FinReg for dummies: the ratings agencies

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[Image source: Tom Toles at Washington Post]

Well, seeing as how the Senate has passed the financial regulation bill, I’ll have to have to continue the FinReg for Dummies series in the context of the bill as it exists.  It won’t change too much, but I guess it means I have to get to it.  Next stop: the ratings agencies.

Ratings agencies are private companies that are credentialed by the federal government to rate the risk of financial investments, such as stocks, bonds and derivatives.  The three major ones are Standard and Poor’s, Moody’s and Fitch.

There are two primary reasons ratings agencies exist.  First, they allow investors who don’t have time to investigate the risk of an investment to have a standardized rating to work off of.  Second, they allow for the establishment of minimum standards to be applied to certain activities.  For example, banks are allowed to take on more debt if they hold a proportionate amount of AAA-rated securities.  Another important example is that more conservative investors, such as pension funds, are legally prohibited from investing in assets that haven’t received a minimum acceptable rating.

There is an argument to be made that the existence of ratings agencies is fundamentally problematic.  If banks and investors do not have to do their own due diligence, then they cannot never truly understand risk of their investments.  And this is exactly what happened.  Banks took any investment that was shrink-wrapped and stamped with a AAA rating, and were thus able to do it with borrowed capital.  It was many of these AAA rated securities, which are supposed to be as safe as U.S. treasury notes, that went sour and caused some banks to collapse.

Thus the role that the ratings agencies played in the financial crisis cannot be understated.  Since investors could not assess the risk of every single mortgage issued, they were packaged together into securities whose overall risk was supposed to be analyzed by the ratings agencies.  So how did we get to a point where investments that were obviously risky – i.e. mortgages given to people who couldn’t afford them – were getting blessed with the highest ratings?

The answer is two-fold.  The first answer is related to the statements you hear about how mortgages were sliced-and-diced into a million pieces.  Here’s how it works: a group of mortgages gets packaged together into a single investment, with the stream of interest payments paying out to the investors.  Within the investment, the mortgages are broken into three risk groups, called tranches.  The least risky investments received AAA ratings, which helped to conceal some of the risk found in the lower tranches.

But the ratings agencies should have seen which assets were being dominated by riskier mortgages, which brings us to the second reason they failed.  The ratings agencies were set up in a fundamental conflict of interest.  They were paid by banks issuing the investments, and the banks were free to shop around for different ratings from different agencies.  Ezra clarifies the absurdity of this:

Imagine a school with three teachers. But this isn’t a public school. It’s a private school testing out an innovative new funding system: The kids write the tests, fill them out and then pay the teachers to grade them. If they don’t like the grade they get, they don’t have to go back to that teacher.

You can imagine how this plays out.  If a bank doesn’t like the rating it gets from one agency, it just moves on to the next until it finds the one that gives it an acceptable rating.  The agencies thus had a profit-driven incentive to rate investments higher.  This reality was confirmed by internal documents at Standard & Poor’s that discussed revising their ratings in response to the threat of losing business.  Crisis seeds planted.

Thanks in large part to Al Franken, the financial regulation bill attempts to fix this.  Instead of letting banks shop around for ratings, the SEC will now randomly appoint approved ratings agencies to rating assignments.  They will still be paid by the bank, but there is no longer an incentive to inflate ratings to get business.  Instead, as Edmund Andrews explains, they now have an incentive to compete on the accuracy of their ratings.

What a concept.

Posted on May 21st 2010 in news

FinReg for Dummies: derivatives

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If I hear the term ‘complex financial instrument’ without any further elaboration one more time, I am liable to throw something at the television. I wish that I could use my Wii remote to launch tomatoes at news anchors who seem to believe their motto is, “We report. You go look it up.”

How can we possibly think we stand a chance of adequately regulating the financial sector when no one can even explain exactly what it is we are regulating?

The most blatant example of things-we-should-fear-but-need-not-understand is derivatives. Given the scarcity of descriptions that go beyond, “they’re complex,” I imagine you’d be hard-pressed to find one non-banker that can explain them.  Yet they are central to this regulation, so let’s try to break it down.  Deep breath…

A derivative, at its most basic level, is a financial instrument that derives its value from another asset, hence the name. There are various types of derivatives – options, swaps, futures, etc. – but they all share this common trait; they cannot exist without the presence of some other underlying asset.

