Busted: Bankers and The Global Economy

April 17, 2008

Banking Changes Needed; Few Ideas

Government clearly dictates the direction that business and banking takes. Most appropriately, the banking and financial world fills the vacuum left by U.S. federal law. The changes in the past made nationally in the United States tend to be adopted and utilized by the world.

Until the summer of 2007, investor demand was strong for securitized credit from pension funds, mutual funds, residential mortgages as well as consumer credit lines for credit card and installment debt. From the humble beginning of packaging securities for residential mortgages in the 1970s, the market continued to increase with up to 60% of all mortgages being securitized. The mania of securitized bonds took hold because of the wild profits due in large measure to rapidly rising household wealth and the profit opportunities available using investments managed by professional asset managers. Computers and new technology made this move easier than ever before.

The capital markets businesses in the largest banks have given rise to new threats to financial stability. These threats are derived from the securitization activity of the very banks that produced them, the complexity of capital markets activity and from the services that banks provide to the asset-management industry, including hedge funds. Risks that are considered more traditional to banking such as liquidity and concentration have appeared in new forms.

The quality of sub-prime origination declined because of a serious erosion in underwriting standards at banks and financing institutions. Underwriting standards for sub-prime mortgages fell as loans were increasingly made on the basis of expected increases in collateral value, without a careful evaluation of the borrower’s ability to repay. Several years of rapidly rising house prices had reduced the delinquency rates on mortgages with historically high loan-to-value ratios, making these mortgages look less risky than they actually were. A similar decline in underwriting standards occurred across the board for other financial marketing areas.

The growth of securitization is in large part a response to the growing demands of institutional investors for fixed-income securities. Investors clearly had a financial incentive to do better due diligence on the sub-prime risks they were taking on, but they largely failed to do so. They may have underestimated the potential for a nationwide decline in housing prices. They may have relied on credit-rating agency analysis that have proven to be inadequate. Banks have often misunderstood the risk of these often very complex securities.

CDOs and other structured credit products can be very complicated. Among the CDOs that invested in sub-prime mortgage-backed securities, it was common for a single CDO to own hundreds of different mortgage-backed securities, each with its own pool of underlying mortgage loans. Clearly, the valuation of these products and the measurement and hedging of the risks they entail are very complex. Innovative financial products outstripped the risk-management capabilities of banks.
Banks made themselves subject to advertising and a misleading triple-A credit risk rating. These banking instruments were not understood and when the market began to contract, banks found themselves in a liquidity bind.

Banks have had a difficult time adjusting. Instead of banning the banking instruments that created the crisis, the Federal Reserve is opting to encourage better understanding and measures to improve risk-management. The Fed is recommending more transparency as well as using instruments that are easier to understand. Banks and investors must put more effort into investing in structured investments without relying on credit rating agencies to do their work for them.

Larger capital and liquidity cushions are needed. The Fed recommends that banks become more involved in raising new capital by selling more of the instruments they have been using. The main problem is not only the confidence of investors, but the confidence of bankers. Even banking regulators have problems to consider. In essence, the Fed admits that nobody really knows the risks or the results of the risks of the banking instruments that the industry currently holds. Securities markets have become so large that commercial banks simply lack sufficient capital and balance sheet capacity to readily fill the gap when markets are impaired.

Banks are more dependent on well-functioning securities markets, and as that dependence and the important role of banks as ultimate providers of funding to those markets became clearer, pressures on banks mounted. Large commercial banks and investment banks have increasingly similar risk profiles, so that all are subject to the same risk-management challenges.

The Fed worries about excessive leverage and susceptibility to runs not only at banks but also at securities firms. They have openly admitted they don’t hold answers to difficult questions. In the meantime, they are encouraging that care is taken and responsibility is engendered. Since the Fed is now in charge of implementing these policies, they will decide what measures will ultimately be taken. They are also looking at implementing banking standards recently imposed in Europe known as Basel II.

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