Crisis Economics Part 8

This time around, instead of letting things spiral out of control, the U.S. government unleashed a shock-and-awe campaign against the crisis. The directors of this campaign had cut their teeth studying the Great Depression, and the failures of their predecessors shaped their aggressive response. They threw everything they had at the problem, borrowing ideas from the past as well as tactics that had never seen the light of day.

They began with conventional monetary and fiscal policy, tossing all the usual weapons into the fight, from tax cuts to interest rate cuts. When those didn't work and deflation and depression became real possibilities, the Fed embraced its historic role as a lender of last resort, throwing lifelines of liquidity to one kind of financial inst.i.tution after another, as well as to ordinary corporations that needed to roll over their commercial paper obligations. Other central banks followed suit, interpreting their statutory powers in expansive, even radical ways.

The scale of the rescue effort was without precedent. It transcended national boundaries, as the IMF stepped into the fray, and the Fed lent to other central banks, directing much-needed dollars to struggling banks and corporations around the world. It was the biggest financial rescue effort of modern times, if not all times.

And it was only the beginning. The government became a shareholder in a host of businesses, buying shares and injecting capital in exchange for an equity stake. The government also guaranteed deposits, money market funds, and even the bondholders of banks. As if that weren't enough, in several high-profile cases it covered prospective losses to investors, then inst.i.tuted outright bailouts of individual banks, homeowners, and others. It even offered to subsidize the purchase of toxic a.s.sets, hoping this might restore faith.

Yet even that was not enough. To lend, to guarantee, and to absorb the losses were one thing; to restore faith to the markets was another. The Fed and other central banks eventually became investors of last resort, wading into government debt markets to inject still more liquidity into the system via quant.i.tative easing. In their most radical interventions of all, central banks attempted to provide demand where demand had all but disappeared, purchasing mortgage-backed securities and other structured financial products backed by everything from auto loans to student loans.

Lawmakers in the United States and other countries did their part too, freeing up funds to underwrite these actions, offering help to distressed homeowners, and most important of all, approving trillions of dollars' worth of deficit spending to underwrite the cla.s.sic strategy of a targeted fiscal stimulus aimed at infrastructure improvements and aid aimed at anyone floundering in the face of the crisis, from local governments to the unemployed.

All these monetary and fiscal measures fell into place over the course of over two years-unevenly, imperfectly, and accompanied by enormous controversy and skepticism. The response to the financial crisis had all the grace and beauty of a battlefield retreat, but in the end it seemed to work: capitalism did not collapse; the fate of particularly hard-hit Iceland was not the fate of the world at large. The measures adopted by central banks, governments, and legislatures effectively brought the crisis to a near end. Some semblance of calm returned to the financial markets, and many nations' economies, while wounded, managed to eke out better-than-expected performances as 2009 came to a close. What had seemed like the end of the world a year earlier now seemed like a very close call.

That's the good news. The bad news is that this stability has been purchased at tremendous cost. Thanks to all the bailouts, guarantees, stimulus plans, and other costs of managing the crisis, the public debt of the United States will effectively double as a share of the nation's gross domestic product, as deficits in the coming decade are expected to hit $9 trillion or more. Economists of a Keynesian bent tend to minimize these risks, pointing out that the United States ran enormous deficits during the New Deal and World War II and managed to pay them off without a problem. The total value of the public debt hit an all-time high in 1946, when it was equivalent to 122 percent of the nation's GDP. By contrast, current projections point to debt reaching 90 percent of the GDP in the near future, though it may certainly go higher.

That's a somewhat comforting comparison, but it's highly misleading. In 1946 the United States was at the peak of its power. Its manufacturing base, unscathed by the war, was the envy of the world, and its future compet.i.tors-j.a.pan and Germany-were in ruins. The United States was the world's biggest creditor and net lender by running current account surpluses, and the dollar had just become the global reserve currency. Little wonder it was able to pay down its debt with ease. Whether the same can happen today is another question. Much of the country's manufacturing base is weak, and the United States has become the world's biggest debtor and net borrower as it runs large current account deficits, thanks in no small part to loans made by China, its apparent rival in the twenty-first century. The United States of today is not the country of 1946, and it's naive to believe that it will be able to escape the shadow of the crisis by deficit spending alone.

The fiscal burden of the response is but the beginning of our problems. At many critical junctures in the crisis, governments opted for forbearance and bailouts over a more aggressive resolution of the problem. The United States did not nationalize problem banks; it gave them easy money, covered their losses, and otherwise kept them alive. Many of these banks were and remain insolvent, but the rescue efforts did not differentiate between the good and the bad. Stabilizing the financial system was the order of the day.

