Effective Financial Regulation Means Addressing Agency Issues

The hot button on Wall Street and Washington is the proper regulation of financial markets so that the United States citizens never again have to endure a period as we currently are living within. Many ideas have been circulated regarding which institutions shall govern, capital requirements and transparency. Those concepts aside, no regulation will suffice if the agency issues of securitization and derivatives are not addressed.

Agency Issue of Securitization

Since loan originators in modern days no longer hold, service or maintain their loans, the true test of a loan's worth is how much they can sell it for on the secondary market. Such loans, once regarded by the industry as one of the safest of debt obligations for an investor to purchase (see Hildy Richelson & Stan Richelson, Bonds: The Unbeaten Path to Secure Investment Growth), now have become one of the most dangerous of debt purchases. Why?, you ask.... It's the agency issue.

Agency issues rarely immediately gain steam. There was a time when the lender was invested in the borrowers successful repayment of the debt they had extended because they had to collect it to recoup their investment. The care and attention put into these loan originations made such debt issuances very stable and quite reliable investments. The combination of a proven track record and the general appreciation of real estate values created new demand for debt as an investment. With demand growth additional sellers, or suppliers, entered the market sending origination volumes skyrocketing.

Like most agency issues, the problem begins to occur once capitalism has inflicted a significant amount of competition on an industry. At this point, survival instincts can get the best of some market participants. In this specific case, the focus becomes originate and sell the loan at any cost regardless of ability of the borrower to pay- so long as a rating agency will stamp it and someone will buy it.

The practice of only dealing with the credit worthy is no longer of paramount consideration because the market place is overrun with competition, making risk less of a concern, and profit the bottom line. Since an originator can sell loans on the secondary market "without recourse," or no downside for nonperformance of the borrower, loan originators do not weigh the dangers of extending credit so long as their investment can be sold for a profit. At this point, the loan is often sliced, diced and divided then passed like a hot potato with the final holder being the big loser (often pension funds and institutional investors who relied on the rating issued by the bond company to judge the debt).

The reality is that the second, third, fourth holder of a debt obligation has no chance to truly evaluate the issuance. The originator is the most capable entity to judge whether or not a borrower will pay. Here is an example:

Joe wants to buy a house and he has a credit score of 700 and a job in construction. When the originator calls to verify employment they are told that Joe is an independent contractor and they use him for about 60 hours a week because of the demand. Joe makes $7,000/month. Now the originator understands that Joe is working way above his capacity for the long term and that the $7,000/ month is probably not sustainable. Nonetheless, Joe looks great on paper, even with two years tax returns. He budgets even though he has a trailer payment, two quad payments and two leased cars.

If the originator knew they had to collect this debt, the loan wouldn't be made. However, the originator can send the loan packet to the rating agency and sell it before the ink dries. Here's the best news for the originator, when Joe works a year at 30 hours a week and makes half the income, they aren't responsible for a dime of the loaned principle. The hazard thus lands with whomever holds the loan when the music stops.

Serious reform, means serious regulation on how much responsibility a loan originator must hold on its own paper. Also, much like the Glass-Steagall Act, the Country must not deviate from this simply because times improve.

Agency Issue of Derivatives

This one is simple- it is bad policy for a disinterested party to buy insurance on someone else's demise. How would you as the reader feel if I was buying short term life insurance on your life? While I understand why someone would want to buy these products, and moreover why people love to sell these "instruments of mass destruction" (Warren Buffet on CNBC, 2007), profit, I don't understand why as a society we believe that this behavior is worth the risks? I, personally, would rather see these firms cheer against little league players or bet the "don't come line" in Vegas than wager and actively participate in the destruction of our system for profit.

Great economies and great societies thrive when a profit leads to greater money flows and greater profits leading to gentle and sustainable inflation of prices. Zero sum game markets such as derivatives pit market participants against one another in an unnatural way- the equivalent of every dollar made is lost somewhere else. In other words, their is not the exchange of goods for currency based on differences in subjective valuations of the parties ( A is a willing seller of a widget for x, and B is a willing buyer of a widget at x), but rather a dollar made is a dollar lost. Derivatives are even different from traditional insurance where the buyer gives currency in exchange for a risk to him or herself, hence the traditional trade off where the seller needs additional capital and the buyer needs less risk.

