Root Monetary Behavior

Capitalism has always featured feedback mechanisms. They never were perfect, as nothing is going to ever be. Instead, market discipline was always a messy affair as it more often throughout history included periods of undisciplined behavior followed closely by mass exodus, crash, and then depression. Economists after 1929 thought of themselves as a replacement mechanism for self-correction.

Regulators had until the aftermath of 2008 believed macruprudential policies and the like might be substituted for what was really a survival instinct. It was widely thought authorities could regulate self-control while at the same time unleashing the worst aspects attainable without it (TBTF was an implicit doctrine long before Bear, LTCM, and many others). Afterward, however, the idea has been rethought at least in the more extreme cases.

In the mortgage market as well as for securitization as a process, it was pretty obvious that volume overflowed all other considerations. One of chief reasons for that was simple risk; mortgage originators were nothing but an initial warehouse. After selling into a securitization, the only “skin” the originator had left was the various present value calculations on the whole future history of the deal whose full gains had already been booked long before a single dollar of cash flow exchanged hands. It wasn’t really much to govern prudent action.

It seemed like such a simple fix in that respect, to require originators and more than them along the financial supply chain to keep a “skin in the game.” Common sense became regulatory rulemaking, though taking this long for various regulations that intended to achieve a much safer system.

Across Wall Street, similar symbiotic relationships have sprouted up as the market for securitized products faces new regulations requiring issuers to eat their own cooking. While each situation is a little different, the goal is typically the same: help firms that bundle consumer and corporate loans into bonds to raise the money needed to comply with the rules without forcing them to pay up themselves. And it’s all perfectly legal.

It should surprise no one that Wall Street had found workarounds long ago. In the reborn CLO market, the skin in the game has itself become securitized. The rule wasn’t even implemented until this past December, so banks and financial firms had ample time to study its finest details to map out their preferred course – even if it might conflict directly with at least the spirit of the rule.

My point in raising the issue here is not to spread the usual alarm about practices that are far too reminiscent of the middle of the last decade, though that is surely something to keep an eye on. Rather, my purpose is far more mundane and indirect, though no less significant (more so in my estimation).

Far too often “experts” take the view of regulations as some hard limitation that greatly affects financial firms (or others in respective industries) above each and every other consideration. In financials, it may be even more extreme, where especially Dodd-Frank and the like are often viewed as not just regulations but an imposed reset in root behavior. When looking for a monetary culprit for the lost decade, for the few who actually do, it has been easy to blame regulations for the distinct lack of risk-taking behavior that was once the common cause for monetary formation and exponential growth.

But, as this one experience with regulation shows, if Wall Street perceives opportunity there isn’t any rule or law that might prevent a product coming to fruition. An army of lawyers, lobbyists, and accountants still work there, and though there may be fewer of them today than ten years ago that is much more about the state of monetary business than the government’s post hoc treatment of it.

The overall shrinking of eurodollar banks has not been due to regulatory changes, though they have had clear negative effects (in terms of balance sheet capacity). Instead, what is missing is what is clear in the example provided above – opportunity. Give a bank an opportunity for serious profit and there is nothing that will stand in its way, no matter how many tens of thousands of pages might fill the Federal Register. But it has become the exception not the rule.

What changed in August 2007 was the perception of much increased risk (which regulations are but a small part) juxtaposed against a world far too devoid of opportunity; one that remains tied to liquidity preferences of all kinds (including stock repurchases) at the expense of real economic benefits. As I wrote with regard to HSBC, a pretty stark example of drastic changes in systemic conduct:

It probably could not possibly have been better said, “trying to shrink itself back to health.” That statement is apropos of so much more than HSBC… In other words, as with the Great Depression in the 1930’s, there is just no going back. You cannot recreate what was illogical now that everyone knows without question that it was. What’s holding back the global economy is that all expectations have been predicated upon going back.

If you look close enough from time to time, though, you still can find the old pre-crisis Wall Street (really Lombard Street). Banks on some level surely still want to do what they used to since that was where all the fun and money was made, but this economy, not government climate, just won’t allow it apart from what are today mere exceptions. The dearth of real opportunity is the problem, not the abundance of rulemaking.

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