On the Brink (60 page)

The successful management of large, diversified financial institutions also demands the presence of strong, independent risk and control functions as well as compensation policies that do not promote excessive risk taking. Risk management, compliance, control, and audit functions are underappreciated and very difficult jobs that must be considered to be as important as those of the revenue-generating traders within an organization. These risk professionals must hold the upper hand in any dispute. This can only be accomplished if the organization has a culture that respects these essential jobs and demonstrates as much by offering a career track and compensation structure that attracts and keeps outstanding talent.

There is now a recognition that regulators need to work with the financial industry to set pay standards, but this can and should be done without regulators’ determining specific compensation levels. Instead, pay should be aligned with shareholder interests by ensuring that as an employee’s total compensation grows, an increasing amount of it is given out as equity that is deferred—vesting and paying out later—and subject to being clawed back under certain circumstances.

Senior executives should be prevented from selling most, if not all, of the shares they are paid; when they retire or leave, their deferred shares should be paid out on a predetermined schedule and not accelerated. It is critically important that those running financial institutions today recognize the understandable outrage about the costs that have been inflicted by the crisis on the public and the taxpayer. It is incumbent upon these executives to show real restraint in their own compensation as an example of leadership that will strengthen the culture of their firms.

Determining the future of housing policy will be among the most difficult political issues, and it will require a decision on the future of Fannie Mae and Freddie Mac. These institutions, which were at the heart of the U.S. policies that overstimulated housing in the past, cannot stay in conservatorship forever. They remain the primary source of low-cost mortgage financing in the U.S. But as the housing and mortgage markets recover, the Fed’s support for the GSEs will end, and private capital will return. Fannie and Freddie should not then be allowed to revert to their old form, crowding out private competition and putting taxpayers on the hook for failure while shareholders benefit from success.

At a minimum, the GSEs should be restructured to eliminate the systemic risk they posed. An easy way to address this is to shrink them by reducing their investment portfolios—and their huge debt loads. I also believe that their mission should be curtailed significantly to reduce the subsidy for homeownership that helped create the crisis. It is important to leave room for a robust private-sector secondary mortgage market that serves the taxpayer and homeowners equally well.

Realistically, these enormous entities won’t be allowed to simply disappear. Focusing on the function of the GSEs as mortgage credit guarantors, Congress could replace Fannie Mae and Freddie Mac with one or two private-sector entities that would purchase and securitize mortgages with a credit guarantee explicitly backed by the federal government. These entities would be privately owned but set up like public utilities and governed by a rate-setting commission that would establish a targeted rate of return. This approach would address the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure.

The stress in this case would come from mortgage originators’ looking for new ways to put risky loans into the pool to get a government-backed guarantee. In this model, safety and soundness regulation would be essential, as would be supervisory oversight to make sure that the quality of conforming loans remained high.

An obvious issue is whether such a utility approach leaves room for the private sector in the secondary mortgage market. The size of the loans subject to the government-backed guarantee, as well as the price charged for the guarantee, would determine the extent of the private sector’s role. This should frame the debate and force policy makers to determine the government’s proper role in stimulating and subsidizing housing.

There is much other work to be done. Not only must we update our woefully inadequate regulatory architecture to better deal with large, interconnected financial institutions, we must also strengthen oversight of complex financial products, reform credit rating agencies, maintain fair-value accounting, change the way money market funds are structured and sold, and reinvigorate the securitization process. Underlying all of these actions is the need for greater transparency. Complexity is the enemy of transparency—whether in financial products, organizational structures, or business models. We need regulation and capital requirements that lead to greater simplicity, standardization, and consistency.

Contrary to popular belief, credit default swaps and other derivatives provide a useful function in making the capital markets more efficient and were not the cause of the crisis. But these financial instruments do introduce embedded and hidden leverage into financial institutions’ balance sheets, complicating due diligence for counterparties and making effective supervision more difficult. The resulting opacity, which should be unacceptable even in normal markets, only intensified and magnified the crisis. This system needs to be reformed so that these innovative instruments can play their important role as mitigators, not transmitters, of risk.

Standardized credit default swaps, which make up the vast majority of CDS contracts, should be traded on a public exchange, and nonstandardized contracts should be centrally cleared, subject to more regulatory scrutiny and greater capital charges. The key to this solution is for regulators to encourage standardization, require transparency, and penalize excessive complexity with capital charges. There will still be a role for customized derivative contracts, but only accompanied by appropriate supervision and increased costs.

One of the most glaring problems to emerge from the crisis was the poor quality of the rating of debt securities provided by the three major credit rating agencies: Moody’s, Standard & Poor’s, and Fitch. All have been granted special status as Nationally Recognized Statistical Ratings Organizations (NRSROs) by the SEC.

When I came to Washington in July 2006, only nine private-sector companies in the world carried a triple-A rating. Berkshire Hathaway and AIG were the only financial institutions so rated; GE, a major industrial company with what is essentially a large embedded financial institution, also had the top rating. Today there are only five triple-A-rated companies; AIG, Berkshire Hathaway, and GE have all been downgraded (as was Toyota). Yet as recently as January 2008, there were 64,000 structured financial instruments still rated triple-A, and many others had investment-grade ratings. As the credit crisis intensified, more than 221,000 rated tranches of asset-backed securities were downgraded in 2008 alone.

