Sitting here in Limbo
Waiting for the tide to turn.
Yeah, now, sitting here in Limbo,
So many things I’ve got to learn.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

And then the harder they come, the harder they fall, one and all!

Whither the GSEs?  A year and a half into their conservatorship, nobody knows – and we could easily wait another whole year with no progress.  As reported in the Washington Post:

The federal government has spent the past half year seeking to roll back its emergency efforts at propping up the financial markets – with the notable exception of its involvement in mortgage giants Fannie Mae and Freddie Mac.

Taking over Fannie Mae and Freddie Mac wasn’t about propping up the financial markets, but rather keeping upright the housing markets.

Houses, not banks

As recently as December, the Obama administration said it expected to release a preliminary report on how to remake Fannie Mae and Freddie Mac around Feb. 1.

The best laid schemes of mice and Administrations gang aft agley.

But no plan was produced, and in response to questions from lawmakers, Treasury Secretary Timothy F. Geithner clarified last month that it would be another year before the government proposes how to restructure the firms.

That’s for me not to know and for you to speculate about, isn’t it?

Sixteen months after they were seized to prevent their collapse, the companies remain wards of the state –

Regarding the GSEs’ continued limbo, I’m of two minds:

1. Don’t risk open-heart surgery.  The GSEs are a lifeblood of the American housing finance system – and hence of the global capital markets.  Tinkering with them now risks a disruption we simply cannot afford.

Don’t tug on that … you never know what it might be attached to

2. Doing nothing is unacceptable too.  Because the GSEs are so important, they cannot be left with no hand at the strategic tiller.  The GSEs should be part of the solution, not simply a metronome ticking away on momentum.

Further, lack of management isn’t just bad strategy, it’s bad governance, and dangerous:

– running a tab that has now exceeded $125 billion in what has become the single costliest component of the federal bailout for the financial system.

Lack of transparency means lack of practical oversight … and we know how well opacity worked for them before, don’t we?

It looked really good until it failed miserably

Some members of Congress have complained that the huge public commitment is unsustainable.

It is – and without transparent reporting, we have no way of knowing whether the GSEs are rebuilding their balance sheets and net equity or continuing to run up losses not of their past executives’ making.

But the administration has been reluctant to start reforming Fannie Mae and Freddie Mac, officials and analysts say, because the firms in their current form play an essential role in supporting the housing market at a time when it is still under severe stress.

Absolutely, categorically true – we cannot allow the housing market’s financial heart to stop pumping liquidity.  Even if it’s artificial.

Don’t worry, your Federal government is at th econtrols

As other financial firms have exited the market and credit has seized up, Fannie and Freddie have been behind the vast majority of mortgages made since the start of the financial crisis. The companies now own or back more than half of all U.S. home loans.

With FHA right behind, and itself weakening.

Moreover, the companies are helping the administration pursue policies designed to make new homes more affordable, ease the burden on struggling borrowers and direct funding to parts of the country especially hard hit by the downturn.

Allow us to be crystal clear here – by continuing to supply liquidity, and to “ease the burden on struggling homeowners” [translation: forbear – Ed.], the Administration is almost certainly increasing Fannie Mae’s and Freddie Mac’s losses. 

A rising tide lifts all boats?

Their bet is simply that the gains to others (e.g. homeowners, other banks, securities holders) and the macroeconomic benefits (lower interest rates, support for employment) outweigh the costs. 

Any initiative to remake the firms could distract energy from these programs or, in some cases, put an end to them.

By their actions, Fannie and Freddie are taking a concentration of the pain that would otherwise be diffused throughout the economy. 

The companies have also been tapped by the Treasury Department to rewrite the terms of home loans for struggling borrowers facing foreclosure. But this program – carried out by Fannie, Freddie and other firms – has had less success. Although 1.3 million borrowers have been eligible, only about one-tenth have had permanent mortgage modifications.

Many of those eligible are under water in all scenarios; most of them should never have been homeowners in the first place.

And keeping the companies solvent has been costly. To cover their losses, the firms have both said they will need additional federal money beyond the more than $125 billion already committed.

As a taxpayer, I think and hope their strategy has been right for the country – I’m willing to pay more if it serves to strengthen the economy.  Were I a director of either institution, I’d want explicit exculpation from breach-of-fiduciary-duty claims.

Yes, something like that

Nor is the administration eager to foster a debate over Fannie Mae and Freddie Mac in an election year, according to analysts and lawmakers.

As a policy wonk, I had overlooked this.  Yes, raising the GSEs’ future now has to be a net loser for the Administration.  With all their current political tribulations and pitched battles on Capitol Hill, the Democrats can ill afford to open another political front.

The pair have long been lightning rods for criticism by many Republicans, who call them [1] an intrusion into the free market and [2] a Democratic patronage haven.

Yes on [1], probably No on [2].  Democrats and urbanists like housing subsidies more than Republicans do, so the leadership of Fannie and Freddie probably veers toward the liberal. 

Many Democrats, even as they faulted companies’ excesses, have defended the firms’ role in fostering homeownership.

Well, if the GSEs haven’t done that, why did we give them all those awfully big advantages?

And with Obama’s campaign to overhaul financial regulation facing resistance on Capitol Hill, administration officials don’t want to add another divisive issue to the mix.

