The disastrous meltdown of structured securitisation represents a dual failure of market discipline and government supervision. At every stage of the securitisation process, incentive conflicts tempted private and government supervisors to short-cut and outsource duties of due diligence that they owed not only to one another, but to customers, investors, and taxpayers.
When commissions and other fees for service are paid upfront, managers and line employees of firms that originate, securitise, rate, or insure loans fear that they are passing up short-run income whenever they nix a questionable deal. At the same time, accountants, appraisers, and even government supervisors know that they can win business from competing enterprises in the short run by establishing a reputation for not challenging a troubled client’s dodgy representations about asset values or assessing its efforts to transfer risks off balance sheet as conscientiously as a third party might suppose.
For government supervisors, incentive conflicts trace principally to short horizons, clientele influence, and pressure to support the expansion of homeownership for low-income households. As credit spreads increased in 2007-08, these incentive conflicts led authorities to temporise by adopting policies that risked allowing the depth and duration of the crisis to increase. Ignoring the lessons of the Savings and Loan (S&L) Mess, Federal Reserve press releases (e.g., that of March 16, 2009) and speeches by Chairman Bernanke and New York Federal Reserve President Geithner repeatedly misframed the difficulties that highly leveraged and short-funded institutions faced in rolling over their debt as evidencing a shortfall in aggregate market liquidity rather than volatile and widespread concerns about the individual solvency of troubled institutions.
CEPR Policy Insight No. 32 attributes the ongoing financial crisis instead to economic and political difficulties of monitoring and controlling the production and distribution of safety-net subsidies. Crisis pressures will not relent until access to safety-net subsidies has been capped and managers and authorities acting together find a way to quell doubts about the future viability of institutions known to be struggling with outsized losses. This can be done in the short run by temporarily nationalising zombie firms and by producing and publicising convincing forensic evidence that their insolvency has been repaired.
Structured securitisations may be visualised as manufacturing risk exposures in a series of work stations located alongside a conveyor belt. The different stations produce contracts that create, disguise, assess, reassign, or insure the risk exposures that move steadily along the belt. Society’s problem is that, during the bubble, Product-Quality Inspectors located at each station (i.e., supervisors) were using their computer scanners to entertain themselves rather than to inspect the quality of the work passing by.
More supervision is not the solution
Although it is dishonest, it is natural for supervisors to blame the poor quality of the final product on weaknesses either in their lines of sight or in the supervisory equipment they had to work with. But giving supervisors more and better scanners or relocating their work stations will not cure the root problem.
The root problem is the de facto corruption of supervisory incentives that poorly monitored safety-net subsidies create and sustain. TARP recipients paid out $76.7 million on lobbying and $37 million on federal campaign contributions in 2008 and (through Feb 2, 2009) received access to $295.2 billion in TARP funds. The ratio of lobbying expense to TARP receipts suggests that, during the initial stages of the crisis, financial institutions have reaped extraordinary benefits from investing in efforts to scare federal officials and to tell them how “best” to dispel crisis pressures. Following this self-interested advice has been ineffective partly because the return from expanding large firms’ investments in lobbying activity has dwarfed the return they could expect to earn from diligently attending to their ordinary business of intermediating the nation’s flow of savings and investment.
A medley of potentially effective reforms
Numerous complementary actions could improve the odds of getting less-destructive bubbles and better crisis management in the future. To be effective, a program of reform will have to rework in both the private and public sectors the way in which supervisory activities are performed and compensated. More importantly, it will have to make sure that compensation schemes and the division of labour mesh across private and governmental elements of the financial-engineering transaction chain.
It is convenient to consider first some purely private-sector reforms. This will occur if and only if the reform is seen to improve the competitive positions of firms that adopt it. The first reform is to incorporate explicit and effective contractual clawbacks for subsequent interruptions in securitised cash flows into the contracts of employees and firms at all stages of securitisation. It is unwise to allow employees and firms that can make, securitise, or over-rate bad loans to collect compensation in advance without bonding their work by accepting liability for future defaults. Second, much like the bottom lines of corporate income and balance-sheet statements, the evolving value of the pools of assets backing various securitised claims needs to be tracked and reported explicitly at regular intervals (say, monthly). This would make it easier for investors and supervisors to identify securitisation chains in which the performance of due diligence is subpar. Third, credit-rating organisations must change the way they rate asset-backed securities and take explicit responsibility for errors they make in rating them.
To improve incentives in government requires reworking the employment contracts of top officials in ways that would define their missions more sharply and make them personally accountable for outsized safety-net expenses. Building on the information used to construct bankruptcy plans at regulated firms, I would require regulators to establish, publicise, and test regularly a benchmark market-mimicking scheme for crisis management. To help them to put crisis-management plans into operation more promptly, I would also require regulators to collect and analyse estimates of safety-net subsidies from every regulated institution and consolidate these estimates in ways that would track over time the aggregate value of safety-net subsidies for the firms they supervise.
Because these reforms would make the jobs of top regulators more difficult, I would also raise the salaries of these officials. However, to lengthen the horizons of safety-net managers, I would fund this raise as deferred compensation that would have to be forfeited if a crisis occurred within three or five years of their leaving office. This would have the further benefit of making new appointees more cognizant of unresolved problems that his or her predecessor might be leaving behind. To discourage elected officials from trying to win special breaks for firms that contribute money to their campaigns, I would require that regulatory personnel report fully on interactions with elected officials that occur outside the public eye.
A third approach to sharpening monitoring and loss-control responsibilities would be to establish schemes in which private and governmental monitors could hold one another responsible for the quality of their work. For example, it has been widely proposed that safety-net managers be required to move trading in over-the-counter derivative and other securities to clearinghouses or exchanges when and as their volume becomes large enough to pose material safety-net consequences.
However, there is no way to prevent bubbles and crises from emerging.
Timothy Geithner, The Current Financial Challenges: Policy and Regulatory Implications, Remarks at the Council on Foreign Relations Corporate Conference 2008, New York City, Mar. 6