Securitization, Derivatives and the Wall Street Act of the House of Representatives
Carlos M. Pelaez
Clear thought on financial regulation and understanding lending by banks require analysis of the functions of banks. Providing transformation services is a critical function of banks. In the model of bank runs of Diamond and Dybvig, banks can be conceptualized as converting monitored, illiquid loans and investments into liquid fed funds. Banks deposit required regulatory reserves at the Federal Reserve Banks (FRB), lending their reserves above those required by the Fed to other banks in overnight loans of fed funds (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). Loans and investments only begin to provide cash flows in the future but require cash immediately to pay for construction, machinery, working capital, wages and the like. Banks accept deposits from the public and provide the funds to business and investors so that they can initiate their projects that provide employment in producing goods and services. Monitoring consists of evaluating the feasibility of projects, a function that banks acquire through their relations with customers and developing techniques of project evaluation. Monitoring also ensures that borrowing companies and investors do not use resources for activities riskier than those in the loans agreement, such as using a loan for buying equipment while investing instead in high-risk stocks. The banking model of Diamond and Rajan analyzes the fragility of banks by the threat of bank runs. A bank can become insolvent if the value of the assets such as loans and investments cannot honor the value of the liabilities or deposits.
Investment in production of goods and services occurs now but cash is first received months and even years in the future. Financial institutions provide the liquidity now so that production and employment can start immediately. The funds for most loans are obtained through risk transfer or securitization (Pelaez and Pelaez, Financial Regulation after the Global Recession, 48-52, Regulation of Banks and Finance, 59-60). A potential home owner requiring money to buy a house enters into a mortgage with a mortgage lender. The money does not originate in a bank or other financial institution. The mortgage originator obtains the money by bundling mortgages of similar credit, maturity and rate into a bond called mortgage-backed security (MBS) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-48). This security is sold to multiple investors including mutual funds and pension funds where many people invest their savings for emergencies and retirement. The payment of interest and principal of the MBS is obtained from the underlying mortgages. If there were not the funds to finance the mortgage, there would not be the construction and employment generated by building houses. The same is true of nearly all loans for business or consumers such as auto loans, credit cards, student loans and so on. Banks generate funds for credit by bundling loans of similar credit rating, maturity and rates in bonds known as asset-backed securities (ABS). Some of the MBS and ABS may be held for investment. A significant part of MBS and ABS are converted into immediate liquidity by means of the repo market or sale and repurchase agreements. The financial institution buys the MBS or ABS with funds obtained by selling the security in exchange for cash with a promise to repurchase it overnight or in a short period paying the interest on the loan with the MBS or ABS serving as collateral. The counterparty financing the MBS or ABS imposes a haircut or reduction in the price in the sale and repurchase contract to protect against a decline in the price of the MBS or ABS in the event that the repurchase agreement is not honored.
The engine of growth of the economy is what Joseph Schumpeter identified as waves of innovation or the application of technology to production or business organization. The world has experienced a second industrial revolution since about the 1970s characterized by new technology. Innovation requires financing for business to invest in plants and equipment and also for credit to consumers to buy the products, students to finance education and so on. The technological revolution created huge new needs of financing that were met with innovations in financial services. The role of regulation is to provide rules for orderly conduct of financial business but without frustrating innovation.
There has been significant growth of credit, interest and foreign exchange derivatives over the counter, that is, in contracts among entities, and in formal exchanges. Consider an example of a derivative used by a German exporter of $10,000 to the US at the rate of $1.3374/euro (Pelaez and Pelaez, Government Intervention in Globalization, 71-2). The exporter would receive 7,477 euros (10,000 divided by 1.3374). But the revenue could decline in a year to 6,403 euros if the dollar devalued to $1.5618/euro (10,000 divided by 1.5618). One hedge would be for the exporter to buy the euro relative to the dollar for delivery in months ahead by means of a forward exchange contract from the exporter’s bank to ensure the exchange rate for conversion of the revenue in euros of selling in the US. In contrast with futures markets for foreign exchange, the bank can tailor the forward contract to the precise needs of the exporter in terms of total value, start date and maturity.
The official interpretation of the credit/dollar crisis and global recession is that banks and financial institutions engaged in an “era of irresponsibility” by taking excessive risks in pursuit of bonuses. According to this view, banks and financial institutions require the sober tutelage of government to prevent excessive risks and the repetition of another financial crisis. The Wall Street Act approved by the House requires that “all standardized swap transactions between dealers and major swap transactions would have to be cleared and traded on an exchange or electronic platform.” A major swap participant is defined as a holder of a substantial net position in swaps, excluding hedging for commercial objectives, or creating significant exposure to counterparties requiring monitoring.
Government does not know better than banks and financial institutions how to control risks so as to prevent financial crises and recessions. Available theory is equivocal and empirical evidence mixed. The credit/dollar crisis and global recession originated in errors of economic policy. The reduction in 2003-2004 of the fed funds rate to 1 percent with the announced intention to keep it near zero as long as required eroded the discipline of calculating risk/rewards by business, households, government, banks and financial institutions (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). These low interest rates caused excessive risk taking and leverage, low liquidity and unsound credit in the expectation that central banks had mastered a technique of promoting sustained economic growth without inflation. The debacle in derivatives originated primarily in underlying nonprime mortgages that were given a seal of government approval by the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac. The announcement in September 2008 of the need of $700 billion for the withdrawal of bank “toxic” assets or the world would face a catastrophe contracted counterparty financing of MBS and ABS, paralyzing financial markets. None of the programs of withdrawing toxic assets in September 2008 and February 2009 withdrew one dollar of toxic assets. Confidence eventually returned when counterparties had the time to evaluate the soundness of assets. It is possible to conclude that the crisis would not have occurred had it not been for the wide swings of interest rates caused by the Fed.
The Wall Street Act restricts the volume of financing, increases the cost of credit, weakens banks and financial markets, and frustrates innovation precisely when financing is critical for business and consumers in the effort to increase production and create employment. There is still time to consider more sober banking and financial regulation that recognizes the need for financing and innovation together with the cooperation of government and business in promoting growth and employment. Excessive intrusion on business by regulation can reduce the volume of financing required for future prosperity. Financial regulation that is stricter than in other countries can export the financial industry outside the US as it happened with Regulation Q created by the Banking Act of 1933 in a depression rush of regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)