Especially if the Administration is unsure what it wants to do.

“We’ve obviously had our hands full, as has the Congress,” said Michael Barr, assistant Treasury secretary for financial institutions. “We’re just beginning to see some positive signs in the housing market, but we’re not out of the woods yet and so we want to be careful to be sure that we had an appropriate, paced process.”

Michael Barr

There’s a Barr in them financial woods

Barr said Treasury officials have been meeting informally with their counterparts at the White House and the Department of Housing and Urban Development and exchanging policy papers to develop principles for overhauling Fannie Mae and Freddie Mac.

All well and good – maybe it starts to coalesce a thought cloud – but a far cry from actual progress, particularly as the Republicans will weigh in strongly before anything happens.

These principles include, for instance, that the government ensure borrowers could still get mortgages even when the private market is no longer offering loans.

A laudable principle if the reason the private market isn’t lending relates to a credit crunch.  But if the private sector is sensibly pulling back from risk, and the GSEs zag when they should have zigged, we will be much worse off.

You are here …

But whatever replaces Fannie and Freddie, it should not be allowed to grow so large that its failure could threaten the financial system.

Oh, brilliant …

“And that’s how there’ll never be any financial crisis ever again.”

“Great, Jackie.”

“They weren’t planning to do much about it,” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, in an interview. “They’re busy, and it’s hard and it’s complicated and they’re trying to put it off.”

So the Administration, understandably, put GSE reform into the too-hard-revisit-later basket.

Where did I file it?

Frank said he is “forcing” the issue by scheduling a committee hearing later this month, summoning Geithner and other officials to discuss options for reforming the firms.

A hearing, useful though it may be, will not force the issue, but at least it will raise the issue.

Once among their strongest supporters, Frank has more recently called for their abolishment.

As independent entities, that is. 

“Independence may be overrated”

Future scenarios for reforming Fannie Mae and Freddie Mac range widely – from total privatization to total nationalization. But no consensus has emerged over the best fix.

Nor will it any time soon.  This is guaranteed to be divisive. 

Spokesmen for Fannie Mae and Freddie Mac said their current focus is on keeping funds flowing into the mortgage market and helping distressed borrowers remain in their homes.

As it should be.

The companies did not address the question of how they should be restructured.

In view of their obvious self-interest, nothing would be gained by the GSEs’ management vocalizing about their future.  They will be keeping their heads down.

When the Bush administration seized the firms, it said it would make $200 billion available to them. The Obama administration a year ago doubled that figure, then decided late last year to offer them unlimited financial assistance as a signal to investors that the companies’ solvency was guaranteed.

But critics warn this has given Fannie Mae and Freddie Mac a blank check.

That is the problem.  They do have a blank check.

Fill in the zeroes later

“This idea of having money laying around that they can spend on whatever they think politically makes sense is certainly consistent with what we’ve seen from this administration,” said Rep. Jim Jordan (R-Ohio), a member of the House Oversight and Government Reform Committee who has called for an investigation into the delay in planning for the companies’ future.  

True enough, but there are good reasons for caution.

“Any suggestion now about future changes could destabilize the market,” said Karen Shaw Petrou, managing director of analysis firm Federal Financial Analytics and a longtime observer of housing finance policy. “The U.S. mortgage market is so fragile that all Treasury needs to say is ‘boo’ and it could fall apart.”

But time could be tight. Under the firms’ agreement with the Treasury Department, they must shrink their mortgage portfolios every year, eroding their ability to support the market.

That is, unless the rules get changed … yet again.

I’m smiling outside, and crying inside

James Lockhart, a former top regulator of Fannie Mae and Freddie Mac, said the administration is erring by waiting another year to begin the reform process.

“The clock is ticking. We need to reinvigorate the private mortgage market and create something new and we know how long Congress takes,” Lockhart said. “It’s unhealthy to have as much government involvement in the mortgage market as we have in this country.”

He’s right, of course, but limbo is no state for us to be in.

Could be dangerous

Sitting here in Limbo

Waiting for the dice to roll.
Yeah, now, sitting here in Limbo,
Still got some time to search my soul.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

I said forgive them, Lord, they know not what they done

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When everyone else gets sick, even the healthy start having symptoms too.

Oh, I should never have gorged on those ‘07 and ‘08 loans

As one of only three stores left open, still selling single-family and multifamily long-term financing, the Federal Housing Administration – the GSE from the right side of the blanket, as it were, the one always acknowledged as part of the Federal government – is showing stresses in its portfolio of new loans.  As reported by The Washington Post:

The share of borrowers who are falling seriously behind on loans backed by the Federal Housing Administration jumped by more than a third in the past year, foreshadowing a crush of foreclosures that could further buffet an agency vital to the housing market’s recovery.

As I posted back in September, FHA’s loan losses will not ‘buffet’ the entity because it is a direct arm of the Federal government, and as such cannot go bankrupt independent of a Federal bankruptcy – and while sovereign bankruptcy is on the horizon for Dubai and Greece, we are not in that situation (thankfully) (yet).

About 9.1% of FHA borrowers had missed at least three payments as of December, up from 6.5% a year ago, the agency’s figures show.

