Joshua Rosner is Managing Director at independent research consultancy Graham Fisher & Co and advises regulators and institutional investors on housing and mortgage finance issues. Previously he was the Managing Director of financial services research for Medley Global Advisors. In early 2003 Mr. Rosner was among the first analysts to identify operational and accounting problems at the Government Sponsored Enterprises, in the third quarter of 2005 Mr. Rosner identified the peak in the housing market, In October of 2006 Mr. Rosner highlighted the likely contagion from structured securities and credit markets into the real economy.
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Sources tell me that at 4:30 yesterday afternoon there was a meeting between Geithner,
Bair, Dugan and Bernanke. When the Chairman of a supposedly independent Central Bank is a direct participant in a meeting of political appointees we should all worry.
Rather than risk becoming a third voice in the room potentially supporting shareholder member banks of the Federal Reserve Bank of NY at the expense of prudential regulatory oversight, he should be consulted and asked his views on the policy implications to the Fed only after an initial policy consensus has been reached on oversight or policy matters. This problem again highlights the troubles of a central bank with regulatory supervision over banks.
In his last position, Tim Geithner was not hired by or paid by the Government, but rather by the Board of the shareholder owned and private corporation that is the New York Fed. Even now, Geithner has chosen a former lobbyist for one of those same banks that he used to report to as his Chief of Staff. Is this the sort of integrity that President Obama spoke of last week in his lobbying rules? It seems appropriate to consider whether the inherent conflicts of interest he brings to the table should require him to recuse himself from involvement in the discussions or decisions of the regulatory approach. Perhaps, as Treasury Secretary, he should only be involved in decisions about the funding and
management of the program after regulators devise a plan.
“Emergency measures” and an inept Congress now regularly justify regulators ignorance or interference in Congressional intent in favor of arbitrary interventions and political decisions that disadvantage the vast majority of solvent, plain vanilla and small banks. After all, it is predominantly the Fed and OCC institutions that are central to the crisis. Their efforts to circumvent the regulatory intent of risk weightings and leverage ratios through a regulatory arbitrage of structured mortgage exposures have caused the system to seize and the costs required to counter the leverage to be so extreme. The failure of oversight by those same primary regulators who now are attempting to protect the worst of their regulated institutions is a dangerous precedent and calls for Congressional
intervention.
Congress and the press should consider whether the fact that the Treasury, the Fed and OCC are determining how to resolve failing institutions constitutes regulatory overreaching. Congress intended that the Federal Deposit Insurance Corporation be the final arbiter of decisions to resolve troubled institutions and directed the FDIC to determine the “least costly” manner in which to do so. Congress, in its wisdom, left these powers to the FDIC precisely to diminish the risk of political interference by conflicted parties (including captured regulators) from impacting the safety and soundness of prudential oversight.
Where the rubber meet the road and the car hits the tree:
It has been suggested that part of yesterday afternoon’s discussion was apparently the potential budgetary implications of an aggregator bank approach relative to the insurance wrap approach. Those in favor of the wrap approach suggest that Treasury dollars are more easily leveraged in the wrap approach. I would suggest that if any approach does not resolve the crisis in an efficient and effective manner it isn’t worth spending any dollars on. I would further argue that if the “bad bank” began, not by buying all troubled assets but instead only troubled assets of troubled banks, the initial implications to the Treasury would be significantly diminished. The vast majority of state chartered banks and community banks are able to handle their currently troubled assets. It is primarily a small number of large institutions overseen by federal regulators that are most troubled. This means immediate focus should be on these banks that are troubled and cannot handle their exposures.
The manner in which the “bad bank” manages or disposes of these troubled assets could provide further leverage to the Treasury by packaging them and selling them as new Government securities. Moreover, the wrap approach leaves bad assets on bank balance sheets and thus provides the banks with the opportunity to own the upside on the recovery of assets that the taxpayer has provided the risk insurance for. A “bad bank” approach could be created with a rational back-end structure to issue securities structured so that the selling bank and taxpayers could share in any recovery on those assets and the selling bank could, in the future, be penalized for any losses not calculated in the original purchase price.
