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A Call to Order

By Robert G. Wilmers

The current crisis in confidence in the financial services industry has already prompted unprecedented forms of government intervention, but which calls for more — much more — action to ensure the long-term stability of our capital markets.
Just 30 years ago, commercial banks and thrifts held 71 percent of all private, non-governmental U.S. loans, under almost total control by the Federal Reserve. The amount of credit extended by the private sector (not including banks) between then and the end of 2007 grew almost three and a half times as much as that provided by the banking system. Throughout the 1980s and 1990s, a new idea about lending took hold. Securitized credit outstanding grew nearly 50-fold from 1980 to 2000 — compared to a mere 3.7 times for commercial bank loans over the same period. Capital markets began to overtake banks as the major source of credit.
Today, the size and growth of the U.S. securitized debt market far overshadows that of bank lending. At the end of 2007, total outstanding loans at all U.S. commercial banks were $6.6 trillion. At the same date, securitized U.S. debt totaled $12.1 trillion, reaching an unprecedented level of complexity. In other words, commercial banks are extending credit for only about one-third of all loans in the United States. Debt backed by Subprime and Alt-A mortgages doubled to $1 trillion from 2003 to 2007. The securities markets also quickly became the venue of choice for those riskiest forms of credit. According to Standard & Poor’s, non-bank investors (including hedge funds) provided three-quarters of high-yield loans to U.S. corporations at the end of 2006, up from one-third at the end of 1997.   One particularly ominous development was the growth in the market for Credit Default Swaps — bets placed on the performance of various exotic derivatives and the institutions holding them. They have grown from less than $500 billion in 1998 to a staggering $45 trillion in 2007. In these and other deals, investors need not actually hold securities or loans themselves to participate in the markets for them. Nor do they have to put any money down.  Who are the players in these new markets, if not traditional banks? Investment banks are central. So too are mortgage brokerage firms, which grew in number from 9,000 in 1988 to a peak of 54,000 in 2005 — overshadowing banks in the mortgage origination business by selling debt directly to capital markets, without worry about whether the loans they initiated would perform. The number of unique, identifiable hedge funds increased from fewer than 50 in the early 1980s to 22,650 in 2007. In that same period, their assets under management grew from less than $1 billion to $2.1 trillion.
Casinos rely on easy money — and that’s just what the Federal Reserve began to provide — both during, and immediately following, the recession that began in March 2001 and was exacerbated by the events of September 11 of that year.  Indeed, the Fed lowered interest rates and kept them so low that, adjusted for inflation, the “real” fed funds rate actually remained below zero from November 2002 to April 2005 — 30 consecutive months. In other words, short-term credit was essentially free.  Rates this low resulted in thousands, indeed hundreds of thousands of homebuyers and homeowners eager to take out mortgages. Between 2001 and 2005, 31 million U.S. homes were sold, and the homeownership rate reached an all-time peak of 69 percent. At the same time individuals and institutions began chasing higher yields, and synthetic investments made it deceptively easy to produce them. New sorts of higher-risk mortgages, promising higher returns, could be packaged into highly rated securities.  The abundance of free money, intended to stimulate the economy, had the effect of constructing an artificial market where the confluence of increasing demand for housing and investors’ quest for higher yields came together. It is now obvious that many who had purchased homes in reality did not have the wherewithal to repay their mortgages. On the other hand, those investors seeking higher returns often made unsound investments that are now worth less — they are left holding the bag.  These events have resulted in an increasing reluctance on the part of commercial banks to lend to each other because of a lack of confidence in the conditions of each other’s balance sheets. Indeed, some large institutions seem to have trouble determining the quality of their own portfolios, as they drastically wrote down their balance sheets several times in short order.  Let’s also not forget the impact to the value of our dollar and the massive losses overseas investors and central banks have incurred from these events. In the United States, some are concerned that our markets are at risk of becoming uncompetitive with international markets due to excessive regulation. That risk pales in comparison to the crisis of confidence that exists in our system today. Left unresolved, this could lead some to question the merits of holding U.S. dollars as a reserve currency, ultimately leading to another source of potential disruption. How significant a role did the Federal Reserve play in the collapse that has ensued, seeing that it holds sway over a decreasing share of liquid assets? Lending has shifted so profoundly to the securities markets that the Federal Reserve even stopped reporting M3, once considered a key measure of the money supply, and publicly doubted M2 as a means to measure inflation. Reserve requirements, the system the Federal Reserve uses to influence lenders’ willingness to extend credit to each other had not changed since 1992.  As a result, some of the tools and reach of the Fed are from another era, leaving it no choice but to find new and creative ways to stem the crisis of confidence that exists in our financial system today.  While we don’t have all the details, we have to respect the Fed’s decision to assist in the takeover of Bear Stearns in an effort to avoid a potential meltdown of our financial markets. But it’s hard for the public to reconcile what will inevitably be viewed as assistance for the wealthy with the nearly 1 million homeowners presently in foreclosure proceedings and an additional 2.7 million who are delinquent on their mortgage payments. They cry out for our attention, as well.  What, then, to do? There is no quick fix. However, among the approaches that must be considered are these.
Restoring the balance of regulatory oversight between commercial banks and investment banks, in exchange for investment banks’ use of the Fed discount window. Doing so will require not just extending regulation, but bringing common sense to the regulation of traditional banks. Our last Annual Report noted that, based on a recent study, it is not unreasonable to estimate annual regulatory compliance costs for the industry’s shareholders to be in excess of $12 billion.
Establishment of a contemporary equivalent to the Depression-era government-owned Home Owners Loan Corporation to help delinquent home owners refinance their mortgages into new, more affordable ones.
Extension for Fed member banks, of its short-term financing program to include maturities of longer duration. As their regulator, the Fed has intimate knowledge as to the safety and soundness of each commercial bank. Term lending to member banks would demonstrate confidence in the balance sheets that the Fed examines and thus would restore banks’ willingness to lend to each other.
Re-examination of the appropriateness of mark-to-market accounting for balance sheet purposes, in periods of illiquid markets. The ability to reasonably determine the fair value of certain assets in times like these is, at best, severely limited — for those that previously made markets in such assets, for all practical purposes, have gone fishing.
Adjustment of the formulaic approaches to loan loss reserve requirements used by accounting policy-makers and regulators — and which has led the banking industry to enter a recession with the level of reserves close to all time lows.
Review and possibly revamp the securities rating system which has depended for its financial support on those issuing securities, rather than on those who rely on its accuracy to purchase them.

These are just some of the issues that need immediate attention. These issues, when taken together, are so complex that I strongly believe that we need a blue-ribbon commission to chart the way toward a new regulatory regime.  Individual changes, made in the absence of a comprehensive analysis, will likely fall short. It is my hope that a thoughtful approach, that revisits the structure and regulation of our financial system, will help restore confidence in the state of our markets and, consequently, re-open credit windows that have closed.

Robert Wilmers is Chairman and CEO of M&T Bank Corporation, an NYBA Director and former Chair. On June 5, he was nominated by Governor Patterson to serve as chairman of Empire State Development Corporation.

Posted on Thursday, July 03, 2008 (Archive on Wednesday, October 01, 2008)
Posted by Scott  Contributed by Scott


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