The same can be said of all the bailouts aimed at homeowners, automakers, and other beneficiaries of the government's largesse. So far the recent crisis has produced precious little of the creative destruction that Schumpeter saw as essential for capitalism's long-term health. Preventing this necessary adjustment via tax cuts, cash-for-clunkers incentives, and programs designed to prop up the housing market will only delay an inevitable reckoning. That's not to suggest that the middle of the financial crisis would have been the best time to stage that shakeout; doing so would only have fueled the crisis. But it will have to take place. Debt will have to be forgiven, banks will have to go under, automakers will have to shutter factories, and homeowners will have to leave homes they can no longer afford.

In a way, our response to the recent crisis has only been partly different from that of Herbert Hoover. True, we have been infinitely more effective in preventing the crisis from spinning out of control via aggressive fiscal stimulus, but we are still trying to reconcile the irreconcilable. We cannot have our cake and eat it too; we cannot rescue everyone who made bad decisions in advance of the crisis while simultaneously restoring our capitalist economy to its former vitality. That's an unpleasant truth, but one that has so far been avoided in the rush to save anyone and everyone from the effects of the crisis.

Nor will this indiscriminate approach solve the growing problem of moral hazard. In the past few decades, central bankers have moved aggressively to contain potential crises. Alan Greenspan led the way, intervening in markets after the crash of 1987, the savings and loan crisis, and September 11. The recent crisis occasionally tested this belief in the Greenspan (or Bernanke) "put"-most notably with the decision to let Lehman Brothers fail-but for the most part, faith in the omnipotence of central banks and governments was upheld. If anything, it seemed that there was nothing that governments wouldn't do to save the financial system.

That said, the cloud has a few silver linings. For example, many of the countries that sustained heavy hits to their balance sheets while managing the crisis began with relatively low levels of debt by historical standards, giving them some leeway to "break the bank" in allocating funds to combat the crisis. Moreover, had they not committed those funds-particularly the various stimulus packages enacted around the world-the long-term cost would arguably have been greater, thanks to a collapse in tax revenues and a need to cover huge portions of the population with unemployment benefits and other aid. While recent fiscal policies may weigh many countries down in the coming years, debt burdens are not yet at a breaking point for many of the advanced industrial nations, even if issues of public debt sustainability and risks of refinancing crises-if not outright default-are becoming sources of serious concerns for financial markets.

The larger problem of bailouts and moral hazard is a bit more complicated. Bailouts of reckless lenders and borrowers can easily lead to even more reckless behavior in the future. That in turn can lead to more bubbles and more crises. But it's important to keep things in perspective: holding the line on moral hazard in the midst of a crisis can inflict tremendous collateral damage. Why? Imagine that someone living in a huge apartment building has done something extraordinarily reckless and stupid, like smoking in bed. His apartment catches fire. Should he be bailed out? In other words, should the fire department come to rescue him? If the fire department doesn't, the entire building may go up in flames, taking the lives not only of the person who started the blaze but of hundreds of innocent people.

That's basically the predicament faced by central banks and governments in the midst of this crisis. Does some investment bank or insurance company that set fire to the global economy deserve to go under? Absolutely. But if the resulting conflagration devours the entire financial system, never mind destroys the lives of ordinary workers around the world, the lesson tends to be lost in the ensuing mayhem. While some fiscal actions were wasteful and some bailouts not warranted, the fiscal stimulus and the backstopping of the financial system prevented the Great Recession from turning into another Great Depression at a time when private demand was in free fall.

The time to address issues of moral hazard, and all the other weaknesses of the financial system, comes after the immediate crisis has pa.s.sed. A financial crisis is a terrible thing to waste: it opens, however fleetingly, the possibility of real, enduring reforms of the global financial system. Just as the Great Depression swept away the contradictions embodied by Hoover and replaced them with the consistencies of Keynes, the Great Recession promises to usher in a new way of understanding and, above all, preventing crises. It is to that pressing matter that we turn next.

Chapter 8.

First Steps.

It's a truism that crises go hand in hand with regulation and reform of the financial system. The near-death experience of a financial crisis pushes many people to contemplate what government can and should do to prevent another disaster. As Harvard economist Jeffrey Frankel wryly observed at the onset of the recent crisis: "They say there are no atheists in foxholes. Perhaps, then, there are also no libertarians in [financial] crises."

Like so much else in crisis economics, this theme is recurrent. In 1826, the year after a speculative bubble collapsed in Britain, leaving behind scores of broken banks, Parliament pa.s.sed legislation that overhauled the entire banking system. In the United States, the panic of 1907 left many lawmakers concerned about the nation's lack of a central bank, and prompted the formation of the Federal Reserve a few years later.

