EconoMonitor

The Beginning of the Beginning: how to resolve the sub-prime crisis

A dry summer of discontent is now upon us, and not a day goes by without some sad or lurid tale of pathos and angst on Wall Street filling the pages of newspapers. If the truth be told, we have yet to even come to grips with the depth of our current predicament, let alone with how to address it. As someone else once said, “there comes a time in a man’s life when he must take the bull by the tail and face the situation”. Surely, that time has come.

A problem can only be solved after it is defined, which means that the right questions are being asked. That process invariably leads to the source, the essence of the problem that enables us to recoil from it and find our selves again. When a man is sinking and does not know how to swim, the only possible avenue is to wait till he hits rock bottom and then push off. This is the “solution” the Federal Reserve is now attempting to implement. The Fed’s Chairman, a legend in his own mind, is busy rearranging the deckchairs on the Titanic and doing a fine job to boot, but we are still sinking. Is there another way? No, for what we are doing now is not a “way”, it is nothing.

Doing so Much and Accomplishing so Little

Before one can act meaningfully, one must get a hold of oneself and stop trying to overcome excesses of one sort with excesses of a different sort. Methadone is not a cure for illegal drug addiction, merely a legalization of it. The obvious first step to a cure for alcoholism is to stop drinking so you can think. Here are three easy steps to momentary financial sobriety.

The first step is to relax. Things can’t get any worse and there is nowhere to run. We are moving inside a circle whose end looks suspiciously like its beginning. We do way too much and think way too little to see the problem as such.

The second step is to ask why such luminaries, those living on Wall Street and entitled to such high incomes, could be so wrong for so long about so much, including their own lack of understanding. Wall Street’s most glaring and fatal mistake seems to have been its apparent ignorance of its own ignorance. Knowing that you don’t know is already the beginning of true knowledge. Are we so much better than they were? If not, why should we be trusted and, some time in the future, cause the very thing we sought to avoid.

The third step is to stop taking ourselves so seriously, to stop believing that what Wall Street is doing is missionary work, instead of what it is really doing, i.e. taking advantage of historical circumstances to which it contributed nothing. The most amazing thing about American finance, once you discover how it actually works, is not that it undergoes ever widening cycles of boom and bust, but that it still exists at all. Even a dry cleaner delivering services of similar quality would long ago have been sued out of existence. Clearly, there must be something rotten in the Kingdom of Wall Street!

What to Do

Granted, the last few paragraphs were depressing, offering more cautionary tales and philosophy than substantive proposals. On the other hand, the world is full of half-baked proposals that took five minutes to put together over breakfast to keep the New York Times in business. In fact, not having a proposal has got to be the best proposal of all.

However, let us venture three measures that, if implemented and maintained, would both eliminate any future liquidity crisis, as if that were possible anyway, and restore credibility to the credit markets in a few weeks. In reality, the mere announcement of reasoned and meaningful action would cause the markets to kick themselves into shape practically overnight.

They are due to Joshua Rosner, and we are pleased to endorse them:

a) A two-year waiting period between working at a rating agency and working at a sell-side firm. This may be moot anyway since rating agencies are themselves fighting for their ultimate survival as we write;

b) Secondary-market monitoring of all existing structured transactions using an automatic true-up mechanism based on monthly servicer reports. The latter are widely available and tell the real story of the deal, not the Disneyland version favored by traders. Ah yes, traders, those who went from Latin lovers to limp losers in one day. An authentic valuation of structured securities would restore liquidity almost overnight, especially when coupled with a moratorium on mark-to-market accounting, something that has never worked to begin with for the simple reason that is self-referential; c) Establishment of primary-market valuation standards. Such standards exist and are now being taught, among other places, at Baruch College in New York City, at the University of California at Irvine, at the Hong Kong University of Science and Technology and at Euromoney Training. At least according to that framework, it is possible for a transaction to show itself not to work, i.e. to be a “non-deal.” This is a major step forward since, as things now stand, all structures Wall Street wants to underwrite are by definition “good”. That is, of course, until they blow up before our very eyes. Was it possible to know such deals were bad a priori? Yes, it was. The question is not that but far more: what would you have done about a deal that had shown itself not to work? Currently, the answer is: whose side are you on? Changing that answer is the real challenge, not coming up with the question. We simply no longer have the will to change;

At the moment, politicians, true to their nature, are doing things right. They are holding hearings and seen appearing on television “addressing issues of concern to their constituents.” Unfortunately, what we need is for them to do the right thing. It is widely and mistakenly believed that it is hard to do the right thing. No, it is not. What is hard is to know what the right thing is. Once you know it, it’s hard not to do it.

8 Responses to “The Beginning of the Beginning: how to resolve the sub-prime crisis”

GuestMay 28th, 2008 at 9:46 am

I think you may be underestimating the depth of public dissatisfaction with the so-called "ratings agencies" on Wall St. It was bad enough that these agencies were both late – and horrendously wrong – with their ratings on CDO’s. But it got worse when we learned that a "computer bug" may have provided completely erroneous ratings – and the company involved apparently did not move quickly to fix the problem or re-rate the products that were messed up. Then it went over the top when allegations were made (apparently true) that banks went to the ratings agencies and cherry picked which ratings analysts worked on their products. This type of behavior is not consistent with "ratings agencies". It is consistent with a complete and utter scam. Once the ratings agencies lose their integrity – they are good for nothing. Why did Wall St keep them around? Looks pretty much like a rubber stamp to me.The public would be better served if the ratings agencies were completely abolished, in my opinion.PeteCA

HellasiousMay 28th, 2008 at 11:14 am

The root of the problem in Wall Street has to do with Other Peoples’ Money (OPM). Not a single major bracket firm is private or a partnership anymore, meaning that principals care only for generating fees and capital gains, which are transformed into annual bonuses. In practical terms, risk is essentially an afterthought since it’s not their OWN money on the line with every transaction.Bottom line? Take as much risk as possible with the shareholders’ money, rake in the bonuses and retire ASAP, ideally before turning 40.Same model applies to hedge funds and private equity. I laugh every time someone is actually willing to pay 2/20 (%) for the benefit of having someone else lose his money via schmalpha.

eparisiMay 28th, 2008 at 11:52 am

Very nice piece. To be fair, none of the points a)-c) are in the realm of politics. Unless you are advocating micro-management/regulation.@Hellasious:OPM wasn’t a problem either for commercial banks or pension funds when risk-free returns were such that you were not actually FORCED to leverage up and search for yield in order to meet your liabilities.

