Looking back over 2007, this certainly has been a year of profound turmoil.
Rarely have there been such large reported losses and such significant changes in the management of large financial institutions. Nor can I remember a time when more people were at risk of losing their homes. The Mortgage Bankers Association recently reported that foreclosures on home mortgages were at all-time highs and delinquencies were at 21-year highs.
The turmoil is far from over. It could be premature to say this, but I believe lessons are emerging from the last several months' events that can be helpful to institutions, individuals, and the government.
The capital markets, for all their vibrancy and innovative spirit, can exacerbate human error. (In this case it is clear that for the most part neither issuers nor investors fully understood the implications of the optionality embedded in more complex mortgage instruments and how they would perform over time.)Put another way, financial institutions need much more than models and a capital market trader's mentality to be strong, and the financial system cannot wholly rely on the capital markets for financing.
Having said that, it is important to note that many of the financial institutions that fared best in this storm have had at their helms traders or financial services executives who deeply understood trading and the capital markets.
The bank charter continues to have immense value in ensuring the stability of our financial system. A combination of banking standards, capitalization, and the FDIC safety net have allowed the American banking system to be a shock absorber in this financial crisis.This shock-absorber feature needs to be retained and strengthened. For example, there needs to be a rethinking of the degree to which the allowance for loan and lease losses has encouraged a mark-to-market mentality within the last few years. Bankers need to have more flexibility to set a robust allowance when they believe it is justified.
The concept of "soundness," the often-overlooked partner in the phrase "safety and soundness," matters a great deal in finance. Soundness historically is meant to imply a level of probity — sound behavior, which is the antithesis of the practices that many mortgage brokers engaged in over the past year. It means treating the customer as a long-term, valued client, where the products offered the customer are appropriate for his or her use and where terms and risks are fully and carefully disclosed. Had this concept of soundness been put into practice over the last five years, the current financial crisis would have been avoided or much less pronounced.
There has been too little focus on liquidity risk, particularly in light of the degree to which the capital markets have intruded into even community banking. The markets can give liquidity in large amounts, relatively quickly and simply, but they can also take liquidity away in a hurry. Banks can expect the regulators to pay much more attention to liquidity and liquidity planning over the next couple of years, and this means at a minimum having thoughtful, written liquidity plans.
Fannie Mae and Freddie Mac remain an important part of the American home mortgage system. The home mortgage credit crunch would be a lot worse if they were not operating today.Conversely, the markets would be much more fluid today if Fannie and Freddie were allowed to buy mortgages in the secondary markets, at least temporarily, and if the limits on mortgages available from Fannie and Freddie were raised — both policies I personally advocate. I would substantially increase the limits, at least in the higher-priced housing markets.
The private sector is undoubtedly the bedrock of the financial sector. The innovation, vigor, and free markets on which we depend can be hamstrung by government excess.However, there is an important role for the federal government to play in regulating not just banks but all financial services players. I for one do not fear that serious regulation causes financial markets to flee to foreign soil.
On the contrary, the transparency and integrity of our markets and financial institutions is a magnet for financial business to be done here, and that transparency and integrity must be assured by federal market regulation.
Also, the "solutions" to the current financial crisis that have been largely relying on private-sector initiatives — sometimes with a not-so-behind-the-scenes government push — are not enough.
Relying only on the Fed to lower the Fed funds rate and the discount rate is not enough. We have to think much more boldly. The government needs to intervene more directly to get the markets started again and to keep people from being forced out of their homes.
In this regard, one part of the solution should be the establishment of a temporary government entity to purchase — at market — subprime, alt-A and other nontraditional prime mortgage products.
Such an entity can be financed through the issuance of its own instruments guaranteed by the federal government. This entity would take a variety of measures not to foreclose on the mortgages it purchases, including a broad and permanent reset limitation on the nontraditional mortgage products it buys. Because this entity is in the market purchasing product, it would provide liquidity to the marketplace. But because it is buying at market or near market prices, it is harder to criticize it as merely a government bailout of those who took bets on bad loans.
Furthermore, because it would be chartered to keep people in their homes wherever possible, with the power to adjust individual mortgage arrangements, it would play an essential role in avoiding the vicious circle that is beginning to spin because of the high level of foreclosures: foreclosures leading to fire sales, leading to lower real estate values, in turn leading to more foreclosures.
There is some helpful analogy here to the Resolution Trust Corp., a temporary, government-created entity that helped us out of the last real estate crisis, though engaged in rather different activities
No doubt we will learn much more from this crisis as it unfolds.
