Friday, April 11, 2008

How To Fix The Credit Crisis

From the AP

The world's top financial officials, shaken by a credit crisis that has roiled markets around the world, are working on regulatory reforms that they hope will restore confidence in the markets.

The plan they have under consideration seeks to boost transparency, strengthen the role of credit rating agencies and bolster cooperation between regulatory authorities in major countries.

Those proposals will be explored Friday when finance ministers and central bank presidents from the world's seven richest industrial countries meet in Washington for discussions to be led by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.

The discussions, which will also include the top finance officials of Japan, Germany, Britain, France, Italy and Canada, are taking place in advance of the weekend meetings of the 185-nation International Monetary Fund and its sister lending institution, the World Bank.

The financial officials are gathering eight months after a credit crisis, which began in the United States with rising defaults on subprime mortgages, has now spread around the globe. It has caused major financial institutions to declare billions of dollars in losses and brought Bear Stearns, the fifth largest investment bank in the United States, to the brink of bankruptcy.

Although it's a bit late to get out of this mess, it's the perfect time to look at how we keep this from happening again. Let's start with what went wrong this time.

Let's compare how mortgages use to work and how they work now to demonstrate the differences between the old and new system. It use to be that people went to a financial institutions (we'll call it Mom and Pop Bank) and the bank held the mortgage for the entire duration of the loan. That is, the borrower's payments went directly to the bank that made the loan for the entire duration of the loan. That's because the bank actually held the loan for that period of time.

Fast forward to now where a completely different process has taken hold. The mortgage broker sells the loan to a smaller bank who then sells the loan to a larger bank who then packages the loan into a pass-through security which is sold to a large institutional investor. Somewhere along the way the packaged security is given a solid rating from a ratings agency so that a large number of institutional investors can buy the security.

The really big difference is the highly fragmented process of loan underwriting and selling. Bernanke observed this in recent testimony before Congress. It is also what has to be overcome to prevent this process from happening again. So here's what we do.

1.) There has to be someone looking over the shoulder of mortgage brokers or anybody that originates loans. They have demonstrated they cannot be trusted to make solid decisions on a consistent basis.

2.) Investment banks that pool mortgages need to perform far better underwriting standards as well. The SEC really fell down on the job on this one. Again -- this comes down to more oversight pf the street.

3.) The ratings agencies -- after first being taken out and publicly dressed down for their complete abject failure to perform any meaningful due diligence -- also need to have someone looking over their shoulder when it comes to ratings. S&P, Moody's and Fitch have all demonstrated they have absolutely no ability to properly rate securities.

What this comes down to is a simple phrase: more regulation (it's not like that should be surprising). As I've said before, capitalism is based in part on greed. But the regulatory system has to control and direct the greed. Unfettered greed is what leads to problems like this.