The agencies are enhancing the transparency, rigor, and independence of their ratings of structured products. But in the future, financial institutions and investors need to do more of their own homework, and regulators should no longer blindly use a high credit rating as a criterion for low capital requirements.

To reduce investor and regulator laxness resulting from overreliance on a few monopoly researchers, I would like to see a further review of how to increase competition among rating agencies. In addition, banking and securities laws and regulations should be amended to remove any reference to credit ratings as criteria to be relied on by regulators or investors to assess risk and capital charges.

Some people have also blamed the use of fair-value accounting for causing or accelerating the crisis. To the contrary, I am convinced that had we not had fair-value—or as it is sometimes known, mark-to-market—accounting, the excesses in our system would have been greater and the crisis would have been even more severe. Managements, investors, and regulators would have had even less understanding of the risks embedded in an institution’s balance sheet.

We need to maintain fair-value accounting, simplify the current implementation rules, and ensure consistency of application both globally and among similar institutions. The U.S. and international accounting standards setters must be allowed to get on with this important task without being pressured to make short-term, piecemeal changes that mask honest reporting by financial institutions.

It is critical to have an accounting system that shines a light on any securities with impaired value for which there is not an active market. These difficult-to-value assets need to be identified and their valuation methodology described in a clear and open manner.

There are more than 1,100 money market mutual funds in the U.S., with $3.8 trillion in assets and an estimated 30 million–plus individual customers. This is a concentrated yet fragmented industry with the top 40 funds managing about 30 percent of the assets. These funds invest for the most part in commercial paper instruments with a top credit rating or in government or quasi-government securities. Before the crisis, investors had come to believe that they would always have liquidity and would be able to get 100 percent of their principal back, because funds would always maintain a net asset value (NAV) of at least $1.00.

In the immediate aftermath of the Lehman failure, money market mutual funds came under intense pressure. A number were on the verge of “breaking the buck.” This dramatically eroded investor confidence, causing redemption requests to soar. In turn, the money funds pulled back on their funding of the many large financial institutions that depended on them for a big portion of their liquidity needs. It was a development that we were not well equipped to address.

We stepped in to guarantee the money market funds to prevent the crisis from getting worse, but the fundamental problems in the industry’s business model remain. Many of these funds charge investors very low fees, often as little as 5 basis points—or 0.05 percent—while offering interest rates that are higher than those available on insured bank deposits or on Treasury bills. If something looks too good to be true, it almost always is. In this case, it was the money fund industry’s soft or implicit guarantee of immediate liquidity and full return of principal with a premium yield and a low fee. Many, if not most, of these funds simply did not have the financial capacity to maintain their liquidity or a 100 percent preservation of capital for their investors in the midst of the credit crisis.

This expectation of complete liquidity with no fear of loss is a problem that should be addressed. Money funds are investment products, not guaranteed accounts. For years, the SEC has tried, unsuccessfully, to address this misperception. The SEC should explore whether fund managers should move from a fixed NAV, which makes money market funds resemble insured bank accounts, to a floating NAV. The funds would still be great products and could offer attractive returns, liquidity, and very low volatility and principal risk. But, as clients saw slight variations in principal, they would have a tangible indication that they were not investing in a bank account.

The credit crisis also exposed the erosion in mortgage underwriting standards, particularly in the originate-to-distribute securitization chain. To strengthen the underwriting practices and better align the interests of all parties, sponsors of these securities should be required to keep a continuing direct economic stake in the mortgages so that they have some “skin in the game,” with exposure to any future credit losses.

As I finish this book, the G-20 has just completed another summit, in Pittsburgh, and has successfully pivoted from crisis management to macroeconomic coordination. Building on the principles and action plan for reform we established in Washington at the first G-20 summit, in November 2008, and on the results of the meeting in London in April 2009, the G-20 will now serve as the major forum at which leaders of developed and emerging markets address global financial and economic issues.

Although the preeminence of the G-20 leaders’ forum rightly gives the emerging-markets countries a greater voice, it is also clear that the strength of the relationship between the U.S. and China will be critical to the functioning of the G-20 and global cooperation. Global problems cannot be solved by the U.S. and China alone, of course, but agreement with China makes it much easier to make real progress on any major issue.

The G-20’s role in tasking and reviewing the work of the international financial bodies will be among its enduring contributions. The creation and expanded role of the Financial Stability Board (FSB), which comprises central bankers, finance ministers, and securities regulators, has been an important outgrowth of the G-20 process. The FSB will have the lead role in establishing the rules of the road for capital, liquidity, and financial products that will need to be implemented by national legislatures. And on politically sensitive matters such as compensation, the FSB has already shown an ability to develop nuanced and constructive proposals. Together with other international standards setters such as the International Organization of Securities Commissions (IOSCO), the Basel Committee, and the International Accounting Standards Board (IASB), the FSB must play a crucial role in ensuring that the G-20 reform agenda is implemented in a coordinated and cooperative way that leads to convergence rather than fragmentation. None of this takes away from the preeminent role of the U.S. in the world economy, but simply recognizes the vital fact of our interdependence.

While much progress has been made, real risks remain, including those of trade and financial protectionism. At each G-20 summit, the leaders condemn protectionism, but they do so against the backdrop of increasing political pressures at home that have resulted in a variety of measures that are inconsistent with their repeated pledges. The U.S.’s own commitment to trade liberalization remains in question. As I complete this book, no action has been taken on pending free-trade agreements, and no progress has been made on completing the World Trade Organization’s Doha round of multilateral trade talks.