Piercing This Bubble For Good

By Roger C. Altman
Monday, March 31, 2008

In the past two weeks, the Federal Reserve has lent or guaranteed at least $57 billion to investment banks. This sudden infusion, the first to Wall Street firms since the 1930s, underscores the financial emergency facing the nation. Yet just last June, the markets were euphoric. How, within nine months, could a lending bubble inflate to gargantuan proportions and then burst into this credit market disaster?

Two points are fundamental as we piece together what happened. First, this is only the latest in a series of modern financial bubbles that have collapsed. Second, while we cannot prevent bubbles, we can prevent a recurrence of this one.

Financial bubbles occur regularly on both the debt and equity sides of investing. Recent ones include the conglomerate stock craze in the 1960s, the junk bond and Japanese excesses of the 1980s, and the dot-com speculation of the late 1990s. The interaction of crowd psychology and the betting nature of markets cause these episodes: After a certain upward point, market momentum can become self-perpetuating -- until it reaches such a peak as to collapse onto itself. Much like putting too much air into a balloon.

Over 2004-05, there developed an unusual combination of low interest rates and low inflation, reasonable growth, and a surplus of global savings recycling into the United States. This meant that all types of lenders were highly liquid but faced low yields from traditional lending practices. Seeking better returns, they lowered credit standards and lent to weaker parties, i.e., subprime mortgage borrowers and over-leveraged firms.

The headlines have been reporting what happened next, but the amount of credit that was extended to these weaker borrowers is amazing. Historically, C-rated borrowers have been unable to borrow much from public-debt markets because over decades more than 30 percent of such low-rated debt has defaulted before maturity. In 2006, more than $25 billion of these securities were sold; the previous 10 years, the average was $2 billion.

The music stopped when home prices, which had soared for five years, finally plateaued and then began to fall last year. This reversal spread nationwide and weakened the entire economy. Unable to refinance, countless overstretched homeowners could not make their mortgage payments. Suddenly, defaults loomed, and every lender changed his stance overnight. Deleveraging became the goal, and the credit spigot was shut.

It was, as always, too late. The Fed has poured emergency liquidity into the financial system to avert a collapse, but foreclosures have already skyrocketed, and hundreds of billions in credit losses have been realized. Our country is headed into a recession.

Several lessons are apparent:

First, too much credit was extended by entities that were not regulated, such as the special-purpose, off-balance-sheet vehicles created for leveraging up pools of mortgages. No minimum capital requirements applied to these, nor were they required to disclose their results. In the future, most of these vehicles should be regulated and subject to both sets of controls.

In addition, the largest investment banks have been made eligible to borrow directly from the Federal Reserve. In exchange, they should be subject to Federal Reserve or equally strong oversight. Requiring J.P. Morgan Chase to bear more of the cost of the Fed's guarantee for its acquisition of Bear Stearns is a small start, though the Fed is still on the hook for the lion's share.

Second, the exotic character of so many new financial investments is an issue unto itself. Many, such as collateralized debt obligations and credit default swaps, carried greater risk and generated more leverage than market participants understood. The world financial system would be better protected if certain buyers of such instruments were subject to enforceable margin requirements, and issuers of them were regulated and subject to capital requirements.

Third, the books of our largest financial institutions are not sufficiently transparent. The retained risks on their off-balance-sheet financings, for example, were not known to their shareholders. This is inappropriate. The Financial Accounting Standards Board, working with the Securities and Exchange Commission, should expand public disclosure requirements applying to these transactions.

Fourth, the credit rating agencies performed poorly. They assisted in creating some of the least transparent and shakiest financing structures. The SEC should require their boards of directors to annually certify, with corresponding liability, to the independence of the ratings process from borrower influence.

Fifth, mortgage brokers created countless inappropriate or fraudulent mortgages. This isn't surprising because they are paid to originate. Whatever happens later to the homeowners or lenders is immaterial. Going forward, there should be national licensing for mortgage brokers that embodies the know-your-customer rule for securities brokers. Non-bank mortgage lenders should also be governed by the same capital requirements and regulation that apply to bank-owned lenders.

Borrowing conditions may not return to normal (pre-2006) levels for at least two years. And we may not see speculative excess for a much longer period. It will return in another form, as bubbles always do. Let's not, however, have a repeat of this one.

The writer, who served as deputy Treasury secretary in the Clinton administration, is chairman and co-chief executive of the investment bank Evercore Partners.

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