Not only is a 9.1% serious delinquency rate high, that’s atop an already high 6.5% rate.  The homeownership arena is still hurting – now not because of declining property values, but rather because of the ongoing structural weakness that the so-called stimulus legislation has clearly done nothing to reverse.

Year-over-year delinquency rate change; it’s worse in the West

Although the FHA’s default rate has been climbing for months and eating into the agency’s cash, the latest figures show that the FHA’s woes are getting worse even as the housing market shows signs of improvement. The problems are rooted in FHA mortgages made in 2007 and 2008.

Loan defaults have an incubation/ contagion phase delay.  As we saw in the decade’s biggest invisible stories, during 2007 and 2008 originators like Countrywide offloaded swaths of their inventory onto long-term government players (like naive Fannie Mae).

Those loans are now maturing into their worst years because failures most often occur two to three years after a mortgage is made.

By now we know it’s regionalized: California/ Nevada, Florida, and the Upper Midwest

If the trend continues and the FHA’s cash reserves are exhausted, the federal government would automatically use taxpayer money to cover the losses –

Which I noted months ago:

The Federal Housing Administration, the original government lender and hence the precursor to Fannie Mae and Freddie Mac; as a forerunner, FHA’s government connection was and is more direct.  It’s an arm of HUD, hence its securities carry the full faith and credit of the United States, unlike its GSE heirs Fannie and Freddie, which borrowed money on the capital markets without direct Federal support.

[Uh, until recently.  – Ed.]

“It’s pronounced ‘feefa’ not ‘fiefdom’”

That means that unlike Fannie and Freddie, who are likely to return to a non-guaranteed state some day, the government is always exposed for the entire FHA portfolio.  And FHA has a further tool that Fannie and Freddie do not: in addition to making direct loan, it offers mortgage insurance. 

Now the piper may need to be paid:

– a first for the agency, which has always used the fees it charges borrowers to pay for its losses.

Uh – except for that Great Depression thing we had during 1934, when FHA was created.

And back then, we had much lower homeownership rates

As these loans from 2007 and 2008 go bad and clear off of the FHA’s books, agency officials said, losses are expected to taper off, aided by the housing market’s anticipated recovery and an influx of more creditworthy borrowers, who have flocked to the FHA’s home-buying program in the past year.

We thus have a race of sorts.  Which will mature first – the capitalized value of the new insurance premiums, or the recognized losses from the recent vintages?  Fortunately, because FHA is already owned by the Federal government, it’s more of an academic and economic-efficiency question than one of national consequences. 

Agency officials said they have cracked down on poorly performing lenders and announced higher qualifying fees for borrowers. On Monday, the agency projected that the fees should generate $5.8 billion in fiscal 2011 [Which ends 30 Sep 10 – Ed.], up from $2 billion this year.

That seems highly plausible.  With Fannie, Freddie, and FHA the only games in town, they are all gulping new market share.

Two whose patrimony was only recently acknowledged

One who always knew who was its mother and its father

That would fatten the FHA’s cash cushion, used to cover unexpected losses.

An exasperating imprecision – FHA has no banks accounts of its own, it draws from the Treasury as required.  A better formulation is that the incoming premiums will significantly increase FHA’s net worth, giving reassurance to the check-writers at Treasury.

The FHA does not make loans but insures lenders against losses. And claims have already spiked. The agency had to pay out on 47% more loans in October and November than in the corresponding period a year earlier, according to an FHA report.

Ouch!

Didn’t see that coming

The number of loans in foreclosure, including those that have not yet been billed to the agency, has also increased. They were up 26% in the last quarter from a year earlier.

Ouch.  Foreclosure, though, is simply a lagging indicator of claims, as claims as a lagging indicator of serious delinquencies.  Neither is an independent variable in itself.

Nice dependent variable

FHA Commissioner David H. Stevens, who joined the agency in July, flagged his agency’s troubles with the 2007 and 2008 loans in October, when he told a House panel that “rogue players on the margin” immediately migrated to the world of FHA lending after the subprime mortgage market collapsed.

Oh, you think?

I don’t like being linked to a phrase like ‘rogue player’

Their aggressive lending tactics attracted borrowers with unusually poor credit profiles to the FHA. “That clearly impacted the books of business in 2007 and 2008, and that performance data is showing up very clearly in today’s balance sheet,” Stevens said at the time.

Even so, at the time Mr. Stevens was optimistic, and no one was under any illusions about the essentiality of keeping FHA in business.  As I posted in October:                            

Would that elected officials and journalists could refrain from politicizing what should be bipartisan evaluations of entity performance and importance.

“FHA has stepped into the void left by the private market,” Representative Maxine Waters, Democrat from California, said at the hearing. “Let’s be clear; without FHA, there would be no mortgage market right now.”

Ms. Waters knows where she stands

Together with Fannie and Freddie, FHA is the credit backstop for about 80% of all US residential lending right now.  While it’s terrifying to think of that much lending being concentrated behind the government, it’s more terrifying to think of any one of the three stopping cold.

No more lending?

But [Stevens] acknowledged that some 20% of FHA loans insured last year — and as many as 24% of those from 2007 — faced serious problems including foreclosure, offering a preview of a forthcoming audit of the agency’s finances.

