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 Often Ignored Collectivism of Capitalism

Many have come to appreciate the very simple realities shared by this blog when one abandons ideology, partisanship and prejudice and logically attacks the issues of today. Partisans and one way thinkers are silly. We all appreciate that fact more when we concentrate without influence on a topic with good old fashioned common sense.

Here are a few simple realities many can't argue with nor agree upon:

1. Socialized Medicine. We already have socialized medicine. The insured pay the bills of the uninsured and under insured. Twenty-five dollar aspirin and rising deductibles, premiums and co-pays are the result of free medical procedures performed by hospitals on the indigent, under insured and uninsured. Our disagreement and inability to manage this reality causes tremendous inefficiency.

2. Mark to Market Accounting. There is no such thing as "mark to market." There is mark to transaction price accounting, but transaction prices aren't always correct. In the short run, transaction prices can run higher and lower than what a reasonable person would buy or sell for. The fallacy resides in the fact that it doesn't count those who refuse to come to the market at a said price, the silent majority. When prices are too high many buyers refuse to do business. When prices are too low many sellers avoid coming to the market. Mark to market only measures what those who are willing to do business under very specific conditions, sometimes unwillingly, are transacting at. As price points shift, often there are very different buyers and sellers who come to market. In other words, if one sale is made at x, and no other sales are made, the price would be x, even if ten thousand transactions would have occurred if the price was y. In the long run, values are functions of aggregate incomes and demands of society, not prices.

3. The back story to the stock market. There is no back story or information that is causal to stock prices. In any given day the only invariable truth is that there were more buyers than sellers or more sellers than buyers. The only reason financial news bears any relationship to stock price fluctuations is that the buyers and sellers believe that such stories are related. This results in a massive and naively trusting game of signaling. So long as, the majority of positions all "agree" to weight the news equally, short term fluctuations can be reasonably explained. That said, it's not the news - it's the agreed upon norm of how to act on such news that moves the price. In the end, its the buying and selling that moves price.

4. The market is always right. The market is nearly never right. Over long, LONG, periods of time, the averages of the market tend to support logical results. On any given day, the market is as wrong as any individual. It could be argued the market is further from truth than any free thinking individual in the tendencies of market participants to stampede in and out of positions moving equilibriums past proper price levels at neck breaking speed. If the real value is five and the market spends ten years at 2 and the subsequent 10 years at 8, than on average it was right even if it never maintained that value.

Of course we could go on and on, but it is important to land the plane on the point of this obvious exercise in logic. Regardless of which issue we speak of, the solution to inefficiency, breakdowns, inequity, fallacy, losses and failures is the point of agreement in society. All of our actions impact our fellow countrymen and women. When we agree, momentum is created, whether it be positive or negative. A point of agreement is anything from a sale to an appraisal. The willingness to stay in an upside down mortgage to ensuring all have access to affordable health care. A decision to place a put or call option on natural resources one doesn't require to thinking for oneself. We are our brothers keeper whether we believe that or not. Our failure to properly conduct ourselves in a positive manner shall manifest itself in the our reality.

Energy prices, home values, loan qualifications, joblessness, health care costs, profits and losses are our decisions collectively. They are the fruit of our actions. It is collectivism, or a positive point of agreement, that creates abundance. Our world is a manifestation of our collective perspective. Gold is not edible, usable or valuable in its own right, only by collective recognition and agreement of its value does it become an inflation hedge or an international currency. Whether collection of our individual efforts results in disruption, decay and depression or prosperity, innovation and hope is all decided by the direction of us as a mass. The apex is thus the superseding values of our population to act in self interest without detracting from the progress of society as a whole and influencing our families, neighbors, friends and coworkers to abide as well.

The Conversation We Need to Have

Wage disparity, the slimming of the American middle class, the strengthening of the multinational corporation and the record breaking bonuses of CEOs are all occurring simultaneously in the United States. The threat of wealth redistribution and government intervention are topics that have become common place. Divergence in the media where Americans can choose their slant by switching the channel, but never get a straight answer is all that is available. Finally, a growing majority of America's youth who believe they shall not be able to achieve the socioeconomic status of their parents is significant.