In contrast to what Congressional theatre would have you believe, derivatives are fundamentally valuable to the process of mitigating risk. The easiest way to explain this is through commodity futures, a type of derivative that allows someone to buy something tomorrow, at a price determined today.  Many businesses could not survive without these arrangements.

Take orange juice futures, with oranges being the underlying commodity.  If you are an orange juice producer, the sustainability of your business is highly susceptible to the price of oranges.  So if you are worried that Florida might have some of the coldest temperatures on record, as it did this past winter, you might be willing to pay a fee lock in a price, just in case.  Because if the frost settles, and the orange crop yield is cut in half, prices will go through the roof.  Your gross profit margin will drop and you may fail to recover all of those fixed operating costs.  Without a degree of certainty, no OJ producer would make the investments necessary to get from harvest to glass.

Orange juice producers thus use orange futures to protect against the uncertainty of the weather.  All the other derivatives, no matter how complicated, are similarly used as protections against uncertainty in the underlying assets.  CEOs are paid in stock options because shareholders are not certain management will increase the value of the underlying stock.  Businesses that invest in other countries use currency swaps to protect against uncertainty in the value of the underlying foreign currencies.  Banks use interest rate swaps to protect against fluctuations in underlying interest rates.

But if derivatives are so important to the process of mitigating risks, why are they most often associated with speculation?  The fact of the matter is that for derivatives to do their job of mitigating risk, someone has to take the other side of the bet.  Our orange juice producer cannot protect against his uncertainty without someone on the other side willing to bet that it will be a perfectly normal winter.  It’s all speculation, but one person’s nay-saying is another person’s insurance.

As you likely have heard, credit default swaps were at the center of the financial crisis.  They are very similar to insurance, in that they pay out to the buyer in the event of a negative outcome.  Their good side is that they allow lenders to insure themselves against the default of their borrowers, but again, the counterparty tends to put us on edge.  Whoever takes the other side of that bet is essentially speculating that the borrower will default.

But when we talk about regulation, the issue is not the speculation, it is transparency.  Most derivatives are not traded on public exchanges, but instead are traded “over-the-counter“.  What this means is that no one aside from the two parties involved in the trade know the terms of the trade, which is where we ran into problems in the financial crisis.  In the absence of the transparency seen on public exchanges, no one understood who was exposed to who or how a domino effect of defaults could tear through the economy.

This is why getting derivatives regulated on exchanges is so important, because it could actually help stave off crises by bringing all the relevant information to light and allowing for some insight on future risk.  One of my finance professors used to say, when vacationing in Florida, he would take changes in the price of orange juice futures over the weatherman’s forecast any day.  Sure enough, orange juice futures shot up in the days leading up to those unusually cold days in Florida.

The argument that has been made is that, if more derivatives had been openly traded, we would have had a much greater understanding of the risks facing the housing market.  If Paulson’s bets against the housing market (the ones at the center of the Goldman Sachs fraud case), had been more transparent, other investors would have picked up on his insights.  As more and more followed suit, investors would have become much more skeptical of the housing boom.

In Congress, both sides of the aisle seem far too ideological on the topic.  Democrats would love to limit derivatives trading, but that ignores the value they hold for individual businesses as well as their potential to foreshadow risks.  Meanwhile, Republicans pretty much don’t want to allow any regulation of anything, and have been particularly protective of derivatives, likely because over-the-counter currently earns their supporters higher fees.

The central plan of the bill is to get all derivatives onto regulated exchanged, and all trades to go through a central clearinghouse to assure investors have enough capital to cover their bets.  To me, that sounds good.  Any efforts to reach beyond that will limit the benefits derivatives offer.  Any efforts to keep certain derivatives off these exchanges will increase the risks of limited information.

I find that I like my financial sector like I like my democracy: all-inclusive, because more information is better.  The more trades that pass through a central clearinghouse, the more we are able to deal with problems of uncertainty.

Perhaps there’s a derivative for that.

Posted on May 15th 2010 in news

Financial Regulation for Dummies

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I consider myself of a former finance dummy.  I studied social sciences in college and worked in non-profit.  I had no clue about how financial markets worked until I enrolled in business school and started taking courses in the unknown, mostly out of curiosity.  After two years of coursework, I now feel like I have at least a proper foundation to start thinking about how the world of finance should be regulated.

But the scary reality is that most of the people charged with writing the financial regulation bill never bothered to take the class.  When Senator Levin went on his public tirade against Goldman Sachs, it was clear that he didn’t understand the difference between trading and making markets.  Yet the public and Congress are clearly moved by these theatrics – shortly after the Senate hearing, the financial regulation bill began moving forward, all of a sudden buoyed by that ever-elusive relic, bipartisanship.