This shouldn’t be entirely surprising, recognizing that in 2008 FHA was the lender of last resort, and as we have chronicled, many of these refinancings were done hopefully.

“Let me simply state at the outset that based on current projections, absent any catastrophic home price decline, FHA will not need to ask Congress and the American taxpayer for extraordinary assistance — we will not need a bailout,” Mr. Stevens said in his testimony.

That is a direct and clear statement.  Let’s hope it’s true. 

If I’m wrong, strike me dead

Is Commissioner Stevens rethinking his view?

With  new facts, I have no choice but to rethink

Plunging home prices have exacerbated matters by leaving some FHA borrowers unable to sell or refinance their homes because they owe more than their homes are worth. Yet with unemployment running high, many borrowers can’t afford to keep up their payments.

Adding to the trouble was a now-defunct FHA program that enabled sellers to cover the down payments of buyers. This meant many borrowers had no skin in the game and were more likely to walk away at early signs of trouble.

In May, 2007, I first wrote about this scandalous program, lambasting it:

It’s sounding more and more like the buyer is merely a patsy, and the non-profits are acting as the sellers’ paid agent.   Do the non-profits act as surrogates for the buyer, making sure prices are held down?

Sellers have tried to recover the cost of the fee they pay nonprofits by raising the price of the house an average of 3%, a 2005 study [text version here -- Ed.] by Congress’s nonpartisan Government Accountability Office found [also referenced here -- Ed.].  

So let’s keep score here:

In a cruder world, what the non-profits are doing might be called ‘procuring.’  In such a procurement, two entities get screwed: buyers and the Federal government (that’s us taxpayers).

This is for us taxpayers

By June, 2008, it was clear FHA was looking at $4.6 billion in losses, mostly from Nehemiah.  That number has now more than doubled:

The program resulted in excessive defaults before it was ended in late 2008, and it is projected to cost FHA an additional $10.5 billion in losses, Stevens said.

Every time I revisit this subject, I become more angry about it.  Congress birthed this atrocity, and Congress protected it against diligent and persistent Bush Administration efforts to kill it. 

For all these reasons, the FHA projects that it will pay out claims to lenders on one out of every four loans made in 2007 – the worst rate in at least three decades.

A 25% claim rate is hideous – but fortunately, Risk = P x L, where P is Probability of default and L is Loss given default.  We can hope for improved recoveries, since the newer-vintage delinquencies are borrower weakness, not property weakness.

The claim rate should be nearly the same on the vastly larger volume of loans made in 2008.

In any case, we can see FHA coming out the other side.

Dirty but still breathing

The FHA-backed loans made in 2009 tended to go to borrowers with higher credit scores than in previous years. These borrowers turned to the FHA when the mortgage market collapsed and other lending sources dried up. By then, reputable lenders doing business with the agency were already imposing tougher restrictions on FHA borrowers, further boosting the credit profile of those loans. The average credit score of an FHA borrower is now 690, up from 630 only two years ago, agency officials said.

These higher-quality loans are expected to result in lower losses, so the agency should make money on loans issued this year and over the next few years, according to an independent audit designed to gauge the agency’s health.

The audit, released in November, found that the cash the FHA set aside to pay for unexpected losses had dipped to historic lows, well below the level required by law. As of Sept. 30, those reserves were estimated at $3.6 billion, down from nearly $13 billion a year earlier. The most recent figure represents 0.53% of the value of all FHA single-family-home loans – far lower than the 2% required by Congress.

Certainly that is low, but compare that against the $3.8 billion “extra” premium FHA earned this year, and if you add that back, you’re at 1.06%, which is not great but is heading the right way.

Yes, I admit it’s getting better

It would become even rosier if, as most private lenders do (and the GSEs did), one counts the capitalized value of the future servicing rights as assets.

But Ann Schnare, a former Freddie Mac official, said the situation could be even worse. She said the audit underestimates future losses because it does not take into account all loans that are now overdue, only those that the FHA has paid claims on.

True enough, but with FHA mortgage insurance, the lender normally assigns the loan as quickly as possible, thirty days after the default.

Stevens said his agency has pored over its data to analyze risk and is taking steps to shore up its financial health. “You have a limited set of options under these circumstances: Raise fees [for borrowers] or make policy changes,” Stevens said in an interview. “We’ve done both.”

In short, tighten credit, limit losses, hence increase profits.

The agency banned 268 lenders from making FHA loans last year, more than double the total terminated in the previous eight years. The FHA suspended six other firms. Among them were some of the largest FHA lenders – Taylor, Bean & Whitaker and Lend America, both of which shut their doors soon thereafter.

The long-overdue cleanup continues.

You made the mess, you clean it up

The agency also proposed a rule that would require banks to hold up to $2.5 million in capital that they can use to repay the agency for losses if they were involved in fraud.

Absolutely!  Originators should always take first loss, and should have liquid capital to cover a substantial loss rate; otherwise the principal-agent risk is too great.

Banks are now required to hold only $250,000.

Not enough.  A ten multiple is a good idea.

Borrowers are also facing tougher scrutiny from the agency. People taking out FHA loans will have to pay higher upfront fees, perhaps as early as this spring. Those with especially weak credit scores will also have to put down at least 10% instead of the usual 3.5% down payment. The amount of money sellers can kick in toward closing costs and other fees will also be limited.