How did this Country who banned together to win: two world wars, a four decade cold war for global supremacy, and the race to the moon become so demoralized? Where did the tough- nosed honest gumption of this population go? It wasn't long ago when an experiment comprised of an enmeshment of immigrants found a common purpose in the burgeoning of an industrial revolution and understood that together they could conquer any challenge. It was against this backdrop Henry Ford declared he "paid his workers well so they could afford to buy one of his cars." Every neighborhood was adorned by a corner market where a family could make a living serving their block as a local grocer. These were the days when doctors would make a house call, and one paid the bill with what he or she had in his or her wallet. Americans left their doors unlocked and finding work was attainable for those who were willing to work.

In these golden days, buying local and buying American was the standard, and foreign labor and outsiders were viewed with skepticism. These Americans believed in honesty, family and Country. This was the era where the boy with a work ethic and a dream could move from the mail room of a company to becoming the CEO. People believed that hard work would lead to upward mobility in society. In these days, bankers let borrowers meet with them face to face, a worker knew the owner, and neighborhoods policed themselves.

America today is in transition. The ghosts of Marx and Schumpeter look over us with parsed lips and a wry smile in a gesture of "told you so." Prices and wages diverged throughout the 2000s culminating in a freezing of the credit markets. In the simplest description, trust between the classes seized in a long coming day of reckoning. If one acknowledges that credit is a bridge extended to someone in need of more money by someone, or some entity, that possesses it, than it becomes obvious why the credit markets seized. Those "without" no longer could afford their current course of consumption. Credit was extended to supplement this shortage, but soon, those "without" could no longer afford to service the necessary debt. Frankly speaking, the wages had fallen far too short of the prices of society. The culmination was $4.50/gallon gasoline and median home prices of $300,000 on an average household income with two working parents of under $45,000/year.

Now it is commonly acknowledged as fact that globalization caused the wage deflation, or at a minimum wage stagnation, in the United States (Thomas Friedman, The World is Flat, Alan Greenspan, The Age of Turbulence, Common Cents, The Current Account Deficit and National Security). American companies became part of the "multinational" corporate model where labor was sought in an environment where a competitive advantage existed regardless of nationality. United States labor laws, environmental regulations, labor unions, and high corporate taxation cemented this outsourcing of labor. In addition, failure to enforce Anti-Trust laws allowed Corporations to reach a size that eliminated competition. An example is Walmart, who breaches contract law with suppliers, drives down wages by forcing competitors to close and subsidizes its low costs by paying wages so low that the workers are encouraged to accept Federal and State welfare for health care instead of the Company's group policy. Most intelligent business people refuse to supply, build or service companies of this size because such Goliaths slow pay and renegotiate contracts as a business practice and ultimately drive their business partners into insolvency.

So after all of the above, what conversation needs to take place? A one on one conversation, nationally televised without commercial, commentary or spin between an American CEO and an American worker. No government, no labor union, no chamber of commerce and no company delegates permitted. Like the doctor on a house call when it was time to settle the bill, business leader and worker need to see one another from a perspective of humanity. Just two brothers of Country, who have avoided one another, speaking only through third parties, for a significant period of time and act with malice despite forgetting how their relationship became so strained. The American worker needs to know what they can do to earn the trust of the American upper class. The American upper class needs to understand that regardless of why they have betrayed the trust of their Country when they chose to export the dignity of work overseas, they will be stronger once such a trend is reversed.

In having this conversation their should be no third party interference, as just in a sibling rivalry, such interference shall cause resentment and defensiveness on the party who feels outnumbered. The wealthy need to soften in resolve with the real needs of the worker and the worker needs to understand and respect the pressure facing the business. Picture it. Two people, who have grown to dislike one another and have refused to directly communicate for decades, locked in a room until they come to a mutually agreeable solution. A solution to bring the United States back into alignment. No longer should the youth be conditioned with a fear of being outsourced by fellow countrymen. No longer should the wealthy feel that those without are spoiled and not willing to work and earn their way to a point of financial security.