The mother of all financial crises-the chain of disasters known as the Great Depression-sparked radical reforms of financial systems internationally. In the United States, the Gla.s.s-Steagall Act of 1933 created federal deposit insurance and established a firewall between commercial and investment banking; subsequent legislation gave the Federal Reserve the power to regulate bank reserves. The government brought the stock market to heel as well: the Securities Act of 1933 required issuers of securities to register them and to publish a prospectus, and it made the investment banks that underwrote the sale criminally liable for any errors or misleading statements in the prospectus. The following year saw the creation of the Securities and Exchange Commission, which remains the agency charged with regulating the buying and selling of securities. Though many other countries adopted similar measures, the United States implemented one of the most comprehensive series of reforms.

In light of this history, we might reasonably expect the United States once again to take the lead in reforming the financial system. The financial turmoil revealed fundamental weaknesses in the operation of U.S. and European financial markets and serious flaws in the existing system of supervision and regulation. But over the course of 2010, the urgent calls for reform faded, and legislation that would radically overhaul regulation and supervision had yet to see the light of day. Just like soldiers in foxholes abandoning their pledges to lead a better life as soon as the firing stops, lawmakers and policy makers now seem happy with the status quo.

There's a perverse irony in all of this. Had policy makers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there's nothing like ubiquitous breadlines and 25 percent unemployment to focus the minds of legislators. But because the disaster was handled more deftly this time, the impetus for deep, structural reforms of the financial system has faltered. Instead, the surviving banks are paying out record bonuses, despite the fact that they owe their lives to government largesse.

This absence of reform is profoundly unfortunate. We live at a dangerous time, when the structural problems that created the crisis remain, even as aftershocks continue to rattle countries and economies around the world. Ma.s.sive intervention in the financial system has restored some confidence in the financial system, but we have yet to undertake the necessary reforms to preserve that confidence and prevent a crisis from recurring.

What reforms make the most sense? Many proposals are now lying on the table, from inst.i.tutions at home and around the world: from the U.S. Treasury and the Federal Reserve; but also from the Financial Stability Board, the Financial Services Authority, and other policy bodies in the United Kingdom; and from the G-7, the Bank for International Settlements, and the IMF. Innumerable further proposals have emanated from think tanks, policy workshops, and academia.

Rather than a.s.sessing the merits of each proposal, it makes more sense to pinpoint the fundamental weaknesses and distortions that plague the world's financial systems, then pose some pragmatic solutions. We stress the word fundamental. There is plenty wrong with the financial system, but not all its problems are essential; many are merely superficial manifestations of a deeper rot.

Unfortunately, fundamental is not always synonymous with simple. Some of the subjects that follow-derivatives, capital requirements-may seem rather recondite. That's true, but getting to the bottom of this mess requires that we deal with such daunting concepts. As the crisis has amply shown, the devil lies in these details, and the discussion that follows should give the reader a genuine appreciation-as well as a clear comprehension-of the complex but core issues that need to be addressed to prevent future crises.

Curing Compensation.

Whenever the question of compensation on Wall Street comes up, visceral anger toward the bankers tends to overwhelm more careful considerations of the underlying problem. Put differently, while torches and pitchforks may seem appropriate under the circ.u.mstances, it's wiser to step back and dispa.s.sionately evaluate the options.

First, contrary to conventional wisdom, the biggest problem with compensation is not the amount of money involved; it's the way this compensation is structured and delivered. Much research on corporate governance suggests that any corporate environment is apt to suffer from the princ.i.p.al-agent problem, which we discussed in chapter 3. That is, modern corporations are run not by the shareholders (the princ.i.p.als) but by managers (the agents). These two groups don't see eye to eye: the shareholders want to maximize their long-run returns from owners.h.i.+p of the company, but the managers want to maximize their short-term income, bonuses, and other forms of compensation.

As we have seen, if shareholders could monitor managers, all would be well. But it's difficult in any corporation and next to impossible in the financial inst.i.tutions at the heart of the recent crisis. Why? Simply put, traders and bankers know much more about what's going on than the shareholders to whom they answer. All traders have their own profit-and-loss budget, and their own strategies for making money in the market. It's difficult for outside shareholders or a board of directors to know what's going on in one of these little cells; it's utterly impossible to know what's going on in several thousand of them, as in a large bank or financial firm. This predicament is known in corporate governance circles as the "asymmetric information problem," also discussed in chapter 3. Translation: one side knows more than the other.

Add to this problem what could be called "double agency conflict." In many financial firms, the shareholders (the princ.i.p.als) are themselves enmeshed in a princ.i.p.al-agent problem: they own shares via large inst.i.tutional investors, such as pension funds. The managers of these funds are their agents, and just as it's hard for shareholders to monitor what traders are doing, it's equally difficult for shareholders to monitor the actions of their proxies. Worse, these inst.i.tutional investors, not the ultimate shareholders, are often the ones who end up sitting on a firm's board of directors.

