Can we know what regulations were appropriate pre-credit crisis?

September 23, 2008 at 4:26 pm | Posted in credit, Housing, regulations | Leave a comment
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I don’t believe in much regulation, but we need some framework. And what isn’t regulated (just a little bit) could (and often does) need rescuing.
Its easy to figure what should have been done after the fact. The challenge in doing it right before the fact is two fold –

First – For a variety of reasons, the US thinks home ownership is good and must be encouraged. Therefore there is a reluctance to tighten the screws too much if that means undermining the home ownership objective. So, good luck trying to tighten regulations when lobbyists (and, unfortunately many in the government) would be very vocal about how Congress is denying the American Dream. Yes, Mr. Greenspan, I mean you.

Second – If you come to me to borrow money, and I am willing to lend it to you, without too much inquiry into whether you could pay it back, or what your resources and income are, arguably, that is my lookout. Government has no business legislating caution or prudence or intelligence or even basic common sense on my part. Survival of the fittest will basically take me out of the business pretty quickly.

I do think things were overly lax. But I’m not sure just where the regulation should have come in. I mean, yes, Lehman was overleveraged, true, but some of that excessive leverage is actually a result of asset write-downs destroying equity, so it is an outcome of the credit crisis, not a cause. But the leverage was public knowledge. Equity investors should have known this was a risk, as should creditors.

You can regulate disclosure. You cannot regulate intelligent responses to that disclosure.

So the best that could have been done would have been to have tougher lending standards. Perhaps more responsibility for consequences on the part of the rating agencies would have ensured a more rigorous examination of their models. Perhaps tighter capital norms. There are a few things that could have contained this problem (more on this later).

But ultimately, if a few firms went bankrupt, and others stopped trusting S&P and Moody’s, the taxpayers may have had a few laughs about Wall Street’s follies and hoped that the bankers learned a lesson.

It is only because, after the fact, we realize that the system is at risk that we want to rescue the system, and care about what it would cost us to rescue it.

Wall Street is now Bank Street

September 22, 2008 at 11:07 am | Posted in credit, regulations, Stock market | Leave a comment
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Goldman and Morgan Stanley – the last remaining independent investment banks – have now requested they be treated like traditional banks, with all the regulations, oversight and capital requirements. While this is voluntary, it acknowledges the risk in the traditional model, and brings to a close the era of investment banks (created by the Glass Steagall Act after the Depression). Glass Steagall was slowly dismantled in the 1990s, but now, it is completely rolled back.

NYTimes has the story here

Goldman Sachs and Morgan Stanley, the last big independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night, a move that fundamentally reshapes an era of high finance that defined the modern Gilded Age.

As bank holding companies, the two banks, whose shares have lost about half their value this year, will have to reduce the amount of money they can borrow relative to their capital.

That will make them more financially sound but will also significantly limit their profits. Today, Goldman Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. By contrast, Bank of America’s has less than $11 for every $1 of capital.

So how would this work? If MS has to go from $1 capital for $30 assets to a more bank-like $10-11 assets per dollar of capital, one of two things have to happen – Either MS sells $20 worth of assets (2/3rds of what it has), and returns the proceeds to debt holders, or raises $2 more of capital.

The first would be disruptive to the markets, bringing a lot of selling pressure while every intervention is aimed at relieving the selling pressure. The second would be dilutive to existing shareholders – The share of existing shareholders would drop by 2/3rds. This is obviously bad for the stock, but, at least the losses are private and limited to shareholders, who kind of took on the risk in the first place.

So they will need time to adjust their balance sheets. Given enough time to get to the required capital ratios through a combination of asset sales and capital raising, and using additional classes of capital (such as preferreds and convertibles), they should be able to emerge as stronger institutions. And they can now buy a commercial bank to help get to the target ratios.

Regulators – absentee parents

September 20, 2008 at 7:03 pm | Posted in credit, economics, Housing, regulations | Leave a comment
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I think regulations and regulatory agencies failed to create an adequate framework for the credit markets.

In essence, while lenders invented 5% down, even the 0% down, no documentation, stated-income loans with down payment assistance, regulations allowed lenders and investors to get away with similar low equity / high leverage balance sheets. Lehman, for example, had a debt-equity of 30-40x (admittedly boosted by prior write-downs of its assets).

This is just like parents raising kids – Some parents regulate kids more than others (I think less- but not too much less- is better, generally), but if you fail to regulate them, sooner or later, they are going to need rescuing – whether you rescue them or want to teach the kids a lesson.

High noise-to-signal in SEC actions

September 20, 2008 at 1:20 pm | Posted in regulations, Stock market | Leave a comment
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This NYTimes article discusses the market reaction to the SEC rules banning short sales. A number of trades in the market were involuntary, forced on by the new regulations. As such, I doubt the strength in the market is sustainable. Nothing fundamental has changed; just a few rules changed, which made some people make transactions in the market in order to comply with the new rules, and made others make transactions in response to the market response. There is not much other information in the response, other than the fact that one can expect the government to continue to rescue and to regulate and market participants have to figure out where the heavy hand will fall next.

The pendulum swung far away from regulation during the “Bush expansion”, now, it is going to swing even further in the other direction.

We already know this. I think the SEC is saying that things are not as bad as they seem (as I said previously here), but then, is that what the SEC really believes, or is this just empty reassurance?

I guess, looking ahead and trying to decide what to do in the markets, this last week was mostly noise and  little signal.

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