My suggestion is metaphorical, symbolic and allegorical; but, drives at the core of our current crisis of credit, unemployment, confidence and patriotism. There has been far too much taking in our culture and entirely too little giving. Giving of employment, giving of opportunity, giving of self and giving of dignity. Government cannot solve our situation without the agreement of those who are able to give these things. The cry of the wealthy that "if the government is to redistribute wealth they shall denounce their Country and take their capital and toys elsewhere" is understandable. Forcing a party to act never ends amicably. The cry of the working class of unfairness is counterproductive, for we need no further sleuthing for problems. We need a solution. A dialogue of how these parties can best participate together.

After all, their existence within the borders of this Country is symbiotic. The worker needs the wealthy for wages, the middle class needs the worker for advancement and the wealthy needs the middle class for sustenance of their situation.

The Accounting Crisis: Mark to market and the Destruction of the U.S. Banking System

Did you ever see the Stephen King movie The Happening, where people throughout New York City are committing suicide in mass? You see people literally turning on themselves to end their own lives as a result of some strange spore released into the air by plants protecting their existence. Well, if you think about it this is analogous to the current destruction underway in the financial system of the United States. Banks literally are turning the knife on themselves by sheepish lending practice while the accounting rule of mark to market is silently spreading to induce the massive death and destruction.

Mark to market is a rule whereby publicly traded companies must "mark," or declare, the value of their assets to what it would be worth if it was to be sold at that very moment. This rule, while widely used in valuing liquid assets such as securities was applied to nonliquid assets, such as real estate, after the Enron scandal. The general hypothesis towards applying the rule to nonliquid and liquid assets alike is to prevent companies from misleading investors by valuing its held assets at higher price than their "real" value.

The problem in the banking world is that banks are regulated stringently by the Federal Government and must maintain a certain ratio of assets to loans to be considered legally solvent. The result is that when a bank must mark its assets down according to the accounting rule, it is legally required to cover that write-down by adding another asset, usually cash, or decrease the number of loans it has outstanding. Since their is no practical way to call loans, banks must raise additional cash when the marketability of their assets fall regardless of whether those assets are performing perfectly.

Approximately 2.5-6% of home mortgages are in foreclosure. A staggering number, but not insurmountable. Now add that under 50% of Americans have a mortgage on their home. What do you come up with? Yes, you're right! The banking crisis has less to do with the foreclosures and more to do with arbitrary accounting rules. As infuriating as the truth is, the mark-to market accounting rule is forcing banks to value the homes that they hold mortgages on down to the values being received in foreclosure sales representing somewhere between 1.25%-3% of total homes!  Even if one intends to pay every last payment of one's mortgage with the paycheck from one's stable Federal government job, and that mortgage payment is less than 25% of one's take home pay, the bank has to value that home as if foreclosing on it today.  

The mark to market rule literally created the same bubble it is bursting.  When the market was trending to the moon in 2002-2005, banks were allowed to mark the assets up to the market price.  This increased the assets on their balance sheets and created more room for lending, thus pushing prices higher as more credit was made available.  This sinful consequence flew in the face of sound accounting where gains on illiquid assets are not to be realized until sold.  Subsequently, as prices began to fall, banks "marked" their assets lower limiting their ability to lend, which limited credit and prices fell further.  Once prices fell further, the banks had curtail lending more and guess what?-Prices fell further.  The sad reality is that the houses being sold determining this market value were not sold by choice, but rather as a result of foreclosure and therefore no true market existed.  Further, with buyers unable to access credit because of banks having to hoard cash to make up for falling values on assets (95-97% of which were performing) fewer transactions occurred to stabilize prices.