Another Nehemiah abuse being shut down.

Should have pressed the Nehemiah shut-down button a long time ago

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[Continued from yesterday's Part 1.]

Yesterday, riffing off a thought-provoking Harvard Business Review op-ed by Lawrence Candell from MIT’s Lincoln Laboratories, we envisioned the composition of a Financial Invention Review Board (FIRB), and bestowed upon it hypothetical powers.

“That’s a lot of powers!”

Creating a new entity and bestowing upon it such far-reaching powers will be difficult enough (imagine the howls of outrage from Wall Street, especially when the politicians succumb to the well-nigh-irresistible temptation to tax all banks to pay for it), so both policy prudence and political practically positively prescribe pruning potential problems pre-presentation.

This FIRB, being a US government entity, would have no jurisdiction beyond America, so that if its review standards were too strict, new FP’s would be introduced globally before they were used in America.  This situation is akin to the FDA, which routinely is more rigorous in its evaluation of drugs that some global jurisdictions, and to the SEC, whose jurisdiction likewise stops at the limits of our shores.  Global competition would then arise among various financial-product regulatory environments, and that might well be acceptable.  Just as you had to travel to Finland for Rogaine (when it was known as the Helsinki formula) or to Mexico for Laetril (sorry, Steve McQueen), you might choose to expatriate some capital and invest it in a whizzo new French security. 

A French security certified by Nicholas Sarkozy himself

Though Mr. Candell proposes to allow the FIRB to design, to me that exceeds its appropriate function.  Analyze, prototype, and troubleshoot is plenty of scope and authority.  How do we constitute this paragon of inventiveness?

That would mean hiring top talent from a wide range of disciplines in both academia and industry in order to provide a high-level systems perspective on problems.

While some become expert purely from the sidelines, most top talent gets to be top talent by working in business.  For the system to work, therefore, we need to capture solons – people who’ve built their pile in industry and now want to give back not their dollars but their wisdom, or those in mid-career or early career who will leave some money on the table in exchange for the satisfaction of national service and being in the intellectual forefront. 

(Yes, Virginia, there are such people.)

The FIRB thus has to have roughly these requirements and limitations:

Financial Invention Review Board: requirements and limitations

1. No conflicts of interest by any executive, director, or shareholder.  (Might mean requiring all investments to be placed in a blind trust.)

2. No revolving door: if you work for the FIRB, you cannot work for, consult for, or invest in any FIRB-issuing entity for at least [three] years thereafter, and cannot derive compensation from any FIRB entity during your term plus three years.

3. Strong confidentiality requirements, especially of withdrawn (non-issued) products.

4. Free review of any proposed Financial Product.  (Although it’s been done sometimes, it’s hard to charge for a mandatory review, particularly as we want to preclude all possible excuses for not submitting.)

5. Federal funding of operations regardless of its decisions.  Immune to political pressure and independent of other regulatory bodies (e.g. SEC, Fed).

6. Pay well enough to attract top talent (including post-private-sector), even after considering the conflict of interest and revolving-door requirements.

Funding is critical:

It would mean having the resources to build rapid prototypes and surrogate test beds—not anywhere near industrial production capacity but sufficient to inform a full-scale approach.

Whoops – here Mr. Candell’s orientation in the physical sciences leads him astray.  One can built a prototype of the B-2 bomber, and even test it under field conditions, without necessarily breaching its secrecy.  That doesn’t work with financial products – once you introduce an idea to investors, people can replicate it, reverse-engineer it, or simulate it.

“Well, sir, we definitely grab the boat”

It also raises a boundary or definitional issue of no small difficulty.  What constitutes a “financial innovation”?  What is the difference between a small tweak of a previously approved product – assuming the FIRB exists, that is – and this little wrinkle?  What if two financial products are perfectly safe used in isolation, but fissionable when combined?

“Now you may ask, ‘Joker, where can I get these fine products?’  Well, you may already have!”

Lincoln Labs and its like work because DoD is a monopsony – the sole consumer of certain products.  If Boeing’s design for a new weapon is rejected, it cannot sell that weapon to any other national defense industry – and we know that the design cost of military hardware is a huge barrier to entry, so in all practical fact, if DoD doesn’t buy your new prototype, it will not get made.

That doesn’t work in financial products, which can be replicated overseas in a New York (or London!) minute.

A better analog is the FDA, which recognizes that its review stodginess means some products become available in Europe long before they are in the States.  Here too we encounter a bit of a problem, since drugs, even if tiny, are physical objects that must be shipped from place to place, whereas money, being dematerialized, can be anywhere at any time.  Even more troubling, we can create domestic instruments to mirror the performance of international ones – ADRs do just this with stocks.  That means an investor buying a US ADR that maps onto a European security is buying, in the United States, the economic equivalent of an instrument that cannot be sold in the United States.  We tolerate that for listed instruments – should we consider prohibiting ADR’s of non-public FIRB-unapproved financial products?

It would mean transferring lessons learned to the industrial base, in part by establishing requirements for novel financial instruments and providing guidance to financial regulators.

