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Ten Ways to Do Better in the Next Financial Cycle

Tuesday, July 28, 2009

We can do better next time provided we take these steps.

Financial cycles are natural and the future will have them, as the past has. They can be aggravated, as the inflation of our 21st-century bubble was, by actions of the government. Going forward, some sensible steps would provide moderation of financial overexpansions and consequent panics. I propose ten such steps:

1.  Create a systemic risk advisor (not a systemic risk regulator)

2.  Develop countercyclical loan-to-value ratios (LTVs)

3.  Require national use of the Pollock one-page loan information form

4.  Use old-fashioned loan loss reserves

5.  Encourage credit risk retention by mortgage originators

6.  Divide Fannie Mae and Freddie Mac into private companies and government agencies, so no government-sponsored enterprise (GSE) is left

Indubitably the best consumer protection is the ability to exercise personal responsibility in making informed decisions about underwriting yourself for the credit and about how much risk you want to take.

7.  Remove government sponsorship of credit rating agencies

8.  Drop the government’s “confidence” slogan

9.  Introduce accounting with multiple perspectives

10. Study financial history


1. Create a systemic risk advisor (not a systemic risk regulator)

The much-discussed systemic risk regulator is a bad idea. It would be bound to fail, since, as the quip often attributed to John Kenneth Galbraith goes, “economic forecasting was invented to make astrology look good.” To forecast the future correctly—and then to control it!—is a literally impossible task.

However, it would be a good idea to create a very senior systemic risk advisory function, which would supply institutional memory of the outcomes of past and recurring financial patterns. This advisory body has to be distant enough from the government and central bank power structures to be able to speak freely and forcefully about the systemic risk that the government and central bank’s own actions are generating.

It should have a heavyweight board, an insightful and articulate executive director, and a small staff of top talent. It must be free to speak its mind to Congress, the administration, foreign official bodies, and financial actors both domestic and international.

It should look first of all for the build-up of leverage, hidden as well as stated. It should be especially skeptical of “new era” rationalizations and belief in mechanistic formulas, and should be aware of fundamental uncertainty. Its purview should be global and its thinking deeply informed by the mistakes and travails, private and governmental, of recent years, decades, and centuries.

I believe such a systemic risk advisor is distinctly worth a try.

2. Develop countercyclical loan-to-value ratios

As asset prices rise in a boom, and even more so in a bubble, more debt and more leverage always seems better because profits and returns to equity get (temporarily) bigger, for both lenders and borrowers. The credit experience makes lenders and investors more confident, because delinquencies, defaults, and loan losses are all low as long as prices rise. Thus the risk of the loans seems to be decreasing, even as in fact the risk is increasing. In the case of mortgage lending, politicians are also made happy and will be cheering expanding home ownership as the risks rise.

At the loan level, leverage is measured by the loan-to-value ratio: how much are you willing to lend relative to the market value of the asset in question—for example, how big a mortgage will you grant relative to the current price of a house?

What is the prime virtue of an investor? No one thinks it is confidence. In fact, it is the opposite: skepticism.

As asset prices inflate higher and higher, and further above their trend line, the risk of their subsequent fall is becoming greater and greater. Therefore the obviously logical and required thing to do is to reduce the LTVs. But what in fact happens is the opposite: with increasing optimism, LTVs rise instead of being reduced. “Innovative” no-down payment and low-down payment mortgages are promoted. This helps inflate the price and credit bubble further, insuring that the ensuing bust will be worse.

Rational, countercyclical management of LTV behavior would reduce LTV ratios as the price of the asset escalates. The systemic risk advisor might contribute to making this possible.

3. National use of the Pollock one-page form

Should ordinary people be free to take a risk to own a home, if they want to? Of course: provided they understand what they are getting into. (This is a pretty modest risk, to say the least, compared to those our immigrant and pioneer ancestors took!)

Should lenders be able to make risky loans to people with poor credit records, if they want to? Of course: provided they tell borrowers what the loan obligation involves in a straightforward, clear way.

A good mortgage finance system requires that the borrowers understand how the loan will work and how much of their income it will demand. Nothing is more apparent than that the current American mortgage system, with its reams of confusing disclosures mandated by regulation, does not achieve this.

In congressional testimony in the spring of 2007, I proposed a one-page mortgage form so borrowers could readily focus on what they really need to know. The one-page form idea was included in bills in both the House and Senate, but not enacted, unfortunately. It remains my opinion that something like it would represent a huge improvement in mortgage finance.

By far the most important use of mortgage disclosures is for borrowers to be able to underwrite themselves—that is, to decide whether they can afford the debt service commitments they are making. In the ideal case, the borrowers would be able to correctly complete the one-page form themselves.

No single accounting rule or set of rules can fully capture reality, which will be more adequately approached through multiple perspectives.

Indubitably the best consumer protection is the ability to exercise personal responsibility in making informed decisions about underwriting yourself for the credit and about how much risk you want to take. This is the best reason to have clear and straightforward disclosures.