If this seems like a hall of mirrors, that's not far from the truth. The entire financial system was-and remains-riddled with these kinds of problems, in which one group delegates responsibility to another, which in turn delegates it to another group. Little wonder that no one knew-or cared-what was going on at all the trading desks.

Here's the upshot: absent any direct or indirect oversight from shareholders, traders and bankers have every incentive to do crazy things that maximize their short-term profits and bonuses (like rustling up a bunch of toxic CDOs and leaving them hanging on the bank's balance sheet). By the time the bank blows up, the traders and bankers have already spent the money on fast cars and that summer place in the Hamptons. And if recent history is any guide, it's easier to get money back from Bernie Madoff than it is to claw back a trader's bonus.

In an ideal world, shareholders and their representatives would be aware of this problem and create a system of compensation that's "incentive compatible," one that stops traders from taking on too much leverage and risk. In theory, this system would align their interests with those of the existing shareholders and make everyone work for the long-term interest of the bank. One incentive-compatible solution would be for firms to compensate the traders who work for them with restricted shares in the firm. (Restricted shares have to be held a certain amount of time before they vest.) That way, everyone would have the long-term health of the firm in mind.

If only it were so simple. In fact, at both Bear Stearns and Lehman Brothers, employees held upwards of 30 percent of the firm's shares. Yet both firms pursued suicidal trading strategies that led to their eventual destruction. This fact raises the unsettling possibility that the problem goes beyond a bunch of rogue traders subverting the will of shareholders. In fact, it points to a grim reality: there are times when the interests of shareholders and traders align to destructive effect.

Sometimes shareholders are more than happy to see traders take on leverage and risk. They're willing to let them do so because they don't actually have much skin in the game. They've put up some of the bank's capital, but not a whole lot of it, and while they don't want to lose their s.h.i.+rts, they're fine turning a blind eye when traders roll the dice. In fact, most of the money that the traders are playing with is borrowed; it belongs to someone else. If the traders win at the roulette table, the shareholders win too. If the traders lose, the burden falls on the fools who loaned the bank money-and, if the recent crisis is any indication, the government. Shareholders take only a minor hit.

This principle is true in good times and bad. When a boom is under way, banks are under pressure to deliver supercharged returns so as to maintain the loyalty of the pension funds, endowment managers, and others who give them money to invest. Even if managers and shareholders both think the trading strategies are risky, they know that if they don't pursue them, their investors will walk to other banks that promise higher returns. Former Citigroup CEO Chuck Prince summarized it best in 2007 when he observed, "As long as the music is playing, you've got to get up and dance."

When things go south, traders and shareholders don't necessarily retreat from risk. Instead, they may share a willingness to double down and bet the farm in the hopes of righting the sinking s.h.i.+p. In banking parlance, this strategy is known as "gambling for redemption," and while it's sometimes successful, it does nothing to curtail the culture of risk taking. This sort of behavior is fueled even further by the presumption that if things blow up, government will ride to the rescue-a belief that, though occasionally tested in the recent crisis, has been affirmed again and again.

At this point, the reader may be forgiven for wanting to put the entire financial system to the torch. On the one hand, if the shareholders of financial firms are virtuous and actually have the long-term interests of the firm at heart, they lack the ability to control the traders. And if they aren't virtuous (because they don't have much skin in the game or are simply seeking oversize returns), they're not going to do anything to stop the traders-which, as the princ.i.p.al-agent problem makes clear, would be impossible anyway. Either way, financial firms are apt to unleash behavior that is ruinous to the stability of the global financial system.

So what to do? This complex problem clearly has no easy solutions. But some very basic, commonsense approaches to dealing with this mess could tackle the problem at its core: the issue of compensation. That is where the problem originates, and it's where the solution should be focused.

For starters, when employees of financial firms are compensated with restricted stock, provisions should be in place that force them to hold these shares for an even longer period of time than is now customary. Currently, many vesting periods are limited to a few years; they should be extended. Employees should be restricted from selling the stock until their retirement, or at the very least, for well over a decade.

That's a good first step, but a small one. The bigger issue is the bonus culture of Wall Street, in which employees are compensated when their bets pay off, but are not penalized when those bets cost the firm money. This system encourages risk taking that generates oversize "alpha" returns in the short term, with little consideration of long-term consequences.