TaxpayerMay 28th, 2008 at 11:18 pm

One of the problems with agency ratings is they almost invariably "gap" down (they never "gap" up).One day your instrument is AAA, next it is Djunk.This must bring into question the legitimacy of the original rating and says nothing for the monitoring of bestowed ratings.Perhaps they could introduce a new "guaranteed not to gap" AAA rating.

eparisiMay 29th, 2008 at 9:42 am

Sylvain Raynes himself hit the nail on the head during the latest RGE conference in NY:Structured securities are designed to be tradable, their primary risk is thus market risk which is not the business of CREDIT Rating Agencies to assess in the first place! (Sylvain, please correct if I misrepresent your view.)

GuestMay 30th, 2008 at 7:55 am

These checks are good but at too high a level. The problem starts with unqualified borrowers at the local level, usually renters who want a home but cannot afford it, applying for a loan.Later on overambitious property investors and speculators join the crowd. Twenty five years ago the subprime crowd would never have secured loans. If they were honest and had a job, the local banker or their realto would give them a plan on how to improve their finances to qualify. The local bank or savings and loan was on the hook and protected its balance sheet. They were also carefully audited and examined by the feds and state.However, the finance industry didnt make enough money this way, from the banker to Wall Street, so they figured out a way to turn bad money into good by packaging and securitizing. Getting the paperwork far enough from the source that the fraud was not obvious. I know because I worked as a realtor and contractor from the early 80s. As long as the local bank was in control, there was a basic honesty in the system. The earnest money contract was one or two pages and the loan documents were maybe six or seven pages. Appraisals were clear and easily understood. Noone had credit cards to put the down payment on and 20 percent loans were the standard.This last 25 or 30 years, coinciding with the deregulation philosophy of the Reagan dynasty, has been one of departure from real value in all areas of assets, documenting the false values, largely based on credit rather than cash or secured sales. The savings and loan failures of the l980s, the junk bond frauds and crises and the entire subprime lending crisis, plus the corruption of Fannie Mae, Freddie Mac, VA and FHA are of a piece. False values that everyone makes money from until the house of cards comes down, like the watered stock of 2 generations ago. Once the cycle starts, appraisers, loan agents, realtors and all kinds of buyers get pulled in. Flipping, double escrows, etc. can only function when the source of credit or investment has no ability to evaluate the collateral and borrower. Umbrella rating agencies are not the problem. We need to return lending to a local level, with competent inspection and severe sanctions for incompetence and fraud. Will this get political support. Maybe not. But this is needed .

GuestMay 30th, 2008 at 7:55 am

These checks are good but at too high a level. The problem starts with unqualified borrowers at the local level, usually renters who want a home but cannot afford it, applying for a loan.Later on overambitious property investors and speculators join the crowd. Twenty five years ago the subprime crowd would never have secured loans. If they were honest and had a job, the local banker or their realto would give them a plan on how to improve their finances to qualify. The local bank or savings and loan was on the hook and protected its balance sheet. They were also carefully audited and examined by the feds and state.However, the finance industry didnt make enough money this way, from the banker to Wall Street, so they figured out a way to turn bad money into good by packaging and securitizing. Getting the paperwork far enough from the source that the fraud was not obvious. I know because I worked as a realtor and contractor from the early 80s. As long as the local bank was in control, there was a basic honesty in the system. The earnest money contract was one or two pages and the loan documents were maybe six or seven pages. Appraisals were clear and easily understood. Noone had credit cards to put the down payment on and 20 percent loans were the standard.This last 25 or 30 years, coinciding with the deregulation philosophy of the Reagan dynasty, has been one of departure from real value in all areas of assets, documenting the false values, largely based on credit rather than cash or secured sales. The savings and loan failures of the l980s, the junk bond frauds and crises and the entire subprime lending crisis, plus the corruption of Fannie Mae, Freddie Mac, VA and FHA are of a piece. False values that everyone makes money from until the house of cards comes down, like the watered stock of 2 generations ago. Once the cycle starts, appraisers, loan agents, realtors and all kinds of buyers get pulled in. Flipping, double escrows, etc. can only function when the source of credit or investment has no ability to evaluate the collateral and borrower. Umbrella rating agencies are not the problem. We need to return lending to a local level, with competent inspection and severe sanctions for incompetence and fraud. Will this get political support. Maybe not. But this is needed .

Sylvain RaynesMay 31st, 2008 at 8:55 pm

Dear Mr. Pete,You are quite correct, integrity is severely lacking in finance and in the world in general. It has never been that high anyway. What we are offering is not a global solution to the problems of mankind, just a restricted set of three risk-neutral and non-contentious measures that would resolve the current crisis while being politically acceptable. There is no more to say. Calling people scamsters and thieves, albeit totally acurate, does nothing to make the world of finance a better place. I would like to invite you to a meaningful engagement, not a cynical look from the sidelines. Playing the game and watching it are two very different things. We need you and your friends to engage now.Sylvain Raynes

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