What would be the penalty for non-compliance with FIRB requirements?  How about criminal liability for selling an unreviewed product later found to have required a FIRB review? 

Mind your head, sir, the press may attack

That would put a potent weapon in the tort lawyers’ hands, since the originators of a security would be exposed for many years.  Required disclosure could be imposed on the entities’ chief executives (”I’m Lloyd Blankfein and I approve this financial instrument”), making the FIRB-certifier a position as dicey as that of a public-company CFO.  (Come to think of it, the CFO should also be a FIRB-certifier, in addition to the product’s principal architect.)

The sheer complexity of the financial system may lead some to believe that such a center could never attain what our national-security-focused labs strive for: a deep understanding of the threats we face, and the know-how to design systems that respond to them.

I doubt the market’s fear is lack of understanding.  My guess is it’s fear of FIRB cost, fear of FIRB delay, fear of FIRB incomprehension/ ignorance/ stupidity, or fear that the FIRB could be subverted.

The only thing we have to fear is the FIRB itselfr

Unlike defense procurement, this problem area may have too many degrees of freedom and too few immutable laws and principles to guide us to some useful solutions.

Certainly, it has much less to control the experiment – by the time you find out (say) CDS’s in combination with securitizations were a dangerous mixture and you under-escrowed for them, you’ve nuked a million 401(k)’s. 

The center would have the greatest possible impact if its efforts were focused at the right level. They should complement rather than duplicate what researchers in academia are already doing, and should therefore target large-scale problems and aim to provide insights that would shape national policy.

Easy to say, hard to do.  Like the Supreme Court, the FIRB could not create a fact pattern just for the pleasure of ruling on it.  Instead the FIRB would have to review applications that came to it, and potentially be drowned in submissions.  (Some investment banks might employ the nefarious strategy of submitting dozens upon dozens of new financial products, with a view to overloading the system and then complaining about its slow response.  If you think investment banks wouldn’t be that cynical, I envy you your happy, trusting life.)

The Promise.

There is little risk in trying.

I wouldn’t go that far – there’s cost (to create it and fund it from the government, and the temptation to tax banks to pay for it would be well-night irresistible), and there’s risk in the possibility of squelching needed innovation and making America uncompetitive in global capital markets.  We also know the howls of agony that would reverberate through Wall Street’s canyons if anyone so much as hinted this might occur – it would need to be imposed by swift fiat or not at all.

That’s a mighty swift Fiat!

To sum up, it looks like this:

Could this work?  I don’t know … but it’s worth thinking hard about.

I’ll take it under consideration

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By: David A. Smith

Before we unleash a new financial drug on the world, might it require some clinical field trials?   That question lies behind a fascinating Harvard Business Review op-ed by of all people and places, Lawrence Candell from MIT’s Lincoln Laboratories:

What can you do in a democracy when you rely on the private sector for solutions in an area of critical national importance?

The few … the proud … the highly paid

The abstract answer is, contract purely technical functions, reserve essentially governmental functions for publicly accountable bodies.  But that answer begs the next question: what functions are sufficiently technical?

One inherently governmental function is the setting of compulsory standards (of disclosure, capitalization, or trading).  With a few exceptions, that business of compulsory standard-setting cannot be left to private entities, for they invariably either form cartels or structure the rules to maximize their upside and minimize their downside.  Enter the government:

In the case of US national defense, the government funds nonprofit research centers like the one I work for—MIT Lincoln Laboratory, in Lexington, Massachusetts.

Massachusetts is a hotbed of ideas

Can this approach be applied to financial products? 

Right now, we have seen the emergence of standard-setting or standard-scoring bodies of greater or lesser independence, sophistication, standard-imposing power, and effectiveness: FASB, the Basel II accords, SEC, and the rating agencies.  None of them is really akin to Lincoln Labs, or its fellow travelers of Greater Cambridge – in this context, both Lexington and Boston may be considered satraps of Greater Cambridge – which is a veritable hotbed of such entities, with MITRE and DARPA. 

And Lincoln Labs, where they build things

These centers are stocked with technology experts and innovation capabilities [A] as good as those to be found in industry, but [B] they answer only to the public, [C] not to profit-seeking shareholders.

Mr. Candell’s summary contains three suppositions: equality of capability, public accountability, and non-profit status.  The third of these, [C] non-profit status, is in my view not essential, since non-profits can in some cases be just as venal as for-profit entities.  A better formulation for [C] is that Testing Centers be [C] free from potential conflicts of interest, a condition which can be achieved in several different ways (to which we’ll return below).

[D] Seated across the table from large defense contractors, [E] federally funded R&D centers function as independent honest brokers:

Now Mr. Candell’s summary adds two postulates to give the Testing Centers clout: [D] mandatory pre-usage engagement between the proponent and the Testing Center, and [E] government funding of the Testing Center.

They allow innovative defense contractors to thrive, as the system needs them to do, but they also check the contractors’ occasional temptation to do what is most profitable rather than what is really needed.

Mmm … profits

I’m no expert on defense-contractor review, and Mr. Candell is, so let’s take as fact his assertion of the Testing Centers’ effectiveness both in checking the taking of unnecessary financial risk (by the government) and in not inhibiting the free.  Can this be made to work in finance?

