1 Interest Rates and Credit. Interest rates were kept too low for too long and credit was too plentiful. This is the responsibility of the Federal Reserve Board. The views of the Chairman of the Fed are considered sacrosanct in the realm of finance. Perhaps he has excessive power. He should be independent of Congress, yet GOVERNANCE of the Fed needs improvement. The Chairman’s fellow directors need to be more active and the Board should pay more attention to competing views.

2 Mortgages. Underwriting standards became excessively lax . Banks are highly regulated, but you don’t need to be a bank to get into the mortgage originating business. Greater REGULATION is needed. Perhaps all mortgage origination for mortgages intended for resale in the institutional or public markets should be regulated, even if the originator is not a bank. Some highly regulated banks also got into trouble. Better OVERSIGHT of the regulators is required here.

3 Mortgages; Affordable Housing. Another destabilizing force is the recent push for affordable housing. A desirable end in itself, the manner in which affordable housing is pursued is irresponsible. Front and center of this problem are Fanny and Freddie. In pursuit of this goal these institutions bought enormous quantities of mortgages executed by borrowers with substandard credit ratings (sub-prime mortgages ) and by borrowers whose income was not be verified (Alt A mortgages). These moves were encouraged by Congress, which also mandated that banks pursue similar lending goals in the Community Reinvestment Act. This was not intended to cost the taxpayers, but unfortunately things did not turn out that way. This is a REGULATORY issue, requiring our legislative and executive branch to exercise some self-control. Our government is running the risk of destroying our currency and our national credit. These issues need to be publicized and debated. If our government wants to help the less fortunate obtain housing, then pay a direct subsidy included in the budget at the time of payment, rather than distorting and destabilizing the financial markets.

4 Securitization. Once upon a time loans stayed on a bank’s books until maturity, but no more. The mortgage and other loans are sold and pooled; the pool is then “sliced and diced“ and then resold by the financial community to investors around the world. The process gives the banks capital to make more loans, expanding the credit available for all, and transfers the risks and the return from the old loans to the investors. The basic idea has much merit, but implementation was faulty. The terms of these pooled mortgage instruments are opaque and have not been explained in plain English. These instruments were not sold in public offerings so there was no SEC oversight of the accompanying disclosures, nor are the instruments available for public scrutiny. The process needs greater OVERSIGHT and TRANSPARENCY. The market for these securities has screeched to a halt. To restart the market, it is essential that the terms of these securities be simply stated and clearly understood.

5 Leverage. Banks and other financial institutions have always been highly leveraged in modern times, but in recent years leverage multiples at the leading investment banks soared to astronomical heights. In good times when interest rates are low and credit is plentiful, borrowing was easy for investment banks and enhanced profits and bonuses. But when bad times come and home prices drop, it is time to deliver by disposing of those mortgage backed securities acquired with the borrowed money, and this is not so easy. Investment banks are regulated by the federal government, so this is a REGULATORY problem. This is also a GOVERNANCE problem. Why did Lehman Brothers take these risks? Surely these sophisticated executives knew about the pros and cons of leverage. Surely they realized that at some point housing prices could go down. What about checks and balances? Where was the Board of Directors while all this was going on?

6 Accounting – Mark-To Market Accounting. Accounting rules are exacerbating the current crisis. Under current rules a portfolio of mortgage securities must be marked to market quarterly even if the institution intends to hold most of these securities to maturity. While not in favor of allowing an institution to hide its bum investments, the current rule must be reexamined now. Absent a default, assets held for investment should not be marked down, especially when no real market exists. Computer simulations, based on products which may be comparable, just don’t cut it. The current situation directly fuels the panic. The accounting rules make the company book a huge loss, capital is reduced to dangerously low levels, the stock price plummets, the credit rating swoons, banks cut off short term lines of credit. All because of a loss which may not exist. This is a REGULATORY problem that needs the immediate attention of the SEC.

7 Accounting-Off Balance Sheet Entities. In our last burst of regulatory exuberance, the Sarbanes-Oxley period, considerable attention was paid to abuses linked to off balance sheet entities by Enron and others. We received numerous lectures on the advantages of principle-based regulation and the dangers of rule based regulation. Despite these efforts, the same thing happened again with mortgage-backed securities. The voluminous rules enacted at the time of Sarbanes-Oxley left apparent loopholes ferreted out by highly paid experts. Certainly, the rules need to be fixed, but more important the word needs to get out. The day of the loophole is over! This is a matter of clear, understandable, principle based REGULATION – No more “ structure to avoid “ and we really mean it!

8 The Treasury’s Plan to Purchase Troubled Assets. The Treasury’s plan may well stabilize the financial markets, but it will of no avail unless we also tackle the root causes of the current crisis . That is the focus of this paper.

9 Forward Looking Approach. We need a sea change in the approach to REGULATION and GOVERNANCE. Certainly past history has many lessons for us and we must deal with current problems. We also need to focus on what the future might hold. At least one group in each government agency dealing with these problems should have this assignment; looking for problems and challenges and formulating plans to deal with them before they arise. Every Board should have such a committee. This is not a pro forma exercise. These folks should be supported with adequate resources and should be listened to. Otherwise, in another ten years we will back dealing with another crisis spiraling out of control.

Mark Thoman
September 23, 2008
100 Ridgewood Avenue
Glen Ridge, NJ 07028

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