Here is the rub, foreclosures had very little to do with the financial crisis, accounting and fear were the culprits, and I can prove it.  If Bank A foreclosed on house 1 previously valued at $250,000, Bank A would not have to mark that asset down so long as they issued a new loan to the next Buyer at $250,000.  Even if the next buyer couldn't afford the house and would subsequently go bad on the loan in one year, the asset value by rule would be $250,000.  As a result, it was lenders unwillingness to lend that literally caused their inability to lend.

Clearly I understand that the moral hazard associated with the securitization of mortgages, relaxed standards by Freddie and Fannie and outright fraud caused much of the bubble of the housing market,  but the illogical extension of marking illiquid assets to the market amplified the problem from a rising market to a bubble and then from  a declining market to a catastrophe. 

 A great example of how the market rule amplifies itself occurred when Wamu was deemed insolvent by the FDIC and Chase Financial was given Federal assistance to take over the massive mortgage lender.  In taking over Wamu, Chase marked all of the acquired mortgages down to what Chase and regulators deemed a palatable level.  Regardless of whether or not the mortgages were performing, Chase marked them down as if they were to be sold that very day according to the accounting rule.  Almost immediately following this transaction Wachovia was on the brink of insolvency as a result of how Chase had discounted the assets.  All the experts agreed that there was no market for new homes and that the most difficult issue facing Wall St. and banks was how to put a value on them.  Wachovia was profitable.  Their loans were performing. Mark to market killed Wachovia because of how Chase valued the assets of Wamu in the forced sale.

Solution:  An illiquid asset is worth whatever it is originated at and at its sale, disposition, trade or disposal a gain or loss is to be recorded.  No matter what the system for valuing assets it will never be perfect, but surely it can be without unintended exaggeration.  After all accounting is supposed to illustrate reality, not create it. 

The Float: What does it truly mean to be a service based economy

Often times folks speak about the United States being a service based economy as a matter of fact and a simple meaningless truism.  While it is a fact that the United States is currently a service based economy, it certainly shouldn't be stated as an acceptable matter of fact.  This is not something to glaze over.  It is an unacceptable reality of decades of laziness that has lead our country to essentially zero growth since the early nineties.   

That's right zero growth.  Look at the value of any meaningful item (and by meaningful I mean substantial durables or assets).  Cars, homes, land and commercial real estate has made no meaningful appreciation.  No three percent per annum, in fact, the value of these are completely flat with the exception of a mountainous spike caused by monetary policy.  Believe it or not, after all the fury, we have made no progress.  How could this be?  Shouldn't our holdings at least have kept pace with the monstrous inflation we experienced up until 2007?

The answer is yes it should have, but no it didn't.  What the media, the government and economists don't want to tell you is that the "global economy" has stagnated our country.  The promise that every generation shall be better than the last is in jeopardy because policy makers don't understand that while globalization is wonderful for corporate profits in the short run, it devastates that same economy in the near term and eventually cripples a nation.  In the short run, exporting jobs to another country causes a company's cost of labor to decrease and even after the paying of shipping costs creates a larger margin for that company.  Those profits are usually invested by the company in new product or corporate investment vehicles that generate more profit for shareholders.  Certainly a desirable result.

Sometimes, a company will even pass along a share of the savings from the labor to the consumer, although this rarely happens as prices generally never fall regardless of where a product is produced.  A funny side note is that many Americans believe corporations pass on the savings from producing items out of the United States despite CPI figures clearly stating cost savings do not result in price reductions.  That said, greater profits derived from cheap outside labor does create greater profits that lead to higher stock prices, shareholder dividends, and greater CEO compensation.  Certainly a logical result.

The problem is that the behavior is short sighted.  It is the equivalent of killing a sheep for its wool.  Over time, the benefit of the exportation of labor gets piled into very few players in the economy.  The failure of a significant portion of the population to purchase anything due to nonavailability of substantive work leads to steep and severe recessions.  To remedy the recessions the government creates lax monetary policy to subsidize the inability of its citizens to function in the market as consumers.  This creates a vast number of service sector jobs centered around finance, sales, distribution, and logistics.  

