And another thing...

I want to continue my rant on the New York Times' recent article about how the subprime mess has led some in the "international community" to call for more input into US financial regulation. (See my screed here and the NYT article here.)

Clearly, greater international regulatory cooperation can be a great boon. However, the arguments posited by Peter Bofinger and Professor Dick Bryan in Heather Timmons' and Katrin Bennhold's article are not among the reasons we need this cooperation. International regulatory cooperation exists for two purposes -- so bad guys can't use the international system to undermine national sovereignty (quite the opposite of what Bofinger is suggesting) by permitting regulatory arbitrage; and, second, so the world's regulators don't step on each others' feet so much, to the detriment of global markets.

I'm harping on this point because these academicians really should know better. For example, the article notes:

Their argument is simple: The United States is exporting financial products, but
losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks. “We need an international approach, and the United States needs to be part of it,” said
Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

Rather than an argument that the US regulators are asleep on the job, isn't this an argument that the European regulators aren't monitoring the risk management practices of their own firms? Were these firms really snookered into believing that the subprime mortgage securities were safer than they are -- particularly when anyone with half a bucket of sense could tell you otherwise?

Likewise, it is certainly true that US regulators have not been keen on engaging foreign governments in determining what US financial regulations should be. Indeed, I suspect that if the US public knew anyone in the United States was even considering it, they would be hanged from the nearest lamp post (which may explain why Basel II is as complicated as it is -- US banking regulators, after all, have such skinny necks). All of that said, I fail to see why US financial regulators would particularly care if foreign investors, in particular, stopped investing in any specific US security. Regulators might care if investors, writ large, started having a problem, but there is nothing magical about foreign investors.

And this, fundamentally, is why these academics' arguments fail. The Fed, the SEC and most other US financial regulators draw no distinctions between US and foreign investors. This is the strength of the US system and why the United States is able to import capital so cheaply, regardless of how many boneheaded statements Congressional leaders might make about foreign capital. What's good for foreign investors is good for American investors, and vice versa. US regulators are unlikely to take advice from foreign regulators who historically have a problem with attracting even domestic investors to their own market.

NYT: World wants a say in US financial regulation

Yesterday, the New York Times had an article on the subprime mess quoting a number of foreign talking heads demanding more international input into US financial regulation. (See Calls Grow for Foreigners to Have a Say on U.S. Market Rules.)

Yeah, what's new? Actually, that should be the title of the article. What I found most amusing, of course, is the arguments put forward about why there needs to be more of an "international" approach -- whatever that means.

“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

I believe logicians call that the "we're your customers, therefore we should have a say into how you run things" argument. I suggest you try it with your cell phone carrier some time -- it really does work.

(As for the "we're going to stop buying your products" thought, Mr. Bofinger, you'll stop buying when we stop being so damn profitable, and not a day before--or a day later, for that matter. Do I have to explain everything to you European government types?)

Granted, I expect that kind of thinking from European academicians. (Do you ever stop and wonder what happened between Rene Descartes and today? I mean, seriously. The Europeans actually invented deductive reasoning, and today we get this?) However, the Aussies are in on it, too.

As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.

“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”

There's your problem, Professor Bryan. You are following the lending rules of the United States because you are actually lending in the United States. If you were lending in Australia, the rules might be different. If you don't like it, stop lending to damn ferriners. (Oh, I guess I don't mean you, personally. I mean Australian financial institutions, who, as we all know, are demanding significantly more regulation in the United States...)

Please, everyone. The old saying is don't confuse brains with a bull market. On the flip side, don't confuse conspiracy with a bear market.

You investors and borrowers out there want to know who's to blame for the subprime mess? Look in the mirror.

Bernanke's competence on subprime crisis brought into question

After all, nothing will bring into question your competence on an issue than for Sen. Chris Dodd (D-Conn.) to say you "get it." (See Fed ‘Gets It’ on Mortgage Crisis, Senator Dodd Says.)

I'm all for addressing liquidity crises, but there is a very fine line right now between holding off a wider, preventable systemic crisis, and repeating the Fed's past mistakes regarding moral hazards and banking bailouts. (Which, in my opinion, include pretty much every Fed banking crisis intervention in the past.)

Just as an example, has there ever been a more blatant case of begging for corporate welfare than Jim Cramer's beserk attack on Bernanke two weeks ago? (Watch here or here if you're interested).

"Bernanke is being an academic!... [William Poole, St. Louis Fed President] has no idea what its like out there--None! They know nothing! The Fed is asleep! My people have been in this game for 25 years ! They are losing their jobs and these firms are going out business!... This is a different kinda market!"

First, never trust anyone who says this is a different kind of market. For 400 years, it's been the same kind of market.

Second, why should we care if you are losing your jobs over your poor investment decisions? (Some people, particularly those betting against you, have been making a lot of money.)

I could be wrong, but given Congress' involvement in previous market-related matters, I can't help but suspect that Chris Dodd is just a slightly more calm version of Jim Cramer (particularly given the number of hedge funds operating out of Connecticut).

