Monday, October 27, 2008

Greenspan’s Remedy for the Credit Crisis

Former Federal Reserve Chairman Alan Greenspan was grilled by a US House oversight committee about his role in creating the rules for the banking system that failed. All the bickering about who is at fault was less interesting than Greenspan’s suggested fix: “I see no choice but to require that all securitizers retain a meaningful part of the securities they issue.”

In case that didn’t make much sense to the average reader, let’s break it down. A securitizer is an organization that collects loans into a big pile and then sells fractions of this pile to others. This doesn’t mean that they sell off each loan individually. If someone buys 1% of the pile of loans, that person will own 1% of every loan in the pile.

Greenspan is suggesting that the securitizer should not be allowed to sell the whole pile of loans, but should have to keep some fraction of it. This leaves the securitizer with some meaningful fraction of every loan.

How would this help? Well, the assumption is that at least some of the securitizers knew that the loans were bad, and that they were selling bad investments to others. But, they didn’t care because they were able to sell off all of the bundled loans for an immediate profit. If the securitizer had to keep a fraction of the pile of loans, it might think twice about buying too many really bad loans.

During the bubble, there were many securitizers playing a game of hot potato. They made money by buying overpriced products and then selling them for an even higher price to a bigger fool. If all securitizers had to hold on to a fraction of the bad loans they buy, they would be pickier about which products they buy. This would severely reduce the demand for potential mortgage holders who have little hope of keeping up their payments.

Greenspan’s rule would force middlemen to take a more long-term view. Instead of making an immediate buck by passing on the hot potato to a bigger fool, the middlemen would have to make some of their money by actually collecting on loans.

4 comments:

  1. Ok, I'm no Allan Greenspan, but I don't see how that would work. Even if they are forced to hold some of their own bad assets, couldn't they just use credit default swaps or some other pseudo-insurance to hedge the risk away?

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  2. Patrick: I guess when it comes to regulation, the devil is in the details. It's true that if you're clever about it, you can effectively pay someone else to take on your portfolio's risks at unprofitable prices. So, instead of finding a greater fool to overpay for the bad assets, you underpay a greater fool to take on the risks of your bad assets. Presumably, Greenspan would have some idea of how to regulate to prevent this, but I don't know exactly how this could be done.

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  3. Like making someone accountable for their actions ever works!

    Ask anyone in prison whether that works...

    ...wait a minute..

    C8j

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  4. The credit default swap market will surely be much diminished after AIG got the stuffing knocked out of it. Banks may have to find some new way of screwing up next time. They're a creative bunch, all they need is time. :-)

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