One way to fix this mess would be to create bonus pools that aren't calculated on short-term returns but are based on a longer time horizon-say, three years or so. Instead of rewarding its employees for making their particular canny bets, a firm averages their performance over the course of several years. Let's say a trader's risky bets yield outsize returns one year and equally outsize losses the next. Under the current system, that trader will get a nice bonus the first year and nothing the second. By contrast, under a longer time horizon, the losses would cancel out the profits, and the trader would get nothing at all.

A variant of bonus pooling has been proposed by Raghuram Rajan. In his scheme, traders would be compensated for their high returns, but their bonuses would be held in escrow for several years. Should a trader incur a loss in subsequent years, it would be subtracted from the existing bonus account. In this "bonus-malus" system, bonuses can be clawed back and nullified according to the ups and downs of a trader's long-term performance. The longer the bonuses are held in escrow, the more likely the traders will be to think more carefully about a.s.suming risk at the expense of long-term revenue.

The bonus-malus system works best if applied on an individual level. Unfortunately, bonuses are often calculated on an inst.i.tutional level, so that when bets pay off, everyone shares in the proceeds. Traders and bankers do not directly suffer the consequences of their bad decisions, which are borne by the pool at large. Still, collective clawbacks-the repossession of bonuses across the board-may nonetheless cast a pall of prudence over all those trading desks.

The problem of compensation has a more diabolical solution: to compensate traders and bankers not with money or with stock but with the very same esoteric securities that they're cooking up in their laboratories. Traders and bankers would get bonuses, but in a very specific form: a little slice of, say, that CDO that they had a hand in making. If traders cook up toxic securities, they get paid with the same. The thinking here is that if traders know that the proverbial chickens will come home to roost in their bonus package, they may be a little bit more careful about the eggs they lay.

A version of this plan is already operational. At the close of 2008, Credit Suisse announced that it was s.h.i.+fting some $5 billion worth of toxic a.s.sets off its own balance sheet and into a special fund. It then paid bonuses to employees out of this fund, replacing the usual form of compensation (shares of stock in the company) with shares of this fund. This raised some howls of protest; after all, many of those compensated had had nothing to do with the bad bets. Still, however imperfect, this is a good start.

Yet another kind of compensation scheme could draw from all of these proposals. For example, rather than retroactively saddling employees with the consequences of their bad bets (as the Credit Suisse scheme does), make it clear from the beginning that bonuses of bankers and traders will be paid in the securities they have a hand in creating. Better yet, put those securities-c.u.m-bonuses in escrow for several years, letting enough time pa.s.s to determine whether they are toxic or not. Finally, forbid employees to hedge against any potential losses on these future bonuses. (They are traders, after all, and if there's one thing they're good at, it's making money regardless of where the market is moving.) Whatever change in compensation is ultimately adopted should be implemented across the board. If one major financial firm adopts some version of the bonus-malus system but no one else does, employees from the more prudent firm will likely flock to high-rolling firms, where they'll be better compensated.

That means government must be involved. In the United States, only the federal government has the power to reform the compensation system in comprehensive fas.h.i.+on. It has plenty of justification for doing so: the government-or more to the point, the taxpaying public-has effectively bailed out and backstopped the entire financial system and has a cogent interest in making sure it doesn't have to do it again. Moreover, given the tangled web of princ.i.p.al-agent problems, shareholders cannot possibly be expected to reform compensation. But government could set across-the-board changes along the lines above.

Let's be clear: we're not suggesting that government cap compensation, though it would certainly be well within its rights to do so, particularly with banks still on government life support. What we're proposing is in a way more radical: that compensation be completely overhauled to reduce risky behavior, and by extension, the likelihood of another systemic collapse in the global financial system.

Those caveats aside, removing traders' incentives for taking on short-term risk (and creating disincentives, in the form of clawbacks) will probably cause compensation to decline. Is this a bad thing? No. In recent years, the financial services industry-and compensation within it-has undergone exorbitant and utterly unwarranted growth, driven by financial liberalization, financial innovation, elimination of capital controls, and the globalization of finance.

In the process, finance's "contribution"-if that's the word-to the U.S. gross domestic product has soared from 2.5 percent in 1947 to 4.4 percent in 1977 to 7.7 percent in 2005. By that time financial firms accounted for upwards of 40 percent of the earnings of the companies listed in the S&P 500, and these firms' share of the total S&P 500 market capitalization doubled to approximately 25 percent. Even more startling, the combined income of the nation's top twenty-five hedge fund managers exceeded the compensation of the combined income of the CEOs of all companies listed in the S&P 500. In 2008 no less than one in every thirteen dollars in compensation in the United States went to people working in finance. By contrast, after World War II a mere one in forty dollars in compensation went to finance workers.