These centers clearly perform a valuable function, and the cost of funding their expertise is less than 1% of the Defense Department’s budget.

Well, 1% of DoD’s $650 billion is still a gargantuan number – but if the Testing Centers really perform the function, that would be money well spent.  And that much money would buy you a lot of smart reviewers.

As the financial crisis erupted in late 2008, some of my colleagues and I couldn’t help wondering why there was no similar setup in the financial industry.

There was supposed to be such a setup.  They were called ‘rating agencies’ and they abdicated their responsibilities, preferring to become symbiotes of those they were rating.

Here was another area of extreme national importance. Why didn’t the wizards who were devising new financial instruments in the private sector have a mirror image operating in behalf of the public?

Here’s a key point.  Rating agencies were never set up to be mirrors, nor to be windows.  They are oracular, and held themselves out as reliable even if inscrutable.  Unfortunately, we learned that behind that inscrutability was unreliability.

I have all the answers right here

Of course, there are many public-spirited experts developing and studying next-generation financial solutions at our universities—just as there are many professors working on military technology. But that academic contingent can’t be expected to protect the public interest.

Of course not, for many reasons.  (1) They are not chartered with protecting the public interest, so they have no standing to intervene, making independent protest so much noise.  (2) They have other things to do – you know, like teach – and can choose to research in their spare time.  (3) In pursuit of intellectual freedom, they resist being slaved to tasks imposed by others.  (4) In terms of resources brought to bear on individual DoD-related problems, they’re massively outgunned.

I’m only interested in knowledge

To decide how best to invest its resources, the Department of Defense needs understanding and guidance at the systems level. The same would seem to be true for a financial industry that annually moves trillions of dollars.

The Breakthrough Idea

Let’s federally fund an R&D center that, borrowing the best practices of defense research centers, could design, analyze, prototype, and troubleshoot financial innovations, making sure they promoted our economic security and prosperity.

Let’s think out-of-the-egg, shall we?

At this point in the article, I said to myself, Hmm … how could this be made to work?

To start with, why hasn’t it been tried up to now?  Several reasons:

1. We didn’t know we needed it.  The industry was unregulated and new innovations are generally unregulated.

2. The difficulty of specifying which innovations are material enough to warrant scrutiny.

3. The last fifteen years saw a net deregulation, as financial products evolved much faster than regulatory thinking about them.  As the new instruments gained market share, the percentage of financial instruments subject to this kind of scrutiny shrank.

4. The talent updraft.  Private-sector employers can and do generally pay much better than their public-sector counterparts.

In any outgunned situation, you need to change the rules, to balance the tension, by providing the government side with something that compensates for its lack of gunnery.  Mr. Candell implicitly addresses these with his last two points (D and E) – standing granted by making the review mandatory, and Federal funding adequate to pay for very smart people.

You vant to sell your decadent innovative securities, tovarisch, you pass our checkpoint.

To create these conditions in our imagined Financial Invention Review Board (FIRB), the nation would need (a) a pre-review of every new type of financial product [Or else what? See below. – Ed.], and (b) delegation of review authority – including signoff authority – to the newly created and fully independent FIRB.

The FIRB would then have the following powers:

Financial Invention Review Board: powers

1. To prohibit sale in the United States of a particular financial product (FP), even to sophisticated investors.  [Or else what? See below. – Ed.]

2. To mandate disclosure requirements for said FP.  These would go beyond the ‘omit no material fact’ standard representation in offering circulars; it would be much more like an SEC S-1 review, with the FIRB able to demand additional information and to compel its disclosure before approving a sale.

3. To require the issuer or banker of said FP to post liquid collateral, with a secure and independent escrow agent, equal to some ratio established by the FIRB.  The FIRB could change the required ratios from time to time, presumably by lowering them based on greater experience.

Want to have power over all finance?  Read on!

[Continued tomorrow in Part 2.]

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[Continued from yesterday's Part 1.]

Yesterday’s post opened the topic of compensating investment bankers and a fortiori investment banks as well, taking as initial text Steven Brill’s New York Times profile of TARP paymaster Kenneth Feinberg. 

Put up your dukes, Feinberg!

Brill is full of admiration for Feinberg’s jawboning down the bankers’ actual paychecks, and pays much less attention to the negotiations also taking place about structure, contenting himself with superficial rhetoric questions like this:

When governments intervene to impose taxes or put limits on bonuses, for example, companies tend to increase salaries or introduce new perks. When the issue is left to the companies’ boards, endless questions peck away at the seemingly simple idea of paying executives based on performance. If pay is based on what an executive’s peers at other companies get, how is a peer group defined? Why penalize and demoralize talented employees if the firm’s stock or profits are down because the economy as a whole collapsed, or because the company incurred a short-term loss while making a sensible long-term investment? Besides, as a general matter isn’t it just plain silly to worry about spending a few extra million to keep the leaders at the top happy when they’re making decisions with billions at stake?

We, on the other hand, are made of sterner stuff.  Yesterday we covered three ideas:

1. Align time horizons between bank earnings and pay.

2. Measure the right metrics of financial performance.

3. Align incentives in payment formulas.

Want to try any of these?

Today we have three more, and we can dig into the reasons why what we’d like to have happened hasn’t happened yet.