We understand that the discussion of “bad bank” versus “insurance wrap” has devolved from an all or none into an even more absurd “cut the baby in half” discussion. Sources tell us that the Federal Reserve is proposing that AFS (available for sale) assets and trading assets be sold to the bad bank while they propose that “accrual” or HTM (Held to Maturity) assets be wrapped. This approach is has the fingerprints of the NY banks all over it. Over the past several quarters these banks have moved massive amounts of troubled assets from AFS to HTM in an effort to avoid having to mark them to market, avoiding the sale of these securities to the “bad bank” would be a clear attempt to avoid a sale event and the required marking the assets. By way of background – when the GSEs were moving assets from AFS to HTM many of these same banks were screaming to the Fed and Treasury that this was inappropriate and that it shouldn’t be allowed. As important, almost all of the whole loan exposures of the banks are in the HTM accounts and those loan exposures promise to be the most rapidly deteriorating assets and the largest future losses of those institutions, circling them is not a resolution it is a delaying of the day of reckoning.
Various sources suggest that the Treasury and the Fed want banks to issue common equity to government in exchange for any capital infusion. This too appears a backdoor approach to tie the hands of a regulator created by Congress to resolve failing institutions. How could the FDIC ever be allowed to act as a prudent regulator and resolve a failed institution in the most appropriate manner, or the manner least costly to the insurance fund, if doing so would cause them to wipe out the equity stakes in banks that are owned by the taxpayer. A more traditional and appropriate approach to resolution would be for the Government, with the discretion and secrecy with which the FDIC resolves institutions, to take bad assets from those large banks rate a CAMELS 4 or 5, infuse capital in that bank and take senior preferred in return. The next morning the preferred holders of the institution would awake to find that they were equity holders and equity holders would find that they were penalized for speculating in the shares of and supporting risky behaviors of poorly managed institutions. If the bank was still in need of capital it would, as an entity with a clean balance sheet, be able to find new buyers of its common shares. Such is the rational nature of economic Darwinism.
I believe that one area that all the regulators agree on is the one that the market seemed to
misunderstand most yesterday. Whether or not the banks have to sell all their bad exposures and therefore “lift the kimono” or whether they have to sell some and get to continue to hide most on their balance sheet, the reality is that nobody is arguing anymore that the government should ‘overpay’ for the assets. Rather, there is an understanding that their needs to be a pricing mechanism that is consistent, replicable, reasonable and independent of either the sellers or third parties that may be chosen to manage the assets. As a result I do expect that there are likely to be very large write-down on bad assets sold to the “bad bank”. Part of the argument, and it seems reasonable, is that distressed buyer’s bids are determined to include an implicit hurdle rate of return and, since the
government is looking to neither make nor lose money in their purchases the price should consider that reality.
If change has really come to Washington then why is it that we continue to seek to protect the interests of precisely those banks that caused the mess at the expense of those banks that have been better managed? Why is punishing the shareholders that approved and funded the bad business decisions of those poorly run institutions as the expense of shareholders that sought to differentiate good businesses from bad ones? Shouldn’t the government recognize that it really is a time for change? With the recently changed deposit insurance limits and qualified financial contract rules, even if there are banks that are too large to wipe out counter-parties, secured debt-holders and depositors of there are no longer banks that are too big to wipe out the equity of. Perhaps that is the capitulation that, along with cleaned balance sheets, would truly mark the bottom of this financial
crisis.
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The Weekly Spew January 2009
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Josh Rosner’s work on the Government Sponsored Housing Enterprises, Credit Rating Agencies and mortgage markets resulted in invitations to present to the Senate Banking Committee, Forecasters Club of New York, Professional Risk Managers International Association, ABSummit Geneva, The National Association of Business Economists, National Association of Business Economists Financial Roundtable, the American Enterprise Institute, the American Real Estate and Urban Economics Association, the Global Fixed Income Institute, CFA Institute, the Hudson Institute, The Chicago Fed Annual Bank Structure Conference and the Fixed Income Forum. He has also privately presented his research to leading policy makers, legislators and regulators. Mr. Rosner has co-authored papers on the risks of Collateralized Debt Obligations to the mortgage finance market and the risk of mis-application of ratings in the structured finance market. Earlier, Mr. Rosner was an Executive Vice President at CIBC World Markets and a Senior Vice President at its predecessor firm, Oppenheimer and Company.
I am stunned every time people/investors react in “Surprise!” to a bad set of economic data.
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