This outsize and excessive growth of the financial system did little to create any "added value" for investors. While many hedge funds, investment banks, private equity funds, and other a.s.set managers claimed that they could provide investors with superior "alpha" returns (in other words, bigger returns than those provided by more traditional a.s.set managers), "schmalpha," not "alpha," became the norm. These high-flying a.s.set managers often got higher returns, but investors saw little of it, because the managers charged higher fees for their allegedly superior services.

The various players in the financial system parted investors from their money in other ways too. Take securitization: at every step of the process, someone-a mortgage broker, an originating bank, a home appraiser, a broker dealer, a bond insurer, a ratings agency-charged high fees for its "services" and transferred the credit risk down the chain. But it was an oligopoly of investment banks that profited the most from this arrangement, exploiting the lack of transparency about these operations to extract profits from credulous investors, most of which ended up in the pockets of these firms' employees rather than those of the shareholders of the firms.

The cancerous growth of finance has arguably had significant social costs too, as innovation and creativity have fled from manufacturing and other old-fas.h.i.+oned industries in favor of Wall Street. Indeed, since the 1970s, as our colleague Thomas Philippon has revealed, finance has attracted an ever-growing number of intelligent, highly educated workers. As compensation soared, graduates of elite schools increasingly went to Wall Street. In fact, among Harvard seniors surveyed in 2007, a whopping 58 percent of the men joining the workforce were bound for jobs in finance or consulting. In a curious paradox, the United States now has too many financial engineers and not enough mechanical or computer engineers.

Not coincidentally, the last time the United States saw comparable growth in the financial sector was in the years leading up to . . . 1929. In the 1930s, compensation in the financial sector plummeted, a victim of regulatory crackdowns that made banking a boring, if more respectable, profession. Reforming today's warped compensation structure is a necessary first step toward making banking boring once more.

Making Better Sausage.

Compensation is hardly the only problem that cries out for reform; the elaborate system of securitization that helped cause the recent crisis must be fixed as well. In the originate-and-distribute model of securitization (see chapter 3), a potentially risky a.s.set-a subprime mortgage, for example-was pooled with similar a.s.sets and turned into securities that would be sold to investors better able and willing to tolerate the risk.

One obvious flaw with this system was that it reduced incentives for anyone to actually monitor the creditworthiness of the borrower. Instead, the various players in the securitization process pocketed a fee while transferring most, if not all, of the risk to someone else. Everyone was complicit in this chain: the mortgage broker who handled the initial loan; the home appraiser, who had every incentive to give inflated values; the bank that originated the mortgage and used it to make mortgage-backed securities; the investment bank that repackaged these securities into CDOs and far more esoteric investments; and the ratings agencies that bestowed coveted AAA ratings along the way; and the monolines that insured those toxic tranches.

Any solution to the problem of securitization must somehow force these different players to more carefully consider the risks involved. In other words, each player must somehow be encouraged to pay more attention to the quality of the underlying loans. One way to do so is to force intermediaries-the originating bank and the investment banks-to hold on to some of the MBSs or CDOs in question. Forcing them to retain some risk, the thinking goes, will induce them to do a better job of monitoring the creditworthiness of the original borrowers (and leaning on the mortgage brokers and others who serve as the first link in the chain).

A number of proposals in circulation push this idea. Some came out of international bodies, including working groups within the G-20; others are homegrown, such as the Credit Risk Retention Act, which pa.s.sed in the House of Representatives in December 2009. This legislation proposes that banks involved in creating a.s.set-backed securities (not only mortgages, but any number of loans) be forced to retain 5 percent of the securities they create; a separate proposal in the Senate would increase that figure to 10 percent. Both proposals wisely forbid the banks to hedge or transfer any risk that they incur by retaining these securities.

Unfortunately, these low amounts of retained risk may be insufficient to change behavior. In the recent crisis, many banks and other financial inst.i.tutions maintained a significant exposure to the various securities that they had a hand in creating. Most of the AAA supersenior tranches of CDOs, for example, were retained rather than sold to investors. At the time of the crisis, in fact, approximately 34 percent of all the a.s.sets of major banks in the United States were real-estate-related; the figure for smaller banks was even higher, at roughly 44 percent. The originate-and-distribute model transferred some risk, but it certainly didn't transfer all of it; most financial inst.i.tutions had plenty of skin in the game. Otherwise, they would not have sustained the losses they did.

Firms retained that risk because traders made money by doing so. For this reason, relying on retained risk or "skin in the game" as the princ.i.p.al method of reforming securitization is questionable. While it's a useful complement-and certainly will focus attention down the line on the risk incurred by holding such a.s.sets-it's unlikely to be a cure-all. Traders may gladly comply with requirements to retain risk, particularly if they can find a way of doing so that yields a bigger bonus. But a bigger bonus, as we've emphasized already, is no guarantee of stability.

