Fees and Leverage
Associate Professor of Finance Louis Gagnon has been a frequent commentator in the media on the banking system and risk management. Throughout the current financial crisis, he has been featured extensively on national television and radio (BNN, CBC’s “ The National”, CTV, CBC Ontario Morning, CBC Radio National Syndication, Radio Canada, RDI, TVO, etc.) and quoted in the Globe and Mail, National Post, and Toronto Star. He and his former MBA student Bill Bamber (whose book excerpt from Bear Trap is also featured in this issue on page 12) headlined a series of presentations at Queen’s Business Club events from Vancouver to New York in October and November.
In the following article, originally published in Sept. 26, 2008, and reprinted with permission, Louis offers insights and some common sense solutions to the financial crisis gripping the world’s markets.
As the global financial system screeches through the deepest crisis of confidence in living memory, the cries for increased regulation are getting louder and louder. An increasing number of market participants draw a parallel between this period and the Great Crash of 1929. Is this the dawn of a new regulation era? Yes, for sure.
In my opinion, we do not need new regulation so much as we need to restore common sense in the marketplace. Let me explain with a brief synopsis of the chain of events that have led us to where we are today and then I will propose a five-point plan to put this train back on its track.
The Great Unwinding of 2008, as it will likely be remembered, originated in the U. S. residential mortgage sector. At the time, the U. S. economy was recovering from a mild recession induced by the bursting of the tech bubble, the Fed funds rate was ridiculously low, and credit spreads were falling. Conditions for a perfect storm were slowly setting in. It dawned on someone that mortgage lending, as we had come to know it, was an awfully boring business, so a new business model emerged (let us call it a lean,mean, fee generating machine) that brought together players such as mortgage brokers, investment bankers, structured investment vehicles and other shadow banks, credit rating agencies,monoline insurers, insurance companies, hedge funds and other "investors", as well as a cocktail of financial instruments, including residential mortgages, mortgage-backed securities, asset-backed commercial paper,credit default swaps and various other structured products falling under the collateralized debt obligation (CDO) moniker. It would be all too easy to blame the Great Unwinding on Fannie Mae's and Freddie Mac's balance sheet expansion.
Under this new business model, prospective home owners with no cash to spare and no confirmed income stream would be lured into the pipeline,with adjustable rate mortgages (ARM) serving as bait, by an army of slick mortgage brokers, the first fee-takers in the chain. Then, the mortgages would be put into a big pool and securitized by an investment bank, for a fee. This process would involve the establishment of a special-purpose entity (SPE), some sort of trust that is "technically" independent of the parent, to purchase the assets from the pool. More fees! This would insulate the parent from the usual regulatory capital charges applying to plain vanilla loans. Regulatory capital arbitrage! The purchase would be financed by selling the income stream from the pool in the form of CDO tranches to a bunch of investors, the hedge fund kind as well as the naive kind. This way, each slice would carry a different likelihood of income shortfall and be given a tranche-specific credit rating (more fees!), which would appeal to a broad pool of investors. Add credit enhancement by the monolines (Ambac,MBIA, etc.) and credit protection insurance by the likes of AIG and you've got the ideal asset class for the risk-averse, yet yield hungry, institutional investor.
This was a vast money machine. Wall Street went at it with a vengeance and the fees were coming in by the truckloads. Even some of our venerable Canadian banks got into the game, albeit with much more restraint than their American and European counterparts. In the boom years of 2005 and 2006,more than half of all the mortgage-backed CDOs coming off the pipeline rested on subprime or second-lien mortgages. Then, as Murphy's Law would have it, house prices started going south instead of north and this took everyone by surprise. What a mess!
It would be tempting to call for massive reregulation of the U. S. financial system but, in my opinion, this would be a mistake. Here is a simple five-point plan that will do much to fix the current system:
First, leverage needs to go down. How on earth have banks lost their ability to assess their institutional clients' leverage ratios? The excessive leverage that has infiltrated the system through hedge funds, private equity funds and other players simply defies common sense. It is time to dust off yesteryear's ratio analysis and assess credit risk the old-fashioned way. Much of the work on this front will happen naturally when the last two surviving investment banks, Goldman Sachs Group Inc. and Morgan Stanley,morph into bank holding companies. Another important channel through which leverage has crept into the system is unlikely to sort itself out on its own: credit derivatives. Concerned about your counterparty's creditworthiness? Don't say a word, keep the relationship going, but buy default protection against it. It's like having your cake and eating it too. This $62-trillion (in notional amounts) market has gone out of control. There is no way to determine if the protection sellers (the insurers) involved in this market have adequate capital or collateral to make good on their commitments. The CDS market is like a gigantic insurance engine with no capital behind it. We've got to put this genie back into the bottle. Bring in a clearinghouse.
Second, banks should not be given the luxury of conducting their securitization activities in pseudo arms-length vehicles such as SPEs, conduits and the like. If we subject them to strict capital adequacy rules and then give them the tools to circumvent them, who are we kidding? Further, we have to stop the migration of illiquid assets from the banking book to the trading book for the sake of achieving regulatory capital relief. Risk never goes away no matter where it sits in the bank's balance sheet and every unit of risk needs to be properly capitalized in order to safeguard the longevity of the system.
Third, with poor transparency, the promise a bank makes to and receives from a counterparty is just as valuable as a cup of salt water in the middle of the ocean. Increasing transparency also means bringing the shadow banking system (hedge funds, private equity funds, etc.) under the microscope. Like banks, these entities rely on short-term funding, they employ a significant amount of leverage and they invest in illiquid assets. The systemic implications of these players' activities clearly make their business our business.
Fourth, managers must be held to account. In trading operations around the world, there exists a very perverse incentive structure. The problem has been identified a long time ago and it is time to address it. For instance, booking profits at the front-end of a long-lived trade is a recipe for disaster. By the time trouble hits, the trader is long gone and the bank and its shareholders are left holding the bag. This is not a sustainable business model. Financial engineers are very creative people. Let us invite them to design an incentive structure that will overcome this problem. If traders have more skin in the game, they will behave differently.
Fifth, we have to keep a close eye on the business. Risk managers have to be given the resources that they need to do their jobs. After all, they constitute society's very last line of defence. We must ensure that the right people are placed in this role, that they have our interests at heart, and that they adapt quickly to the rapidly changing dynamics of the marketplace. Creative financial engineers from the front office have to meet their matches in the risk management office. Fight fire with fire! Regulators have to sharpen up, too. Allowing our regulators to be one or two steps behind the business is another quick recipe for disaster.
As this mess is being swept up, it is useful to remind ourselves that the tools we use cannot be held responsible for the mischief that we cause. Derivatives, like any other financial instrument, can create a great deal of value. But, as common sense would have it, if you put them into the wrong hands or if you use them improperly, they, like dynamite, will blow up in your face.