September 24, 2013 / 3:31 PM / in 4 years

COLUMN-The top five unlearned lessons of the financial crisis

By Bethany McLean

Sept 24 (Reuters) - In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks. Seriously, how many times have you read that more capital will save the banks from another Armageddon? Even the banks point to capital as a reason to have faith. “Financial institutions have also been working alongside regulators to make themselves and the financial system stronger, more transparent, more resilient and more accountable,” wrote Rob Nichols of the Financial Services Forum, which is made up of the chief executive officers of 19 big U.S. financial institutions. “Specifically, capital, which protects banks from unexpected losses, has doubled since 2009.” If you were a cynic - who, me? - you might say that the mere fact that the banks are pointing to capital is proof that capital is not all that.

Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct. On his Interfluidity blog (which I found courtesy of Naked Capitalism), Steve Waldman writes, “Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital,’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank.” In other words, even if you give bankers credit for good intentions, the accounting that would truly capture “capital” may not exist. Or as Waldman writes, “Bank capital cannot be measured.” Layer in some real world realities. The next time things get tough, will regulators once again practice forbearance and allow firms to overstate their capital, which has the perverse effect of making no one trust reported capital? Let’s not forget Lehman, which according to Lehman had a very healthy Tier 1 ratio of 10.7 percent on May 31, 2008 and a total capital ratio of 16.1 percent. This didn’t matter, because no one believed Lehman’s capital was real.

On the list of cures for the sick financial system, the concept of “risk retention” ranks right behind capital - but there are a couple of neat little twists here. The narrative of the crisis is that because mortgages could be sold off to banks, who would turn them into securities and sell those on to investors, who thought they were buying triple-A paper courtesy of the rating agencies - well, no one had any incentive to care about credit quality. In a piece in the Wall Street Journal entitled “How to Create Another Housing Crisis,” MFS Investment Management’s former chairman Robert Pozen writes, “With ‘no skin in the game,’ the originators had little incentive to determine whether the borrower was likely to default.” As a result, one provision of Dodd-Frank requires securitizers of any asset, not just mortgages, to retain 5 percent of the risk of loss. Barney Frank has said that the risk retention rules are the “most important aspect” of the legislation that bears his name.

The first twist is how risk retention became risk liberation. The housing-industrial complex went to work. Into Dodd-Frank went a provision that certain “safe” mortgages, called qualified residential mortgages, or QRMs, would be exempt from the risk retention requirement. “Safe” was left to the regulators to define. Cue more lobbying. The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement. In other words, the very asset that most people believed led to the credit crisis is also the asset that is pretty much exempt from the new rules! Classic. In the joint announcement on August 28, the regulators wrote, “The Commission acknowledges that QM does not fully address the loan underwriting features that are most likely to result in a lower risk of default. However, the agencies have considered the entire regulatory environment, including regulatory consistency and the possible effects on the housing finance market.” (That last bit is super scary.)

That said, the real twist here is that risk retention is no silver bullet. After all, firms like Countrywide, Washington Mutual, Merrill Lynch, AIG and Citigroup went under or almost went under precisely because they retained so much risk on their own balance sheets. Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.

Which leads to the next issue. So much of the safety of the financial system still depends on the Street’s ability to manage risk. But if the last years have taught us anything, it’s that risk management might be an oxymoron: Maybe risk is risk precisely because it can’t be managed. Just for the fun of it, I searched Merrill Lynch’s 2007 10K. They used the phrase “risk management” 76 times. “Subprime” was mentioned 11 times.

Next, I searched JPMorgan Chase’s 2012 10K and found 166 mentions of risk management. (Give or take - I got a bit dazed.) But while JPMorgan was busy talking about how great they were at risk management during the crisis, and while we were busy listening, the bank’s chief investment office was busy making crazy bets that ultimately cost the company more than $6 billion - bets that the CIO was valuing at different prices than the same positions were being valued in the investment bank, thereby violating a cardinal rule of Risk Management 101. And no one inside the bank seems to have noticed!

So now, JPMorgan is spending $920 million to settle civil charges brought by a host of regulators. A criminal probe is ongoing. As part of its settlement with the SEC, JPMorgan agreed that its trading losses “occurred against a backdrop of woefully deficient accounting controls” in its chief investment office; the OCC said in its consent order that the bank’s oversight “did not provide an adequate foundation to identify, understand, measure, monitor and control risk.” And according to the Wall Street Journal, JPMorgan is spending an additional $1.5 billion and committing 500 extra employees to get better at what it was supposedly already great at. “Fixing our controls issues is job No. 1,” CEO Jamie Dimon told the Journal. “This is a huge investment of people, time and money ... but it will make us stronger in the long run.” Oh, I sure do hope so. But big banks are very subversive places.

Speaking of subversive, I think that both risk management and new regulations are set up to be subverted if the incentives aren’t right, too. (Put rules, regulations and incentives in a 2 on 1 Ultimate Fighting Championship, and incentives will score a knockout every time.) Yes, there have been lots of changes to incentives after the crisis. There’s more disclosure, and firms often have “clawback” provisions, meaning that bankers who do bad things have to give the money back. (Three JPMorgan traders were hit by this.) And bankers are getting a smaller percentage of their pay in upfront cash. A chunk, which is often in the firm’s stock, is held back, or deferred.

This is all well-intentioned and I‘m trying to be optimistic. But the history of attempts to align individual compensation with a firm’s results is a case study in unintended consequences. (See stock options.) And there are warning signs about the current “fixes.” Take deferred compensation, which often means that bankers get a small part of their bonus in upfront cash, and the rest in stock, which can only be cashed out over a period of years. One problem is that for bankers to cash out their deferred stock, they often have to remain employed at the same place. One of the good things about the old system was that people moved on. Now, people are encouraged to stick around even if they’ve already checked out, thereby clogging up the system. “The inefficiency generated by the current illiquidity of people moving now can not be underestimated,” a former senior banker tells me.

While we’re on the subject of inefficiency, let’s talk about our regulatory system. In 2007, before most people realized there was a crisis brewing, Hank Paulson, then the Secretary of the Treasury, released the Blueprint for a Modernized Financial Regulatory Structure. You can dismiss this as writing reports while housing burned. Fair enough. But one of Paulson’s key ideas was to streamline the regulators, and he was right. As he later wrote about regulators in a Financial Times piece, “It is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive.” We did get rid of the worst regulator, which was the Office of Thrift Supervision. But if you think the problem has been solved, just read the Wall Street Journal’s excellent piece on the skirmishing over the Volcker Rule (which seeks to ban proprietary trading by banks). According to the Journal, Treasury department officials had to bribe staffers from other agencies like the SEC with Bojangles fried chicken to get them to make the trek across D.C. History repeats itself, first as tragedy, second as farce.

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