Now the big problem comes.  The money from the lax standards purchases all it can and because the population does not create, build, develop or manufacture anything there are no jobs of substance that can continue to function.  The country stops buying at the current levels and the ripple effect literally shatters the economy shattering price levels back to pre-lax monetary policy levels.  Its all float, and that's what no one understands.

If all we do is sell to each other without any substantive jobs, there is no true production in our economy.  We cannot fall back on making diapers, toothpaste, clothing or pens.  If we were building these items, then those jobs would carry the service industry jobs through downturns and lead to the general increase in standard of living of all members of the country.  As population grows, those substantive jobs would grow in numbers and they would not be lost simply because the economy slows.  These jobs might slow, but not vanish.

The float is how Americans currently make a living.  They don't even truly sell anything.  Here it is in a nutshell: Joe American grabs his catalogue of foreign manufactured widgets and agrees tp sell them to Sam American for $10 a piece.  Once the order is placed Joe puts his order in and purchases those widgets for $5 a piece.   Joe isn't selling anything, just pushing through a meaningless profit margin.  Worse yet, as more players enter Joe's business his profits erode.  Since Joe has no power to innovate he will simply have to cut back on his standard of living to continue in his business- thus reducing the standard of living of everyone else that Joe interacts with.

 

Now, Joe paid for those widgets on  a line of credit from Clueless Bank of USA.  That's the float. Joe American and Clueless Bank of USA are on the seas of uncertainty.  Contract or not, if Sam American cannot pay because of a failure in his service based business, mostly because the "Joes" of society aren't buying from Sam because they have reduced spending due to the increased competition now in the "pushing profits" business, Joe is stuck paying interest.  If he cannot pay the principal or resell the widget Joe will default on the loan.  Clueless Bank of USA takes the loss which affects its ability to lend, creating a scenario which multiplies and duplicates itself by the cessation of credit lines to people similar to Joe American.

If everyone has jobs like Joe  American the economy is literally a string of dominoes with the tipping of the first domino leading to all of them falling in line.  This situation cannot sustain itself.  Can everyone see what is missing?  The creation of a good.  That's right a substantive business that literally performs a real function.  Turning plastic into containers or textiles into clothing.  These jobs are a necessity.  Someone must build the widget and when credit is extended to a company that builds widgets, at very least that bank has the widgets, machinery, real estate and assets necessary to build those widgets as collateral.  Further, that bank has the security of knowing that widgets must be made,  and if the business it loans to fails, someone must come and take their place to satisfy the citizens need for widgets.  This places a stability under the value for the companies assets.  Moreover, the workers at the widget factory create stability in the market for consumer goods and services as they are still working due to the demand for widgets.

In the case of the servicer, he has no purpose.  Anyone can sell the widgets.  Further, there is no meaningful collateral for the widgets especially because the bank's basis of $5 per unit is not the true cost, it is the true cost plus foreigner's profit plus shipping.  The bank is buried going into the transaction.  Moreover, we have no steady worker to buffer the loss of consumption during slowdowns in the economy.

From Rome to Great Britain, no great empire has sustained itself once it has engaged in free and directionless trade with foreign countries.  While it is true that trade empowers both parties with greater production and utility than could have been achieved without trade, economists never distinguish how that benefit breaks down between the parties.  In the case of super power and non industrialized country, the benefits are skewed dramatically in favor of the non industrialized country.  In the long run, the small gains of the industrialized country are significantly smaller than the gains of simply producing the goods unilaterally.  History has taught us this lesson with every great empire losing its stature subsequent to succumbing to mercantalists tendencies to trade away its production capacity.  

Trading allows the weaker country to gain relative strength against the stronger country.  Eventually that strength grows to bargaining power which leads to greater wealth.  Wealth leads to ambitions, and in time the smaller country shall be formidable companion with its own voice and identity.  Should that identity differ from the once greater trading partner the once strong empire shall find it has created a security; as well as, financial threat to itself.  If it continues the weaker party shall gain, not only identity but the will to oppose the stronger.

Like my good friend always said when we played bones, "Not all money is good money."