Wow. It has been written in the Wall Street Journal today Geithner Vents at Regulators as Overhaul Stumbles. that Treasury Secretary Tim Geithner blew up at his chief regulators last week in a;
One of the many things going on in Washington is financial system regulatory reform. I have a suggestion that I have brought up before on this blog. How about a guy like Paul Volcker or Henry Kaufman gets nominated as the "Common Sense Czar"? I used to read about how Henry Kaufman used to walk the floors of Salomon Brothers, poking his head in to different trading desks and saying things like, "Hi,I see you guys are up a lot so far this year. Are those gains realized, or are we still holding risk? Who's buying the bonds you're selling? Who are we buying our hedges from?" Mr. Kaufman was like the "Czar of Common Sense." He would collect a bunch of this information and figure out if the firm was over-exposed to anything.
Think about how a Common Sense Czar would have approached our current crisis BEFORE it fully developed. Let's use the year 2006. If we snuffed out the growing disaster then, we still would have had a disaster, but not life threatening. Anyway, lets fantasize!
- First the Czar visits the folks making tons of money "guaranteeing things". Guys like AIG and Ambac and MBIA and asks the question, "Hi, how are you making your money?" They would say, "We have this great business where we get paid to use our AAA rating to guarantee bonds that ARE ALREADY RATED AAA! In fact sometimes we guarantee bonds by writing credit default swaps against bonds that ALREADY have another AAA rated company guaranteeing them! It's like taking candy from babies!" The Czar of Common sense does some quick math versus those firm's capital positions and says, "Wow, I guess as long as you don't take a 10-15% loss against this portfolio you don't die. Still, if the losses ever become significant won't you get downgraded? If you lose your AAA don't you lose your franchise?" The guarantors say, "?".
- The Common Sense Czar then goes to Freddie and Fannie and asks them, "Hi, how are you making your money?" Freddie and Fannie say that they are a combined mortgage insurance shop and leveraged mortgage investment portfolio. For the insurance they have private mortgage insurers to mitigate risk (especially the sub prime credit they have guaranteed) and with regard to investments they are in a AAA position on the dodgy credits so they are more than fine too. The Common Sense Czar does some quick math on Freddie and Fannie's combined $3.5 trillion guarantor book and $1.5 trillion retained portfolio and says, "Wow, if you take a 2% loss on your mortgage insurance portfolio you lose $70 billion? You have that kind of capital?" Freddie and Fannie pick up the phone and call Barney Frank and Chris Dodd!
- Now the Common Sense Czar has similar calls with the private mortgage insurers and they essentially say the same thing that Freddie, Fannie, AIG, MBIA, Ambac, etc have said. The Czar of Common Sense does the same quick calculations and arrives at similar conclusions, a small percentage loss on a BIG number wipes these guys out too.
- The Czar of Common Sense pauses and says, "Man, all these guys with pretty thin levels of capital are relying that these mortgage bonds can't lose money because the ratings companies rated them AAA or AA- at worst. I need to go visit those guys but before I do that I am going to drop in on Bear Stearns and Lehman Brothers since they are the two biggest underwriters of these bonds.
- The Czar goes to Bear and Lehman and says, "Hi, how are you making your money?" The two investment banks tell the Czar that they make their real money from originating their OWN dodgy loans, structuring them and selling them to a variety of investors for a much higher price. The Czar asks, "How is this possible?" Bear and Lehman say that through the magic of diversification, they are able to create a very large percentage of AAA bonds that sell for a much higher price than the subprime loans backing them would. The Czar says, "Hmm, that is interesting. It all seems to come back to these rating companies. Oh, by the way, do you guys ever get stuck holding some of these bonds?" Bear and Lehman say, "Well, we certainly wouldn't call it 'getting stuck'! But yes, we each have about $50 billion laying around earning us GREAT carry." The Czar says, "Wow! How do you guys finance that? After all, you aren't banks so you don't have retail deposits." Bear and Lehman tell the Czar, "Oh contraire, we have hedge fund prime brokerage cash. That money is stickier than the best mom & pop retail deposits. Besides that, our commercial paper programs are over-subscribed every month! The last thing we are worried about is funding! The Czar says, "Commerical Paper? You guys issue CP backed by this stuff?" "Oh sure, but we don't do THAT much. You should go talk to Citigroup. They are doing hundreds of billions, UBS too!" The Czar makes a note to ask New York Fed President Tim Geithner about this. Surely he is on top of it.
- Now the Czar takes a trip out to California to see the subprime giants Ameriquest and New Century. The Czar says, "Hi, how are you making your money?" The subprime guys say, "We have thousands and thousands of loan brokers prowling the countryside making the loans that give folks a chance to have things they never had AND make loans that the boys at the Wall Street shops say they need. We get paid a premium for the loans and we make a lot of fees." The Czar says, "The subprime sector used to be pretty small. Now suddenly it is very big. How did that happen?" The subprime originators say "?". The Czar asks for a sample of the loans and sees they look pretty horrible. He then asks the subprime originators, "By the way, what happens if these loans go bad early on. Don't you guys have to buy them back? How much capital do you have?" The subprime guys say, "Oh we have some capital, but not to worry because if guys default we just sell the property and no one takes a loss. After all, real estate only goes up!" The Czar says, "Well yeah, but lets just pretend real estate goes down and a lot of these borrowers, especially the ones who are speculators shrug their shoulders and default. Wouldn't you have to buy all these bad loans back at par? Do you have enough capital to do that? Oh, and who regulates you guys?" The subprime originators answer those two questions by saying, "?" and "?".
- Now the Czar is a little worried. It seems like the entire financial system is betting that somehow these loans were magically transfigured from garbage to riskless assets. It's time to visit S&P and Moody's. The Czar says, "Hi, how do you make your money?" The ratings companies say, "Oh, we make lots of money rating all these structured securities. We are having record earnings every year!" The Czar says, "Who pays you?" The ratings companies say, "Why, the issuers of course!" The Czar is now pale. He gulps a drink of water and says, "How is it possible to take $1 billion of subprime loans and create $800 million AAA rated bonds?" The ratings companies say, "Well, diversification of course. All real estate is local and all economies are local. Real estate prices can never go down NATIONALLY at the same time as we are having a recession and folks are losing their jobs. Anyway, even if we do have a recession, economies are local and diversified too. And even if they are not, if we have a recession and the dollar falls, the Arabs, Europeans and Asians will just come in and support real estate prices. It's all covered see?"
- The Czar call the President and says, "Houston....we have a problem!"