate the CDS market from traditional insurance regulation. Importantly, the new law does not require that purchasers of CDSs have an insurable interest.

  When you go to an insurance company to buy fire protection on your house, it will want proof that you own the house. It does not want you buying insurance protection on your neighbor’s house. That would give you an incentive to burn your neighbor’s house down. For centuries, a central tenet of insurance has been to insure only against losses that the insured may actually sustain. Without such a requirement, insurance simply becomes a means to gamble on other people’s losses, creating economic incentives to inflict harm on others to reap the insurance payout.

  Without an insurable interest requirement, the CDS market has become primarily a speculators’ game. The market is heavily subject to manipulation, given the lack of regulation and the ability of speculators to influence prices. Moreover, it has been able to grow to such an astronomical size because speculators are free to bet against default on a wide range of securities without actually owning any of them. Just as there is no limit on the amount of money that can be wagered on who wins the Super Bowl, there is no limit on the number of speculators who can bet on whether the Italian government will default on its bonds or, as was commonly the case in 2007, whether investors would suffer losses on mortgage-backed securities and the infamous CDOs.

  Some of the early resistance to our loan modification initiatives came from hedge fund managers, who would make money if mortgage defaults went up. This was because they had purchased CDS protection against losses on mortgage-backed securities they did not own. If they had been required to hold mortgage investments that exceeded the dollar amount of their CDS protection, they would not have had an incentive to oppose loan modifications. Similarly, it used to be that when an investor bought the debt of a company and that company got into trouble, the investor would work with the company to restructure its debt to help the company avoid a costly bankruptcy. Now, with investors being able to buy CDS protection that far exceeds any underlying bondholdings, if anything, they have an incentive for the company to go bankrupt.

  Opponents of an insurable interest requirement argue that CDS can be used to protect against losses on other investments that are related, but not identical, to losses covered by the CDS contract. For instance, a bank that has made a lot of loans to borrowers in Spain might be worried about the Spanish government defaulting on its debt and the adverse impact that could have on the Spanish economy. So the bank buys CDS protection on Spanish bonds, even though it does not own Spanish bonds.

  I think there are probably more direct ways to hedge against an economic downturn in Spain—for instance, by curbing new lending activity and requiring more collateral from Spanish borrowers. Alternatively, the principle of insurable interest could apply by requiring the purchaser of CDSs to demonstrate that it has a financial risk that is correlated to Spanish debt and requiring that the purchaser document financial loss before being able to recover on the CDS claim. You have to prove you have suffered economic loss before collecting on an insurance claim. Why shouldn’t they?

  An insurable interest requirement for purchasers of credit default protection is yet another example of commonsense regulation that is needed. We do not want Wall Street speculators having incentives to drive our housing market or major corporations into trouble so they can collect on their CDS bets. Requiring CDS users to have some skin in the game aligns their economic incentives with the broader public interest.

  Impose an Assessment or Tax on Large Financial Institutions

  My deepest disappointment in the Dodd-Frank battles was over Congress’s failure to give the FDIC authority to charge an assessment on the nation’s largest financial institutions. With that authority, the FDIC could have imposed assessments based on all of the risk factors that fed the crisis, such as heavy reliance on short-term funding, high-risk lending, and trading in complex, illiquid securities. The assessment would have made the large financial institutions internalize the risks they pose to society and helped level the playing field between small banks and financial behemoths. Funds raised through the assessment would have insulated taxpayers from supporting the liquidation of big financial institutions, even temporarily.

  Secretary Geithner worked hard to defeat the assessment in the Dodd-Frank bill. He has also traveled to Europe to work against European officials who are considering a transaction tax on large financial institutions. The U.S. administration has made token proposals to impose temporary taxes on financial institutions based on TARP expenditures, proposals that everyone understands will go nowhere. Perhaps with a new administration economic team in 2013, there will be more serious efforts to impose an assessment or tax on financial risk taking.

  The FDIC assessment is not a tax, as the revenue collected would be held in a special fund and used only as working capital for FDIC resolutions. A tax, on the other hand, would go to general revenues and support government operations. (Both, however, would help reduce the budget deficit under government accounting rules.) I prefer the FDIC assessment because it provides the government with more flexibility to adjust the assessment based on new risks and avoid gaming, whereas a tax would be written by Congress and thus be harder to change once enacted.

  However, either option would make it more expensive for financial institutions to engage in short-term transactions. That would have a stabilizing influence on our markets. For instance, if a financial institution had to pay an assessment or tax each time it borrowed money, it would become much more expensive to continually fund operations with repeated short-term borrowings. In contrast, institutions that funded themselves primarily with long-term debt would have to pay the tax only every few years, when the debt was renewed. Similarly, those who invested long term would seldom pay the tax, but those who actively traded to make short-term profits would be paying very high amounts.

  Both the FDIC assessment and a financial transaction tax would provide incentives and rewards for long-term market behavior, as well as produce revenues to reduce the budget deficit and help restore the damage to our public finances caused by the financial crisis and ensuing recession. Main Street should strongly support either option.

  THINGS THAT WILL MAKE OUR REGULATORS WORK BETTER

  Keep the Consumer Agency

  I don’t know how anyone can say that we have done a good job of protecting consumers in financial services. Payment shock mortgages with abusive prepayment penalties, fee-laden credit cards, excessive overdraft fees—these are three examples of the types of products where disclosures have been inadequate and the products too complex for consumers to understand what they were getting themselves into. Moreover, the situation is worse with regard to nonbank financial providers, for example, payday lenders and money remitters, who charge fees and interest equivalent to several hundred percent. Similarly, the most abusive subprime loans were typically made by nonbank mortgage originato
rs.

  Pre-Dodd-Frank, the Federal Reserve Board had the job of writing the consumer rules for financial products, and its efforts were woefully inadequate. The core problem, I believe, was that the Fed’s responsibilities for monetary policy and safety and soundness supervision always came first. Insufficient attention was given to what was happening to consumers. What’s more, when the Fed did write consumer rules, they were generally lengthy and highly complex, making it difficult for consumers to understand their rights. The complexity and cost of complying with the rules also forced many community banks out of the business of consumer lending.

  It is a very good thing that Congress has now created an agency devoted exclusively to consumer protection. I have high hopes that this new agency will work hard to simplify and strengthen consumer protections, while bringing much-needed enforcement of consumer rules to the nonbank sector. People of goodwill can differ on the structure of the new agency. I prefer that a regulatory agency have a board instead of a single director. A board brings a diversity of viewpoints that can help guard against regulatory capture, which is one of the reasons why I believe the OCC—if we keep it—should also be headed by a board. But the continuing debate about the structure of the consumer agency should not impede its ability to carry out its important functions. The agency deserves to have a Senate-confirmed head to lead it.

  Restructure the Financial Stability Oversight Council