4. Old-fashioned loan loss reserves

Successful private credit risk-bearing requires much bigger loan loss reserves created in the good times. If you lever up during the boom and do not build reserves, you will probably end up in the government’s clutches when the bust comes.

This was forcefully stated by George Champion, the former Chairman of Chase Manhattan Bank, when he recommended in 1978 that banks “increase the reserve for bad debts to the point of having at least 5 percent of total loans. This would not be out of line with the enormous losses that had to be written off in the last few years.” His peroration: “Don’t apply for privileges in Washington. You lose your strength. You lose your independence. Don’t get in a position where you are going to have to rely on the government to bail you out.”

The whole issue is perfectly summed up by the dictum of an old chief credit officer of the 1950s: “Bad loans are made in good times.”

Perhaps there should be a required course in the recurring bubbles, busts, foibles, and disasters of financial history for anyone to qualify as a government financial official or senior manager of a financial firm.

This eternal financial truth is all you need to know to understand why the accounting theoreticians were wrong, once again, when they opposed building reserves in the aforementioned good times. They claimed this would mean “cookie jar accounting during periods of bumper profits.” But the “bumper profits” of a credit expansion, let alone of a bubble, are not real—they are an illusion created by the credit expansion itself.

This illusion then turns into real cash outflows from the banks: big bonuses, dividends, and outsized stock repurchases, to be later very much regretted, since they made equity disappear and vulnerability increase.

With bigger, more old-fashioned loss reserves, we can do better in the next cycle. We will also be reflecting wisdom that long antedated even classic old credit officers: Genesis, Chapter 41. This is Pharaoh’s dream of the seven fat cows and the seven lean cows, from which Joseph drew the correct lesson: make provision during the fat years for the coming lean years.

5. Encourage credit risk retention by mortgage originators

One of the lessons painfully taught by the savings and loan collapse of the 1980s was that for depository institutions to keep long-term fixed rate mortgages on their own balance sheet, while funding them with their short-term deposits, was extremely dangerous. The danger was interest rate risk, not credit risk.

The answer of the markets, also strongly promoted by government policy, was securitization. Mortgage loans were sold through securitization trusts to bond market investors in order to divest the interest rate risk to those better able to bear it. As a side effect, the credit risk was also divested, so the lender making the credit decision did not have to live with the credit results.

In the wake of the mortgage bubble and bust, everybody has belatedly realized that divesting the credit risk created big problems on its own, breaking the alignment of incentives between the lender making the credit decision and the ultimate investor actually bearing the credit risk. I say “belatedly,” because in 1997 I helped design and launch a mortgage program in which the originating lenders kept a credit interest for the life of the loan. The resulting mortgage portfolio has always had superior credit performance and is probably the highest credit quality mortgage portfolio existing today.

Some commentators have now referred to the good old days when the savings and loans kept the loans for themselves, displaying their ignorance and how short the memories are of the disaster that caused.

The right synthesis of the competing historical lessons is for securitization to continue to address interest rate risk, while encouraging structures in which significant credit risk is retained by the original lender. There are unfortunately numerous regulatory and accounting obstacles to this approach, but its obvious superiority makes it worthwhile to work on getting them removed. The assignment to do so should be forcefully given to an appropriate group of regulators and accountants.

6. Divide Fannie and Freddie into private companies and government agencies, so no GSE is left

The world famous, now infamous, government-sponsored enterprises, Fannie Mae and Freddie Mac, made a huge contribution to inflating the housing and mortgage bubble. Now that they are broke, it is essential to remember that their ongoing taxpayer bailout is a government intervention to save a previous government intervention.

So the GSE risk turkey, weighing in at $5 trillion, is roosting in the dome of the U.S. Capitol. Like Edgar Allan Poe’s celebrated raven, it will not go away, so the elected representatives of the people can remember the mistakes they made in fattening it up.

Once past the crisis, Fannie and Freddie’s prime mortgage loan securitization and investing businesses should be privatized and sent out into the world to compete like anybody else. They should become private companies, sink or swim, flourish or fail.

The other element of the former Fannie and Freddie would consist of those activities that are not businesses, but can only exist as part of the government: principally conveying housing subsidies in one form or another and providing non-market financing for risky loans. These should stay in the government as explicit government activities. Their funding should have to be appropriated by Congress in a transparent way, instead of escaping the democratic discipline of appropriations by being hidden in the GSEs.

Such governmental functions of Fannie and Freddie should be merged into the structures of the Department of Housing and Urban Development/Federal Housing Administration/Ginnie Mae. The end result of this restructuring would be that no GSEs are left—a consummation devoutly to be wished.

7. Remove government support of credit rating agencies

The credit rating agencies say they are in the business of publishing opinions, and they are. All opinions are liable to error, and opinions based on models are liable to systemic error of vast proportions, as the mortgage bust has made obvious. So why should the U.S. government want to enshrine certain opinions as having preferred, indeed mandatory, status? It should not, but it did, enshrine them in dozens of regulations of numerous regulators and also in various statutes.

