Investors Scrutinizing the Regulators

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June 9, 2008


Jeff Sanford


So that’s it then? The global credit crisis is over? A recent Globe and Mail headline suggested as much. So too does the idea that the Bank of Canada is closing its emergency lending windows to banks.


But before we leave all of this behind I promised to run more comments from my interview with David Rothkopf, a fellow at the Carnegie Endowment for International Peace, who, over lunch one day, provided an interesting assessment of the role of regulators through the recent mortgage-lending debacle.


According to Rothkopf one of the reasons we saw mortgage-lending stray into the unconscionable areas it did is a result of the lack of regulation of global financial services that has prevailed over the last several decades. Let’s be honest. None of the worst abuses of the recent credit bubble had to happen. Regulators could have stepped in at any time and put a stop to cases where unsophisticated borrowers were steered into mortgages they couldn’t afford by sophisticated mortgage originators (who were simply writing mortgages to gain a fee with no consideration of the long-term viability of that mortgage). There were warnings being made about this as far back as the early part of the 2000s (and from members of the Federal Reserve no less) that lending was out of control.


So why did regulators choose to stay out of the way? According to Rothkopf the reticence was a result of two things. On the one hand it’s just the way economy has evolved. The private sector has globalized in a way that governments have not, and we now gave a global financial services industry, but no countervailing global regulatory regime, and that has left global banks free to operate in the spaces between national regulators. As well, global financial services have been successful in promoting the idea that self-regulation works just fine, and that has been the prevailing idea toward financial services regulation for a generation now.


There are also structural forces at play that have fundamentally changed the way financial services work. One of the most key has been securitization (where loans made to banks are bundled up and sold to other investors, taking that debt off the books), which has seen debt obligations “lifted” from the balance sheets of the banks and shifted over into all kinds of off-balance sheet vehicles like the non-bank ABCP “conduits.” These special investment vehicles that have come to hold all of those mortgage CDOs only relate back to the “core” books of the banks through things like liquidity agreements written into the laws of each country (and which, in the case of Canada, sharpened the recent non-bank ABCP debacle).


Some have argued the loose liquidity provisions around the non-bank ABCP conduits found their way into Canadian law as a result of influence by the big global banks. That has yet to be definitively proven, but the regulations as they are were certainly conducive to the way the banking system operated.


As a result of securitization, the banks, traditionally moored by the longterm debt on their books, have been able to levitate and begin moving through markets unencumbered by this debt. One of the biggest changes in the business model adopted by the world’s big investment banks has been the trend toward “trading on their own book,” which sees investment banks deriving a good chunk of their earnings by using their own money to place bets in the market, a fundamental shift from a time when the majority of their trading was done only for clients. In some sense, the biggest global firms have become trading organizations that feed on one asset bubble after another, their survival dependent only on whether or not they get out of each bubble early enough. Call it the “greater fool” theory of banking. But it is the system we have today.


I’ve come across this idea in my own reporting. Shortly before the credit bubble melted down last summer I talked to a private equity banker who expressed dismay at a JP Morgan quarterly earnings call he had recently listened to. During the call the bank reported good earnings from its subprime lending activities. But then, just a few minutes deeper into the call, the bank mentioned it was devoting more of those earnings to a fund that would buy up distressed sub-prime securities. “My partner and I looked at each other like, what?” said the private equity manager. It seemed counterintuitive to him that a single trading organism would both be profiting from a business but already making plans to profit from that business when it went bad.


That might not be such a bad thing at base, but it has changed the risk of the total system in that we’ve created a banking system where the key to survival is successful speculation and trading on the part of the main players, not traditional finance and banking operations. The consequence is the construction of one asset bubble after another, which brings with it a continuous stream of economic volatility that typically sees the most unsophisticated investors suffering the most economic damage (or was almost the case with retail holders of non-bank ABCP who only got their investments back after a massive hue and cry).


But that’s the way the system works these days says Rothkopf. “The trading mentality in most of these institutions has created a view that you don’t have to be right, you don’t have to know what the risk is, and you just have to be ahead of the market. You just have to be the first one out of the room and you’ll make money. It has nothing to do with the evaluation of real investment value,” says Rothkopf. “We live in a trader’s world. It’s a giant game of hot potato with the world economy and the last person holding it is screwed. To me this, it’s unconscionable, it’s probably illegal, yet, it’s driving the global economy.”


The forgotten, or overlooked risk to everyone else is what happens when the lack of oversight leads to a piling up of bad debt, as we saw through the mortgage lending crisis.


As it was, the government was forced to step in and undertake historically unprecedented actions to provide liquidity and keep the system from coming unglued, as a result of lending activity that was so loose and pervasive it threatened to take down the global banking system. Here in Canada, Parliament ended up passing a bill, which allowed banks to post some of that bad debt as collateral for fresh, new (untainted) money.


To Rothkopf the fact central banks stepped in like they did is proof of the power the private sector has amassed through this period. “Investment banks aren’t regulated by the SEC and the Fed in the way that other banks are, and yet they had the power to step in and get them to act in a way that the average homeowner didn’t. So, A, it revealed the power. But B, it revealed the gap, and the gap is in the spaces between national regulatory mechanisms. You’ve now started to see people say, how do we do this regulation better. People are saying this is unsustainable,” says Rothkopf.


As it is, the only power that national regulators have today over global institutions is an ability to “convene” the actors involved. There is no framework for forcing global banks to abide by anything national regulators might like to enforce says Rothkopf. The only possible response is to coordinate a response once the latest bubble has blown. “The real power is to go to the people with the real cash and persuade them to go along with the solution. When [U.S. Federal Reserve chairman Ben] Bernanke goes and talks to the biggest 14 or 15 institutions, they’re U.S., German, Swiss, French. Maybe there’s a Canadian firm there. Maybe Royal Bank is in there. But there are no Japanese firms in there. There’s nobody else from anywhere else in the world in there. It’s not a representative group saying what’s in the best interest of the world and investors in there.”


This is the perfect example of the power of the global banks, and they have become adept at preserving their interests in a global world. “Power comes not from a positive plan to run the world, but an absence of countervailing forces on the global stage. They’re filling a void. Power structures abhor a vacuum,” says Rothkopf. “And when you don’t have formal power structures you get informal ones. You get little clusters of people, mostly private sector, who are stepping in and acting in their self interest.”


I run the idea by Rothkopf that the Office of the Superintendent of Financial Institutions, Canada’s national banking regulator, doesn’t need to regulate global banks that operate in Canada because these banks are regulated in their home countries (as OSFI has argued in the case of the non-bank ABCP debacle). “The technical financial term for that is ‘bullshit,’” says Rothkopf. “They’re not actually regulated in their home market. And many of these vehicles that are created are linked to places that have much laxer codes. It’s a race to the bottom. And, in a lot of these things, if you don’t know who the counter parties are, the risk is totally opaque,” he further explains. “We’re playing in a whole new ballgame in which the regulators are doing this thing from the Wizard of Oz, ‘well not this way, not this way. It’s not me. It’s somebody else’s problem.’ The issue, of course, is what kind of catastrophe is it going to take? I think this crisis is the tip of the iceberg. We’ve got a big recession to go. And we really haven’t seen a failure in the really opaque market. This is a crisis that the Fed working with big institutions has been able to fix. What happens when they have a real crisis?”

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