Sub-prime credit rating agencies

Sean Egan, head of boutique rating agency Egan-Jones and co-founder of some lobbying group designed to get his firm recognized by the SEC as a Nationally Recognized Statistical Rating Organization ("NRSROs" as they are known to their friends) wrote an op-ed in last Thursday's Financial Times (see Sobering lessons of the Bear Stearns losses). Given Egan's previous writings to the SEC and other groups, the FT piece is actually pretty good. Which means, of course, that I doubt he really wrote it. (Must have hired a new PR firm recently.) Egan correctly points out that the Basel II accord has basically made the role of credit rating agencies (CRAs) more important than ever, even as recent structured finance deals and the all-to-predictable sub-prime fiasco call into question whether these CRAs really can be trusted to properly rate the component parts that go into a structured finance deal or a collateralized debt obligation (CDO).

Structured financing and CDOs have become an important part of our economy. In "finance for dummies" terms, these are complex arrangements that let banks or others lend money, and then sell off the IOUs from those debts to other investors. Groups of these IOUs are broken into "tranches" according to the risk that the borrowers will default, and then bits of those tranches are sold off as securities. The idea is that the lender can diffuse its risk among a wide range of investors, each with a different risk preference. You want to invest in rock-solid debt? Then you buy securities from the AAA tranche. You want to take your chances, buy low with a very high chance you'll get nothing, but a chance that you'll make a killing? Then you buy into the "junk" (or sub-prime) tranche. You're an idiot and don't want to get paid back at all? I've got securities in the M.D. Fatwa tranche right here!

In an ideal world, this system is great and, according to some economists, is the reason that the last two recessions in the United States were as painless as they were. (You think they weren't? Then you are a punk and obviously can't remember the early 1980s.)

However, in the latest go around, Egan notes:

Investors in two hedge funds managed by US investment bank Bear Stearns were wiped out in June, which was surprising given that the securities in the funds were rated either AAA - the same level of safety as US Treasury bonds - or one notch lower at AA. Within a couple of months, $1.5bn of capital was lost in only two funds. This development is particularly sobering because, from the obvious indicators, the two funds were insubstantially better financial condition than most banks: they had equitymore than twice that of most banks, at 15 per cent of assets compared with only 6 per cent or 7 per cent for the majority of banks. These funds therefore met and exceeded the requirements of debt-to-equity ratios under Basel II. Additionally, the assets of the funds were rated higher than the typical bank's assets.

This event is a reminder of the weak underpinnings of the mortgage financing market. The problem is a shift in the mortgage business to a situation where all the participants have an incentive to complete the transactions; the mortgage brokers, bankers, investment banks and rating firms are paid if and only if a deal is completed.

This structure is significantly different from the markets of yore, in which a local banker would check borrowers' income and grant a loan only if there was an adequate ability to pay. Even if the banker became too aggressive, there were bank regulators to keep the business on the straight and narrow. One could argue that rating firms today are capable of assessing credit quality and halting the flow of garbage by withholding a rating. Unfortunately, in the ratings field, the tough rater is likely to be the underemployed rater. One of the major rating firms, Moody's, announced last week that it lost market share when it became less liberal than its
competitors.

Egan's point about Moody's is very good. Moody's recently noted that ever since it toughened up its standards for reviewing commercial mortgage bonds, it has been shut out of 70 percent of this market. (See Moody's Shut Out of Rating Commercial Mortgage Bonds.) Moody's is one of the biggest CRAs and if it is being ratings-shopped, it's not hard to imagine that CRAs may be becoming subject to the same types of pressures that undermined securities analysts a few years ago.

However, as cogent an argument as Egan makes, he actually undermines his point (and his own firm) in his op-ed. In particular, as Egan has consistently noted, the big CRAs are all paid by the issuers they rate. A clear conflict of interest. The big guys argue that if they didn't charge issuers, then no one would pay them since email and fax machines mean that once they issue a rating to even one person, news of that rating travels fast (and the more respected their ratings, the faster the news travels). However, Egan-Jones and other small CRAs are paid by subscribers and investors, and not by the issuers they rate. No conflict of interest, right?

But then Egan writes:

...regulators must pay better attention to incentives. If a rating firm receives 90 per cent of its compensation for ratings from sellers of securities, it is difficult to envision that the interests of investors are paramount. This issue of incentives is all the more pressing given the great difference ratings make to a bank's capitalisation requirements. Under the Basel II accords, $100 of AAA securitised assets requires a bank to hold 56 cents of equity to back up the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equity - a far more onerous proposition. (Last week Standard & Poor's cut the ratings of several securities from AAA to BBB in one day.) This greater burden of holding lower-rated assets increases pressure on ratings firms, which depend on issuers of debt for business.

Wait a minute. Sure, I get your first point -- if a CRA receives 90% of its revenue from issuers (sellers) of securities, it's hard to see how the CRA will make the interests of the investors (buyers) of these securities paramount. But then you say that, under Basel II, the greater burden investors face in holding lower-rated assets increases pressure of the CRAs to up the ratings. But aren't the banks getting screwed by a lower rating the investors you were just talking about? So who's putting the pressure on the CRAs? Sure, I can see an issuer not wanting a low rating on a debt offering, but once that debt is out there, the pressure will be coming from the banks and investors. And aren't those guys the ones paying your bills, Mr. Egan?

So who's conflicted here?