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Elliott Morss | April 23, 2014

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Barney Frank on Regulatory Reform

Barney Frank on Regulatory Reform

Elliott R. Morss, Ph.D.

 Introduction

The American banking system collapsed, causing a global recession. Now, regulatory reform is in the air. Geithner has offered has ideas and the Financial Crisis Inquiry Commission has started its hearings.

Barney Frank is my Congressman. More importantly, he is the chairman of the House Committee of Financial Services and consequently will play a key role in whatever regulatory reform is enacted. Last summer, he gave a talk at the National Press Club available here on what he and other members of his Committee want to see happen. I will use quotes from his speech to summarize his views along with my commentary.

Innovation

Barney believes innovation is good, it comes in waves, and there is a new wave of innovation now taking place in the financial industry:

“…first of all, a large part of this came from innovation, a good thing. Securitization — thirty years ago, most loans were made by people who expected to be paid back by the borrower. And that meant you had to wait until the borrower paid you back to re-lend that money. Securitization comes, and it means money that’s outside the deposit-taking system because there are new sources of liquidity, and it means that you don’t wait to be paid back.”

Securitization, a good thing? “New sources of liquidity? Let us start with a clarification – securitization does not increase the economy’s liquidity – when a bank sells a mortgage, someone has to buy it. Of course the bank is more liquid as a result of the sale, but the buyer is less liquid by the same amount.

But what is the most important result of the securitization that created a secondary market for bank mortgages? A fundamental change in the incentive structure of banks.

Before securitization, banks made loans with great care because they knew their very existence depended on the money being paid back by the borrowers. My father was the president of a small bank in Boston. I estimate that at least 30% of the bank’s staff time was spent watching over their loans – staying in touch with lenders and helping them out as needed.

 Now, banks and mortgage companies live off commissions resulting from selling off their loans: the more loans/mortgages they make, the more income they make from commissions. Is this a good system? No, not at all. Do banks now worry about the quality of their loans and getting paid back? They do not. Because they now get paid via sales commissions, they focus on writing and selling off as many loans as they can.

 Consider this – these banks are using our deposits to make these loans. And that is why FDIC insurance should be limited to banks  that manage their the loans they make (see my detailed arguments here).

 Liquidity

In fairness to Barney, he also sees this problem:

If I lend you money and I expect to be paid back, I’m going to be more careful than if I lend you money and you’re going to pay back somebody else. And securitization has weakened that borrower/lender relationship and the discipline…. We think you need to put some limits on securitization. People should not be able to lend money without having any risk retention.”

Frank deserves credit for seeing and understanding this – very few legislators do. But Barney only wants some limits because he is worried about reducing lending too much if you go the 100% route. Reducing lending by too much after what has just happened?

But beyond this, he is missing a very important component of the global financial picture: banks are now only one of many large sources of lending and investment. Table 1 provides data on the largest 500 global money managers. They are currently managing/investing $53 trillion worldwide. According to the Federal Reserve Flow of Funds, total US bank credit is only $9.2 trillion (for more on this, see here).

Table 1. – Leading 500 Global Money Managers (in US$ bil.)

Manager

Total assets

Barclays Global Investors

$1,516

Allianz Group

$1,462

State Street Global

$1,444

Fidelity Investments

$1,389

AXA Group

$1,383

BlackRock

$1,307

Deutsche Bank

$1,150

Vanguard Group

$1,145

J.P. Morgan Chase

$1,136

Capital Group

$975

Bank of New York Mellon

$928

UBS

$821

BNP Paribas

$810

Goldman Sachs Group

$798

ING Group

$777

Credit Agricole

$776

HSBC Holdings

$735

Legg Mason

$698

Natixis

$630

Wells Fargo

$574

All Other

$32,901

Total Leading 500

$53,356

Source: Pensions and Investments/Watson Wyatt World 500

Barney, relax, there is plenty of money out there to buy mortgages in the secondary market. But let’s get our banks back to taking great care with the loans they make. After all, they are lending out our deposits.

Regulation

Frank says:

“Our general view, and by that I mean the members of our committee and the people who work with me on the staff, and members of the House in general and our Senate counterparts, is that the problem was non-regulation. And it’s very important to stress that it’s non-regulation, not deregulation.”

In other words, Barney believes we have the tools to effectively regulate the global financial system. What specifically does he think we can do?

·        “We think that there needs to be somewhere in the system an ability to limit leverage.”

  • “We need to contain derivatives.”

I do not agree with Barney on either of these points. We have regulations in place that completely failed in 2008 leading to the global credit freeze and recession. What more can we do? In the US, the banking regulators are overwhelmed in trying to implement the Basel I Accords. And in those countries that use the Basel II Accords, banks also collapsed.

It is important that readers understand the complexity of what some people believe we can regulate. Consider the updated Citigroup 8-K report to the SEC at  http://www.citigroup.com/citi/fin/data/k08cu.pdf?ieNocache=875. Go to the PDF page 90 and read through page 109. And this is just one bank. Or go to Bank of America at – http://media.corporate-ir.net/media_files/irol/71/71595/reports/2008_AR.pdf, and go to pdf page 91, Table 42, and then go to page 133, and read Note 4 on derivatives. And Barney thinks our bank examiners can understand and effectively regulate these activities? This is nonsense. We can’t understand, and much less regulate this stuff.

But consider this: what if our depository institutions were not allowed to trade? What if we said banks can’t hold or trade derivatives?

If such a system had been in place when the asset-backed security market collapsed in the fall of 2008, what would have happened? AIG, Lehman, Merrill, Goldman, and many other investment houses would probably have collapsed, lots of money would have been lost, but the global banking system would have remained intact. The credit freeze would not have occurred; there would have been no need for TARP….

FDIC insurance should be limited to banks that earn 10% or less of their income from trading. We cannot effectively regulate banks as they are currently structured, so let’s simplify them down and do what we want them to do which is to manage our deposits and lend some of them out in a prudent manner.

Barney is absolutely right when he says:

“What we should care about is the financial stability of our depositary institutions.”

Hedge Funds, Private Equity, and Other New Investment Institutions

Barney is in favor of protecting people:

“We need to protect consumers because protection of consumers now has dissipated in ways that result in a lack of activity because there is no way to focus responsibility.”

 Frank wants to regulate hedge funds, private equity, and other investment vehicles that will come along. This is reasonable. As we do with publicly traded companies, mutual funds, and ETFs, we should require new investment vehicles to:

  • register with some regulatory body;
  • provide verifiable records of current and past performance/finances;
  • provide a clear statement on how your money would be invested;
  • provide a way to isolate your investments from those of the investment institution.

But after that, Barney, I believe in caveat emptor.

Mortgage Foreclosures

 Frank is concerned that the President’s program to reduce mortgage foreclosures has not been effective. Why has it not worked? A major reason is the securitization of mortgages. Secuitization often breaks up the mortgage in three separate packages, each with some monetary value:

  • the claim on the property if the payments stop;
  • the income flow from the payments;
  • the fee for collecting the mortgage payments.

 So what happens when the President asks to find people who qualify for assistance to avoid foreclosures? The only remaining connection with these people is through the payment collection agents. What do they know about these people? Nothing more than whether or not they are making their payments monthly. That is all we know. That is hardly enough to justify a Federally-sponsored mortgage break. 

Executive Compensation

 Barney is concerned about executive compensation. So am I. More on this next week.

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