Regulating finance is enormously difficult because it’s never about individual actors.  Sure, there is the occasional Bernie Madoff and Fabulous Fab Tourre, but they don’t bring down entire markets.  These are serious collective action issues, which makes them all the more difficult to regulate.  Imagine if the government tried to regulate trending topics on Twitter.  Though I would welcome it, I really doubt they could find a way to stop those damn Justin Bieber tweets.

I worry, because no regulation founded on fundamental misunderstandings can ever be effective.  So I will attempt to do my part, with a brief series to explain what I think are the most important elements of financial reform: derivatives, the ratings agency, the resolution trust authority, and the consumer financial protection agency.  As someone with no ties to Wall Street, I only hope to demystify these things in a way that both recognizes the risks involved as well as some of their benefits.

so stick around.  derivatives are up first…

Posted on May 13th 2010 in news

Small enough to matter

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[Image source: Grassroots Economic Organizing]

A familiar seed grows amidst the ‘too big to fail’ trees in our financial forest:

After months of anticipation, the East River Development Alliance (ERDA), a non-profit organization established in 2004 to help public housing residents by expanding their economic opportunities, [has] finally opened its Federal Credit Union (FCU) – the first to be chartered in New York City in 10 years.

According to ERDA, three out of 10 people in the Ravenswood, Queensbridge, Astoria and Woodside Houses – which will be served by the new credit union – currently lack bank accounts.  [The credit union] will help change that, ERDA says, by providing public housing residents with a means to build capital, manage their money and achieve their financial goals. Proponents also believe the FCU’s presence will spark economic development in the area.

A credit union is a cooperative financial institutions that is owned and controlled by its members and operated for the purposes of promoting thrift, providing credit at reasonable rates, and providing other financial services to its members.  I call them familiar because they’ve existed for quite some time – the first credit union in the U.S. was founded in 1909 and they’ve been under federal supervision since 1934, backed by the full faith and credit of the FDIC.

The ERDA credit union launch ties in quite nicely with my recent thoughts on microfinance, particularly with respect to its lack of freshness. Here is a centuries-old system of community-based finance, owned by its depositors – sounds an awful lot like a Grameen Bank.  Yet for all the fanfare that has surrounded microfinance, people often overlook the credit union as a tested tool for financial reform in this country.  ERDA’s is the first credit union chartered under the Obama administration, and the first established in New York City in over 10 years.

So props to ERDA for reminding us of the tools we have!  As we contemplate how to regulate institutions that are too big to fail, it’s quite reassuring to know that we might also promote those that are small enough to matter.

* on a related note, check out Raghuram Rajan’s radically provocative thoughts on why deposit insurance should only exist for community-based financial institutions, via Ezra.  It’ll make you go ‘hmmm.’

Posted on April 29th 2010 in news, OrgWatch

On Microfinance

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I worked for a microfinance organization, so it’s a little strange that I have not come around to talking about it yet, but a recent New York Times article touched on all of issues surrounding microfinance that I have been pondering.  So I guess its time for me to confront my opinions.

Microfinance has been hailed by Muhammad Yunus and many others as the elusive formula to improving the lot of the world’s poor.  It is thought that providing small loans to poor people will allow them to pull themselves out of poverty by virtue of no longer having working capital constraints on their entrepreneurial ventures.

One must first consider that lending to poor people is not, in and of itself, a novel idea.  People with capital have always been there to lend it to those who don’t have access to it, and to take profits off the top.  We called these people loan sharks, and have long stigmatized them in film.  They sit in dimly lit rooms and finance a protagonist at a time of desperation. Later, when the loan goes sour, they use violent methods of collection.

There are certainly these sorts of loan sharks out there, but that is not the whole story.  Some are just moneylenders, respected members of their communities, attempting to fill a capital gap because banks, the “formal” arbiters of small business finance, refused to lend in these communities.  The banks considered it too costly to reach these borrowers, and the interest to be earned off of their small balances, has not traditionally been worth the effort.

Enter microfinance.  It has always been an attempt to “formalize” the practice of small-scale lending, to provide safe and affordable access to capital to the segments of society forced to rely on predatory lenders.  And formalize they did.  MFIs simply institutionalized the practice of community lending that existed, which is why many people remain so skeptical.  The interest rates still appear predatory and there are still rumors of abusive collection practices.

