Preventing the Bubbles That Go Boom

A major focus of the Obama administration's proposals to redesign the financial regulatory system is to bring all the major financial institutions that were implicated in the current crisis (or might be implicated in the next one) under regulation. These include hedge funds, investment banks and mortgage companies, which have been only loosely regulated.

The general presumption seems to be that if all the major categories of firms are regulated, with clear lines of regulatory responsibility, all should be well. But will it?

There should be some unease about this presumption because major banks and thrifts previously subjected to extensive regulation have nonetheless been caught up in the crisis. The holding companies for Citibank and Bank of America were regulated by the Federal Reserve, while the banks themselves were regulated by the Office of the Comptroller of the Currency (OCC). Washington Mutual, IndyMac and Countrywide were regulated by the Office of Thrift Supervision (OTS).

The plan is to shift major responsibility for regulating all systemically important firms to the Federal Reserve, which is the most trusted of those three agencies. However, the major cause of regulatory failure during the period leading up to the crisis was the same for the Fed as for the OCC and the OTS. They all lacked a critical regulatory tool: the power to require a system of mandatory transaction-based reserving.

Financial crises arise out of the interaction of a major external event with a financial system that happens to be extraordinarily vulnerable to just such an event. In the savings-and-loan crisis of the 1980s, the external event was an explosion in interest rates sparked by efforts to contain inflation. The vulnerability was the unbalanced portfolios of savings and loans, which financed home loans carrying fixed rates for long terms with short-term deposits. Their interest cost on deposits rose sharply with rising market interest rates, but their interest income on mortgages changed very little, spelling disaster for thousands of savings and loans. The circumstances that produced the S&L crisis are very unlikely to be repeated because systemic vulnerability to an interest-rate shock has been largely eliminated.

In the current crisis, the external event was an unsustainable increase in housing prices that created a market bubble. The vulnerability was an incentive created by the bubble to generate income by ignoring the risks associated with the inevitable collapse in prices. Here is an oversimplified illustration for a lender I call "A," which is a composite of many firms.

During the bubble period, lender A originated $1 billion of home loans every month, on which it made $75 million. Since it took five months to sell these loans, A always had an unsold inventory of $5 billion. These highly profitable loans maintained their value so long as home prices continued to rise. The month that home prices dropped, however, the value of these loans fell by 20 percent, causing A to incur a $1 billion loss on its inventory and prompting it to close. The loss was absorbed by its creditors.

During the 40 months that A was operating, it generated $3 billion of "income" for its owners and managers. I put the word "income" in quotes because, while it constituted income in a legal sense, about a third of the money should have been allocated to a reserve for future losses. Had A done that, it would have survived the shock of the house-price decline. If every firm had done the same, there would have been no crisis.

But the incentive system is strongly biased against setting aside reserves. For most firms, it makes more financial sense to ignore the risk, pay out all the revenue as income as it comes in, and go broke when the bubble bursts. If it bursts after a short period, reserving would cost them, and if it runs for a long time, the firm can withdraw an obscene amount of money that, barring fraud or other illegalities, the ultimate losers (including taxpayers) can't take away. Even our tax system discourages reserving, since the amounts reserved would be taxed as income.

While the financial system is far less vulnerable to an interest-rate shock, it remains vulnerable to bubbles in the housing market and elsewhere. There is no plausible compensation system that could change this, and the search for one is a useless digression.

For a reconstituted regulatory system to prevent bubble-generated financial crises, it must have the authority and know-how to impose and enforce a system of mandatory transaction-based reserving. In such systems, varying amounts of what would otherwise constitute income, based on the riskiness of individual transactions, must be allocated to a reserve account that cannot be accessed except in an emergency.

Such systems now apply only to firms chartered as insurance companies -- including mortgage insurers -- which are regulated at the state level. If a mortgage insurer had insured the loans originated by A in my example, its risk would have been very similar, but in contrast to A, it would have placed half of every premium dollar it collected into a contingency reserve.

Most of the knowledge and experience required to apply such systems to other financial firms currently can be found in state regulatory agencies. This provides an ironic perspective on the Obama proposal that the federal government take over the regulation of insurance companies from the states.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag; Distributed by Inman News Features