Forcing firms to retain risk won't do much to resolve an even more pressing problem: the fact that securitization has, despite government subsidies, all but ceased. The reason it remains comatose is that even now, it's not really clear what went into the alphabet soup of securities that fed the boom. Indeed, securitization in the go-go years was a bit like sausage making before the creation of the Food and Drug Administration: no one knew what went into the sausage, much less the quality of the meat. And so it remains today: financial inst.i.tutions can still churn out the sausage, but given what we know might (or might not) go into these things, is it any surprise that investors have lost their appet.i.tes?

Some people believe that securitization should be abolished. That's shortsighted: properly reformed, securitization can be a valuable tool that reduces rather than exacerbates systemic risk. But in order for it to work, it must operate in a far more transparent and standardized fas.h.i.+on than it does now. Absent this s.h.i.+ft, accurately pricing these securities, much less reviving the market for securitization, is next to impossible. What we need are reforms that deliver the peace of mind that the FDA did when it was created.

Let's begin with standardization. At the present time, there is little standardization in the way a.s.set-backed securities are put together. The "deal structures" (the fine print) can vary greatly from offering to offering. Monthly reports on deals ("monthly service performance reports") also vary greatly in level of detail provided. This information should be standardized and pooled in one place. It could be done through private channels or, better, under the auspices of the federal government. For example, the SEC could require anyone issuing a.s.set-backed securities to disclose a range of standard information on everything from the a.s.sets or original loans to the amounts paid to the individuals or inst.i.tutions that originated the security.

Precisely how this information is standardized doesn't matter, so long as it is done: we must have some way to compare these different kinds of securities so that they can be accurately priced. At the present time, we are stymied by a serious apples-and-oranges problem: the absence of standardization makes comparing them with any accuracy impossible. Put differently, the current system gives us no way to quantify risk; there's far too much uncertainty.

Standardization, once achieved, would inevitably create more liquid and transparent markets for these securities. That's well and good, but a few caveats also come to mind. First, bringing some transparency to plain-vanilla a.s.set-backed securities is relatively easy; it's more difficult to do so with preposterously complicated securities like CDOs, much less chimerical creations like the CDO2 and the CDO3.

Think, for a moment, what goes into a typical CDO2. Start with a thousand different individual loans, be they commercial mortgages, residential mortgages, auto loans, credit card receivables, small business loans, student loans, or corporate loans. Package them together into an a.s.set-backed security (ABS). Take that ABS and combine it with ninety-nine other ABSs so that you have a hundred of them. That's your CDO. Now take that CDO and combine it with another ninety-nine different CDOs, each of which has its own unique mix of ABSs and underlying a.s.sets. Do the math: in theory, the purchaser of this CDO2 is supposed to somehow get a handle on the health of ten million underlying loans. Is that going to happen? Of course not.

For that reason, securities like CDOs-which now go by the nickname of Chern.o.byl Death Obligations-must be heavily regulated if not banned. In their present incarnation, they are too estranged from the a.s.sets that give them value and are next to impossible to standardize. Thanks in large part to their individual complexity, they don't transfer risk so much as mask it under the cover of esoteric and ultimately misleading risk-management strategies.

In fact, the curious career of CDOs and other toxic securities brings to mind another, less celebrated acronym: GIGO, or "garbage in, garbage out." Or to return to the sausage-making metaphor: if you put rat meat and trichinosis-laced pig parts into your sausage, then combine it with lots of other kinds of sausage (each filled with equally nasty stuff), you haven't solved the problem; you still have some pretty sickening sausage.

The most important angle of securitization reform, then, is the quality of the ingredients. In the end, the problem with securitization is less that the ingredients were sliced and diced beyond recognition than that much of what went into these securities was never very good in the first place. Put differently, the problem with originate-and-distribute lies less with the distribution than with the origination. What matters most is the creditworthiness of the loans issued in the first place.

That's why reform should focus on the circ.u.mstances in which loans are originated. It's not as if the regulatory apparatus for doing so isn't in place. In the United States, the Federal Reserve, the FDIC, the Office of Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Administration all have jurisdiction to oversee and regulate the sorts of loans that end up in various kinds of a.s.set-backed securities. The existing regulations and guidelines must be beefed up and given real teeth to ensure that what ends up in the securitization pipeline isn't toxic.

The Federal Reserve has already taken steps in that direction, proposing significant changes to Regulation Z (also known as Truth in Lending). These changes would make it significantly easier for potential borrowers to recognize the true costs of the mortgages they're a.s.suming. It would also place restrictions on those originating the loans. Compensation of mortgage brokers and loan officers would no longer be linked to the interest rate of the loan, much less any of the other terms. Likewise, mortgage brokers and loan officers would be expressly forbidden to steer consumers to bigger or more expensive loans, simply to increase their compensation.