The question of whether or not small loans, in and of themselves, can eradicate poverty is hotly debated.  After much internal debate, I have come to the conclusion that, financially speaking, it is simply not feasible.  Even the cheapest microfinance organization is lending at well above 20% APR and thus for this sort of small-scale entrepreneurship to be sustainable, microborrowers would have to be earning above that.  Now, imagine what Compartamos borrowers would have to earn.

But not even the largest, most efficient corporations in the world are capable of consistently earning returns like that – the market average is, at best, 10%.  If it were indeed the case that microentrepreneurs could consistently earn 30-130% on borrowed capital, we’d all be hawking handmade goods on the street and selling fish out of the back our cars, and you can be damn sure that banks would be lending to us.  This is why the interest rate question is so important, because if you can’t earn above the cost of borrowing, the only options are then deeper indebtedness (i.e. more microlending) or bankruptcy.

But I am still a huge proponent of microfinance.

The way I see it, microfinance is the stepping stone between the bottom of the pyramid and the true engine of wealth building, savings.  Microfinance has introduced millions to formal financial services, and as MFIs struggling to become self-sufficient have turned to collecting deposits, they are introducing people to the real consumer benefits of banking, saving.

In the future, we will see that MFIs simply laid down the distribution channels, proving that the poor demanded financial services and that they could be reached affordably – that was the true innovation. And as mobile technology and other innovations bring down the cost of banking to the poor, the logical conclusion of the story, like it or not, will be the transformation or consolidation of MFIs into the traditional banks.  MFIs may survive as full-time distributors, selling loans and receivables between banks and borrowers, but the net effect will be the same, JP Morgan and co. trolling around the bottom of the pyramid.

The reason this scares people is that they think banks will profiteer off of the poor.  But one should remember that banks are heavily regulated with respect to the interest rates they can charge; the same cannot be said for all MFIs, especially non-profit ones.  If there is any reason that banks and MFIs can get away with charging exhorbitant interest rates, it is because the local usury laws permit it.

This is not a question of greed and profit margins.  It is a question of democracy, the will of the people and the rule of law.  It is about what interest rates we as a society are willing to accept.

At the end of the day, if we get the laws right, we will have expanded access to financial services to all corners of the globe, with regulated lending and the opportunity to save open to all.

And isn’t that what we truly want?  Because think about it: if the end of this story is not about savings, are we not just creating another generation of debt-addicted citizens?  Are we not just blowing up another lending bubble?

[The caveat of all this, of course, is financial literacy and how  well we educate ourselves on the responsible use of financial services.  This is not limited to the poor.  It should be a mandated part of high school curriculum for all]

Posted on April 14th 2010 in ideas, news

Miami and Vegas Sucker Punch Smart Growth

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Smart growth has simple concepts at its core.  The primary principle is that it is more efficient and environmentally friendly to have development patterns that are 1) mixed-use, 2) compact and 3) connected.  With those elements, transit functions efficiently, people can walk places, and development has a lighter impact on the natural environment.

The smart growth movement got a huge boost from the development boom, but the real estate bust has been especially hard on smart growth.  Even though people liked smart growth developments, our society has started to revert back to supporting suburban sprawl over smart growth because of the financial instruments that are available, or rather that are no longer available, to finance smart growth.

What happened?

Huge speculative condominium projects in places like Miami and Vegas went down in flames when the real estate bust hit.  Bankers and investors lost their shirts on these condo projects.  Large numbers of these condos went into default.  As a result, secondary underwriters, mainly Fannie Mae and Freddie Mac, changed their underwriting rules so that no buyer, no matter how qualified, could get a loan to buy a condo if the condo project did not have at least 70% sold to owner occupants (this rule is still in place).   Because most condo projects have more than 30% renters, it is now very difficult for someone to get a loan to buy a condo.

This over-tightening of credit to potential buyers of condos drastically reduced the pool of potential condo buyers, and simple supply and demand economics kicked in – demand was cut and prices went down.  And since condo prices dropped faster than the market on average, people have been further disincentivized from buying condos and prices have become even more depressed.  This negative feedback cycle has made developers and investors more reluctant to build mixed-use buildings and condo buildings in the future.

Without the ability to build condos, it will be nearly impossible to build dense, mixed-use projects.  This is a huge impediment to making meaningful progress in creating smart growth developments and tackling climate change.

Posted on February 12th 2010 in news
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