What Went Wrong?

I was fortunate enough to attend the Medtronic Business and Law Roundtable at the University of St. Thomas Law School on March 19th. The subject was, "Our National Challenge: A Blueprint for Restoring the Public Trust."

Professor Lyman Johnson of the University of St. Thomas and Washington & Lee University was the moderator. He noted that the loss in value of public companies from late 2007 until now was $35 trillion, not including the value of assets like homes. 88% of those polled in a recent survey did not trust the stock market. 75% of those who favor Federal regulatory intervention are less confident in the current menu of proposals on the table. He said that regulatory trust capital is as important as financial capital, and it needs to be rebuilt.

Professor John Coffee of Columbia Law School is one of the foremost commentators on corporate securities law, and he gave a very informative and provocative presentation. He noted that asset backed securities issuance was trivial in 1992-1993, but by 2002, issuance of asset backed securities had surpassed the total issuance of corporate bonds. Between 2001 and 2006, much of the available mortgage funding was channeled into "high latent demand" zip codes. These were zip codes in which the denial rate for traditional mortgages was 80% or higher. From 2001-2003, almost 80% of the applications in these same zip codes were accepted. Congressional pressure through the Community Reinvestment Act fed this process, as well as did the availability of funds. The loans issued were the so-called "liar loans," or "ninja loans." These loans had a very high rate of securitization, and they were sold by originators to unaffiliated financial firms. Professor Keys and other researchers at the University of Chicago School of Business note that a securitized loan portfolio was 20% more likely to default than a retained portfolio. By 2003, the loans to these same zip codes were showing significant increases in default rates. By 2006, these low documentation/no documentation loans accounted for 51% of all securitized loans and accounted for
92% of securitized loans that carried adjustable rates.

This activity would be irrational unless there were people willing to buy the loans, and the investment banks would increasingly buy a loan portfolio without any due diligence. This begins Act II of the tragedy in Professor Coffee's presentation. The investment banks bought loans because they knew that they could securitize them on a global basis if they could get "investment grade" ratings from two of the critical gatekeepers, names the rating agencies S&P and Moody's. Two ratings were needed for investor acceptance. So why did the gatekeepers fail to do their jobs?

When Moody's and S&P were focused on corporate bond issuance, no one client accounted for more than 1% of their business. When structured finance overtook corporate bond issuance, their business mix changed dramatically. In 2006, for example, 56% of Moody's revenues came from the top investment banks for structured finance product ratings. In addition, now the rating agencies generated consulting revenues from the same investment banks, counseling them on how to design a marketable structure. This concentrated their business and reduced their independence.

An additional wrinkle came with the acquisition of Fitch, and the new French owner's decision to grow its market share. Now, instead of a duopoly, you had three firms competing for the two ratings that had to accompany every "investment grade" deal. Professor Coffee had a dramatic slide that showed significant grade inflation for both investment-grade and below-investment grade securities. Act II now concludes with the top six banks (Lehman Brothers was number 1) issuing and distributing 52% of all the mortgage-backed securities worldwide in 2007.

Leverage ratios at the investment banks had been climbing since August 2006, Lehman, Morgan Stanley, and Bear Stearns were all about 33%. Because the SEC in 2004 had spared the global banks from coming under the scrutiny of European regulators through something called the Consolidated Supervised Entity program, there was no ceiling on the leverage ratio. This program also further neutered the SEC because it allowed each bank to develop its own risk model, and Professor Coffee describes the SEC review process as an army of PhD rocket scientists descending on three freshly minted SEC MBA's to get their assent. Remember Buffet's words, "Beware of geeks bearing formulas." Well, the geeks carried the day, and now the investment banks who were principals as well as agents were beyond any meaningful scrutiny.

In 2007, the banks reported their VAR (Value at Risk), and Lehman Brothers for example reported $124 million VAR, an increase of 400% from the prior year! By August of 2008, Lehman Brothers announced writedowns of $8.2 billion (!) related to subprime loans.

What are the lessons? Financial institutions are fragile and face a fundamental mismatch of assets and liabilities. Their "originate and distribute" model leads to excesses, inadequate screening and substantial moral hazard. "Competition is good, except when it is bad," according to Professor Coffee. Competition among the investment banks led to excess leverage and inadequate diversification.

Perhaps the defining quote in Act III comes from Charles Prince, the former CEO of Citigroup, who said, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Systemic Risk Regulation is the answer according to Professor Coffee. This SRR could be a centralized regulator, along the lines of the British Financial Services Authority, or a "Twin Peaks" model, with one regulator for the banking system and another for securities regulation. The relationship of such an SRR to the central bank is an open question. These two types of regulators will have significant cultural differences. A securities regulator will be focused on disclosure and transparency. A bank regulator will be worried about the free flow of information, especially in real time, because their overriding fear is a run on the bank.

So, on mark-to-market accounting, bank regulators would say "No," because it would require additional capital and stir up fear. Securities regulators would say "Yes" to mark-to-market accounting. He closed by saying that due diligence had to be restored to the process of securities issuance.

This was a great presentation, and I will continue with some of the other presentation summaries next week. Post questions and comments!