The changes would be sensible, but cleaning up securitization requires that policy makers consider another important aspect of sausage making: the meat inspectors who grade these products. Their financial equivalent would be the ratings agencies, and like their counterparts in the USDA, they haven't always lived up to their responsibilities.

Reforming Ratings.

In the United States, three major private ratings agencies-Standard & Poor's, Moody's Investors Service, and Fitch Ratings-wield remarkable power, slapping grades on everything from mortgages to corporate bonds to the sovereign debt of entire nations. These grades reflect the likelihood that the borrower or borrowers will default on their debt, and they are central to how financial markets ascertain risk. In effect, ratings are a way to outsource due diligence: if Moody's says a particular CDO tranche is supersafe and gets an AAA rating, then it spares anyone else from having to pop the hood of the security and look at the underlying a.s.sets.

The ratings agencies' rise to power began in the 1930s. Their forerunners issued ratings that federal regulators used to a.s.sess the quality of bonds held by banks. This stamp of government approval helped cement their influence, and while their power waned in the immediate postwar era, it rose again in the 1970s, a time when bond defaults rose, and ratings became increasingly important to evaluating risk.

In 1975 the Securities and Exchange Commission created a category known as Nationally Recognized Statistical Rating Organization (NRSRO). Fitch, Standard & Poor's, and Moody's were among those granted this coveted designation. In effect, anyone selling debt had to get a rating from one of these specially designated agencies. While the SEC eventually recognized seven of these agencies, mergers reduced their ranks to the three familiar firms, though the SEC has recently given this designation to a handful of lesser-known companies.

Over the course of their careers, the ratings agencies have changed dramatically. In the early years, they made their money from investors, who paid them to evaluate potential investments. Over time this revenue model s.h.i.+fted, partly because some investors obtained ratings by photocopying their friends' rating manuals instead of paying for them. To get around that problem, the ratings agencies adopted a new business model: they would sell their services to issuers of debt rather than to investors. At the same time the SEC's reforms effectively put the onus of obtaining a rating on anyone who wanted to sell debt. By the 1980s the transition was complete: issuers of debt now paid for ratings.

This arrangement, however, created a ma.s.sive conflict of interest. Banks looking to float some securities could shop around among the agencies to find the best rating. A ratings agency that looked at a proposed offering and slapped a subprime rating on it risked losing business. Increasingly, the ratings agencies had an interest in giving the customers what they wanted-and if a customer wanted a AAA rating for an MBS made up of subprime mortgages, there's a good chance that's what it got.

As if that weren't bad enough, the ratings agencies started to generate revenue from other, equally problematic sources. A bank putting together a structured financial product would go to one of the ratings agencies and pay for advice on how to engineer that product to attract the best possible rating from the very agency the bank would ultimately pay to rate its securities. This service was described as "consulting" or "modeling." Perhaps. In fact, it was a bit like a professor's accepting a fee in exchange for telling students how to get an A on an exam. That's not kosher.

How, then, might the ratings agencies be reformed? At a bare minimum, the agencies must be forbidden to offer any consulting or modeling services. They should exist for one purpose: to a.s.sign a rating to a debt instrument. That's it; anything more introduces a possible conflict of interest. While the SEC has issued rules that forbid the ratings agencies to consult with the companies they rate, this ban is extraordinarily difficult to enforce. Instead, the SEC should forbid the ratings agencies to consult or model for anyone.

It also makes sense to open up compet.i.tion in this privileged realm. While this proposal might have been difficult to justify ten years ago, when the collective reputation of the big three was still intact, it's an easier sell now. Unfortunately, the SEC makes it very difficult for new companies to obtain that coveted NRSRO rating: newcomers must have been in business for several years and have many major clients. But it's hard to get major clients without first being inducted into the sacred circle. To address this problem, the SEC needs to lower the barriers to entry, so that more compet.i.tion-free market compet.i.tion, if you will-enters into this vitally important industry.

More radical still would be to take away the semiofficial role that the ratings agencies now enjoy. Everything from SEC regulations to Basel II capital requirements formally recognize the NRSROs as the only place from which ratings can be obtained. That recognition invests them with disproportionate, if not excessive, power. Taking that power away would be another way of opening up compet.i.tion.

An even more comprehensive reform would be to force the ratings agencies to return to their original business model, in which investors in debt-not the issuers of it-pay for the ratings. Unfortunately, this is easier said than done. One reason is the "free rider problem": once a set of investors pays for a rating and makes a decision based on it, other investors can figure out the rating and make their own decision free of charge.