The liquidity and hedging benefits are far less important to the market as a whole than the costs of having to pay off these bets when the market is least able to bear the cost to do so.

Without addressing the agency issues of these two products the market is not safe from another collapse. Effective reform must make market participants accountable for the sustenance of the markets in general; as well as, their own actions.

The When, Where and Why of Government Involvement in Commerce

When Republicans are in power, the cry of the people is that the government is denying us our freedom and interfering by playing favorites. When the Democrats are in power, the cry of the people is that the government is denying us our freedom and interfering by playing favorites.  While neither party will constructively work  along side the party in power in fear that good government will lead to the reelection of their nemesis,  American citizens drown in rhetoric and double speak from both parties about what good government looks like. Regardless of one's political affiliation, this blog attempts to engage readers with the logical, not partisan, discussion of what is necessary government involvement in commerce.

First, let us start with an irrefutable fact of the order of operations.  Government is the first step in economic activity.  Government is necessary to provide at a bare minimum: property rights, police protection, infrastructure and recognized mediums of exchange, or currency.  Yes, I am aware that many anti-establishment Locke Liberals and libertarians would argue against the last two, but in our current developed state these two are enough established to be considered necessities of commerce (i.e. roads, electricity, water, etc.)  They are essential because without any of them, commerce would subside as a matter of natural progression from its current state. 

What levels of commerce would we have if one could take property from another by force?  If there were no roads?  If the electricity was not delivered? If agreements were not binding or valid? If we had to barter with goods to make a purchase?  Certainly not an economy the size, strength and complexity as ours.  Whether it is good or bad, it's where we are at. 

So, the right question is not where government involvement should or should not be, but rather how far should government go?   In a credit based economy, like ours, the government speaks for and develops the value of the assets in our economy (i.e. the government borrows notes from the Federal Reserve, or dollars, at a rate if interest in exchange for true "dollars" that the Fed holds as collateral along with all assets held within the Country).  Oh by the way, for those of you conspiracy theorists, the same is done by many States with Motor Vehicles ( A state takes a manufacturers' "statement of origin" from the maker of the vehicle and in exchange delivers a "title," or license for use, and the ability of that vehicle to be used within that State through the process of registration.  As a result, that State then issues a Driver's License so that it has jurisdiction over the driving patterns of the user thereby controlling the licensee, or "owner," to use that " registered motor vehicle" on their publicly owned streets and highways.  But I digress.

The simple answer is that the proper role of government in commerce is the amount necessary for commerce to "work."  By work, I mean that citizens can effectively participate in the money multiplier and achieve, or reasonably believe that they can achieve, their personal goals and happiness.  This ability, or  at a minimum the belief in this ability, allows the society to function in a peaceful manner as its citizens have an outlet to achieve there desires, or work.  After all, and I recognize people who quote the Declaration of Independence as an authoritative document are annoying, the point of America is the right to "Life, Liberty and Pursuit of Happiness," right.  The key is for people to have the freedom of the pursuit, that's right THE PURSUIT, of happiness.

In closing, I recognize that the Declaration of Independence is not authoritative in nature.  That said it carries persuasive authority into the intent of our Founders.  Government's role in commerce is the creation and maintenance of channels for commerce so that Citizens can access and thrive in that system.  The government is there to provide and maintain the artery, so that the heart, or private commerce, can pump blood and that blood can freely flow without blockage or interference.  The artery must be maintained though, to maintain its shape so that blood doesn't spurt every where thereby killing the body; as well as, ensuring clear passage.  Further, the artery is to be for the benefit of one's own body.  Should the artery be ruptured, by outside attack or internal disruption, its integrity must be put back in tact to ensure survival of the being.  That said, at no time shall the artery be altered outside its purpose of a conduit and shall never alter the course of which platelets cross its path.  

Now that it is defined in theory, I let you decide the application of this framework in practice.