A Brief Guide To Fixing Finance

A Brief Guide To Fixing Finance:
Know What Went Wrong Before Beginning To Fix Anything
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By Martin Neil Baily and Robert E. Litan, The Brookings Institution | 27 September 2008

There has been a "domino-like" character to the financial crisis that is now readily apparent to all:

1. the bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;


2. the peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;


3. losses thereafter on the complex "Collateralized Debt Obligations" (CDOs) that were backed by these mortgages;


4. increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued "credit default swaps" contracts (CDS) that insured the CDOs;


5. losses suffered by financial institutions that held CDOs and/or that issued CDS’s;


6. cutbacks in credit extended by highly leveraged lenders that suffered these losses.

These events, individually and in combination, have led to the bear stock market, whose downward slide accelerated Monday, September 15 through mid day Thursday the 18, after Lehman Brothers filed for bankruptcy and the Federal Reserve lent AIG $85 billion to keep it afloat— although the market quickly recovered at the end of the week after the Administration’s massive mortgage securities rescue initiative was announced.

So far, the financial turmoil on Wall Street has had a surprisingly modest impact on Main Street. Despite the crisis and the surge in commodity prices, the non-financial sector of the economy has continued to grow, spurred in significant part by a large growth in exports (fueled, in turn, by a steep decline in the dollar). Whether this pattern will continue— and specifically whether consumer spending will hold up in the face of the recent nerve-racking financial events and the steady climb in the unemployment rate (now over 6 percent)— is one of the large uncertainties confronting us all.

Likewise, in retrospect it is now relatively easy to see that much of this financial carnage, and thus any subsequent economic damage, could have been avoided:

• Had policy makers reined in the increasingly irresponsible subprime mortgage lending practices that were apparent earlier this decade— the proliferation of "no-doc" loans, often taken out with little or no equity from subprime borrowers, and frequently on adjustable terms with seductively attractive initial "teaser" interest rates, all on the widely held assumption that home prices would continue to rise— it is likely that this crisis would been largely, if not entirely, avoided. When there is a significant probability that an asset market is in a speculative bubble, it is time to tighten lending standards, not loosen them.


• Had Federal policymakers in both the Congress and the Administration not pressed so hard on "affordable housing goals" that encouraged lenders to extend and borrowers to take out loans that could not be reasonably serviced unless home prices continued to rise, and which Fannie and Freddie began to buy in large volumes in the last several years, Fannie and Freddie may have escaped the fate that has befallen them.


• Had the credit rating agencies whose stamps of approval were key to the sale of CDOs and other complex securities that later suffered losses been more transparent in how their ratings were provided and in the limited nature of the data on which they were made, it is likely that these securities would have been much more difficult to sell, and thus in turn, that subprime mortgages would not have been so easily originated.


• Had regulators done a better job monitoring the risk exposures of commercial banks, especially through their creation of off-balance entities known as "Structured Investment Vehicles" (SIVs), the market for CDOs would not have been so deep (the same is true for the state insurance regulators who oversaw the "monoline" insurers that insured CDOs and AIG, the nation’s largest insurer, that issued them).


• Had policy makers not permitted investment banks to vastly increase their leverage so that they were far more exposed to failure when they suffered losses from their various investments, the previously independent investment banks may have been able to avoid their forced alliances with commercial banks (or, in the case, of Lehman, failure).


• And had financial institutions followed their own internal risk management guidelines, then it is possible that the current crisis would not be so deep and that the face of both of the commercial and investment banking industries would now not be so radically changed.

Recognizing what went wrong is important in assessing what needs to be changed in the future. We do not plan to get into the blame game, nor is it productive for policy makers to do so (though we expect a certain amount of this during an election campaign). Instead, it is vital that those charged with fixing this mess draw on what is now widely known and agreed upon so as to develop appropriate reforms that would dramatically lower the risks and consequences of future such financial crises, without chilling the financial innovation for which America’s highly entrepreneurial financial sector has long been known. That is the approach we will follow in this project, and in the broad suggestions outlined next.

  M O R E. . .

Normxxx    
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