The resulting “NRSRO” (“nationally recognized statistical rating organization”) system played a key role in helping inflate the bubble. In considering any system, look for concentrated points of possible failure. The government-sponsored NRSRO system made the dominant rating agencies into just such a point of concentrated possible failure—which then indeed failed.

All regulatory requirements to use the ratings of certain preferred rating agencies should be eliminated. When it comes to opinions about the future, my view is: the more, the merrier. Having more rating agency competitors, especially those paid by investors (not issuers of securities), increases the chances that new insights into credit risks and how to conceptualize, analyze, and measure them will be discovered. It will also reduce the economic rents (duopoly profits) that were granted by government sponsorship to the old cartel.

Of course, any sources of opinions that are too often mistaken, late or uninformative, will have little value to investors and other credit market actors. They would not be purchased in a free market.

8. Drop the government’s “confidence” slogan

An endless theme in public statements about financial markets is that the government should promote “investor confidence.” But I suggest that a confident investor is a stupid investor.

What is the prime virtue of an investor? No one thinks it is confidence. In fact, it is the opposite: skepticism.

From a macro perspective, it is more than dubious that confidence leads to efficient resource allocation. Consider, for example, that government-inspired confidence led the public to continue to make deposits in insolvent saving and loans, which allowed these institutions to continue their disastrous speculations. Later it made the world confident in the debt of Fannie and Freddie, with the same outcome. Then it promoted highly leveraged house buying.

The right idea is to have the public understand that skepticism, not confidence, is the key investing virtue. In this, ordinary investors should emulate the professionals. If they can help it, they should never let their skepticism slip while listening to the “new era” stories, the gossip, the TV and Wall Street pontifications, the (former) explanations of why house prices never fall, and the official government assurances.

They should look with special skepticism at any official figure who announces the intent to make them “confident” (let alone one who believes that financial statements can really be made “transparent”). If people become more careful buyers of securities, buyers of houses, and makers of deposits, that will be all to the good.

9. Introduce accounting with multiple perspectives

The FASB (Financial Accounting Standards Board) has labored mightily for three and a half decades to produce uniform, top-down, hyper-detailed rules to define official, GAAP (“generally accepted accounting principles”) accounting. The result, as one accounting expert said, is that we should “force people to . . . no longer rely on GAAP income statements and balance sheets.”

Pontius Pilate notoriously asked, “What is truth?” Were he with us today, the cynical Roman might ask in particular, “What is accounting truth?” As Professor Baruch Lev has written, “Practically every material item on the balance sheet and income statement, with the exception of cash, is based on subjective estimates about future events.”

A central axiom of GAAP is to impose a single perspective, such as “fair value,” which helped make the recent financial panic worse. But I suggest that accounting truth is more likely to lie in multiple perspectives. Why is the idea that there are multiple ways to represent economic activity so threatening to accountants? Perhaps only because it attacks the dogma of uniformity.

Consider an analogy. What is the true view of a statue? As we walk around it, we see something different from each angle. The president’s fiscal 2006 budget correctly observed: “No single framework can encompass all of the factors that affect the financial condition of the federal government.” The same can be said of many other entities.

No single accounting rule or set of rules can fully capture reality, which will be more adequately approached through multiple perspectives.

Realizing this may help us do better in the next cycle.

10. Study financial history

“The mistakes of a sanguine manager are for more to be dreaded than the theft of a dishonest manager,” wrote Walter Bagehot. Jesse Jones observed “the wreckage of the banks which . . . had died of exposure to optimism.” The best protection against excessively sanguine and optimistic beliefs is the study of financial history, with its many vivid examples of how easy it is to be plausible, but disastrously wrong, both as financial actors and policy makers.

Perhaps there should be a required course in the recurring bubbles, busts, foibles, and disasters of financial history for anyone to qualify as a government financial official or senior manager of a financial firm.

We could require all such officials and managers annually to sign a form certifying that they have re-read the following passage from Bagehot’s Lombard Street, which was true when published in 1873, is obviously true now, and will be true in the future:


The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes. Such a period naturally excites the sanguine and the ardent; they fancy that the prosperity they see will last always, that it is only the beginning of a greater prosperity. They altogether overestimate the demand for the article they deal in, or the work they do. They all in their degree—and the ablest and the cleverest the most [my italics] . . . trade far above their means. Every great crisis reveals the excessive speculations of many houses which no one before suspected . . . The good times of too high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while.

Try hard to remember this when asset prices and leverage are cycling up again.


Alex J. Pollock is a resident fellow at the American Enterprise Institute. Previously he spent 35 years in banking, including 12 years as president and chief executive officer of the Federal Home Loan Bank of Chicago.

FURTHER READING: Pollock recently wrote “The Greenspan Gamble,” on purposefully igniting a housing boom, as well as “Is a ‘Systemic Risk Regulator’ Possible?” and “Why Not Negative Interest Rates?” Also in The American, Pollock wrote “A Theory of Two Big Balance Sheets,” explaining the recent period of bubbles, busts, and bailouts, “Did They Really Believe House Prices Could Not Go Down?,” and “Your Guide to the Housing Crisis.”



Image by Darren Wamboldt/Bergman Group.


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