4. Match compensation structures to newly invented risk slices

In my world, some people are paid on an eat-what-you-kill basis — their compensation is entirely contingent on them delivering something.  Normally this is applied to commission salesmen, but if the payment is in cash, we get back into the agency risk associated with bad lenders and bad loans.  And that doesn’t work at all with investment bankers and financial product designers.

Or does it?

You’ve won – aren’t you happy?

It’s common enough in securitization for the originating bank to take the majority of its compensation in the last tranche – the B piece or C piece that is left over after the senior pieces have been sliced off and sold.

What are those tips worth?

If the loan pool performs, quite a lot

There’s a certain Willy-Wonka justice in all this; if you’re paid in parts, and the parts is rotten, then you get the indigestion.

Gloop!

This can actually be done, and without too much complexity.  Any time an activity adds value by creating a new commodity, pay the creator with a piece of the commodity.  Land developers have been paid in lots (no less than Frederick Law Olmsted was once so compensated), sharecroppers in a portion of their grain, and hedge fund managers in a portion of the yield earned on their investments. 

Willing to be paid in kind: Olmsted in 1857

If derivatives, CDS’s, CDO’s, and so on, are such great investments, create a tranche reserved for the managers, and preclude its sale for several years – at least through the seasoning period.

This one has been properly aged

For instance, consider this structure used at AIG:

My friend (who did not want his name used because, he says, “being associated with AIG is not safe for my family”) is a mild-mannered math whiz who worked at a unit of AIG Financial Products that, he says, had nothing to do with the small London-based credit-default-swaps group that sank the company. Over the last half-decade, he made millions every year from a bonus pool composed of the profits supposedly made by Financial Products.

But he had to leave roughly half of his bonuses in the pool for five years so that the payouts could be adjusted for any subsequent gains or losses from Financial Products’ trades. (That’s an extreme version of what’s called a “claw back,” another reform that Feinberg’s guidelines would require.) When the credit-default-swaps unit went bust, he personally lost tens of millions in that pool. (Which would also mean that he took home tens of millions over those five years.)

Observe that this structure was already in place at AIG, and yet AIG is the sickest of the sick:

5. Mandate risk disclosure

“Let’s face it – this isn’t the worst thing you’ve caught me doing.”

– Tony Stark, aka Iron Man

Nothing to worry about here

If we cannot forbid risk-taking (and we can’t), and we want to enable the market to innovate (and we do), then investment banks will always be taking risks.  But we ought to know what they are, oughtn’t we – particularly if public companies are involved?

So much sense does this make that we’ve been trying it for years, ever since one of the last decade’s biggest invisible stories, FIN 46, which sought to compel risk transparency and became so entangled with complexity as to render the original purpose unachievable … and worse, clouded by the misapprehension that it was working, when it wasn’t.

“Respondents were consistently incisive, reproachful and vehement in their criticism of FASB’s year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB’s responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, ‘over-reaching’ measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure).”

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

Aftermath.  FIN 46, now renamed as FAS 167, is now a permanent part of the landscape, but the puzzles it poses remain unsolved.  Consolidation is still a bete noire in accounting and CFO circles.

You still haven’t dealt with me

6. Regulate the ability of publicly-traded entities to take on financial risk

In the first possible principle, I suggested aligning the time horizons of managers and financial counterparties – lenders, equity investors, and stockholders.  Yet that principle – enforced financial partnership over long intervals like multiple years – is antithetical to another principle on which our equity markets are founded – namely, liquidity. 

Anyone who’s ever owned a publicly traded stock knows that markets move fast – much faster than government — and that they are constantly incorporating new information, sifting it in a marketplace of ideas whose aggregate expression is a single number, the price of the last stock trade.

How the markets keep score

Yet markets are notoriously inexpert in pricing abstract risks, new risks, and low-probability ‘black swan’ risks.  In fact, everything about the publicly traded company discourages taking the long view.  Moreover, corporations that trade in the public markets are by definition taking vast sums from ordinary investors – and when these publicly-owned companies go upside down, Joe Sixpack gets hurt … which means Uncle Sam rides to his rescue, with costs and consequences for all of us, as we’ve seen with the bailouts of numerous companies, mostly questionably GM and Chrysler. 

Remind me what public purpose we served by putting money into GM?

There is a solution to the challenge of public companies taking on risk – make them collateralize it.  Already, regulated financial institutions are required to maintain particular capital ratios, under both Basel II accords and FDIC/ Treasury/ OCC rules – and these, in turn, are tied directly to the assets on their balance sheets, as valued under FAS 157 or otherwise.

In a world where every financial institution is effectively a bank, and every bank is a Bank of Glass, one could assign to every financial instrument a risk assessment (even a crude metric would do), and then require that the issuing institution hold in high-credit liquid instruments (e.g. Treasury bills) capital equal to the total assessed risk.  In effect, this would institutionalize and automate the post-TARP stress-testing done to the TARP recipients. 

There’s our six options – sensible, right?

Well, some of them are silly

All rights, that’s too silly

Now, finally, we can settle down with our fat Steven Brill article, and discover the four big reasons why it’s hard to implement any of the compensation structuring reforms just presented.

[Continued tomorrow in Part 3.]

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