Higher Bank Capital Amounts Comment

A comment I posted on The Wall Street Journal article, "Number of the Week: Banks Should Hold More Capital" by Mark Whitehouse:

There is no contradiction. Modigliani and Miller wrote about an ideal situation with no bankruptcy (insolvency) and no taxes. It is a solid foundation to build upon and incorporate real world dynamics.

M-M did not incorporate into their research government backed deposit insurance and too big too fail government intervention. Government intervention through deposit insurance and too big to fail undoes much of Modigliani and Millers arguments. Their main arguments rely on market pricing and risk adjusted pricing of equity and debt. Government intervention, in any sector or industry including banking, interferes with risk adjusted pricing of equity and debt.

Fifty years ago, researchers realized that the addition of tax deductibility of interest expense would push firms to increase their debt levels. Similarly, the increasing risk of bankruptcy with increasing debt levels would push firms away from more debt financing. Whether the two forces offset each other or one dominates if at all is an open research question and much has been written on the topic.

Even at 52 percent capital, banks will go insolvent because banks face not only a valuation insolvency risk, debt value greater than asset value, they face liquidity and cash flow insolvency risk.

A bank with 52 percent capital can face a 'run on the bank' and if its loans and investments are illiquid, cannot be sold quickly in the market and converted into cash at face (par) value prices, it will not have adequate funds to pay withdrawals. If too many depositors withdraw their funds, the bank will face a run, and the government will step in to help with needed funds, or operate the bank, or force a takeover or close the bank and pay depositors from the insurance fund.

Banks face several different forms of insolvency risks and high capital amounts do not solve all the potential solvency problems banks face.

Regulators like capital because it is computable and measurable by a formula, easy to observe and fill in on a form, can be set at a precise level and avoids the appearance that the government acted arbitrarily against a particular bank. High capital amounts are not the end to future bank problems, and a low amount of capital amount is not the cause of bank problems.

'Skin In The Game' In The Mortgage Securitization Market Is Bad

A comment I posted on "Research: ‘Skin in the Game’ Is Good for Mortgage Market" on The Wall Street Journal Real Time Economics blog:

Mortgage providers' skin in the game does not reduce any particular borrower's chance of default. A lower credit rated borrower's risk of default is still the same. Skin in the game makes mortgage providers more cautious when lending to a lower credit rated borrower out of fear of losing their working capital to fund new mortgages. With skin in the game, lenders will turn off credit to higher risk borrowers.

Skin in the game appears to work because it denies credit to a whole class of borrowers.

The study [Mortgage-Backed Securities: How Important Is “Skin in the Game”? by Christopher M. James] cited in the article also finds that there was a higher yield to investors on mortgages with higher expected defaults. In other words, the financial markets worked and investors received a higher interest rate for higher risk. The article states:

"The final question is whether investors anticipated performance differences and therefore demanded higher yields or greater credit enhancement for MBS in which originators had less skin in the game. To address this, Demiroglu and James compare the average yield and percentage of securities issued with AAA ratings for affiliated and unaffiliated deals. Controlling for mortgage and borrower risk characteristics, they find average yields are significantly lower on securities in affiliated deals relative to securities in unaffiliated deals. In addition, affiliated deals were able to issue a relatively greater proportion of securities with AAA ratings. These results suggest that investors considered moral hazard when pricing MBS."

Skin in the game goes against many well understood macro-economic and finance principals. The capital available for mortgage lending will shrink significantly and skin in the game will act as a brake on economic activity, possibly causing recessions. The Fed will lose some of its macro-economic power to increase lending during those recessionary times because increasing the money supply will not enable banks to lend more to the housing sector since they will be constrained by a lack of available capital and funds to use for skin in the game requirements.

Skin in the game will also limit financial intuitions' institutions' abilities to diversify their asset holdings. The institutions will be required to retain mortgages and will not be able to decrease that asset class to control and diversify their lending risk. If constrained by skin in the game, the institutions will also not be able to increase that asset class to control risk. Diversification is a fundamental risk control mechanism and skin in the game limitations will create a whole host of currently unforeseen unintended consequences as financial institutions use other means to control, increasing or decreasing, the amount of their mortgage and institutional risk.

The credit rating agencies incorrectly labeled high risk MBS's (also ABS's) as low risk. The incorrectly labeled AAA securities brought in many investors who should not have invested in these securities. The undeserved AAA ratings also allowed banks to hold less capital than needed and regulatory required for the securities' risk. Dodd-Frank removed the power of a Nationally Recognized Statistical Rating Organization (NRSRO) to determine indirectly an asset's required capital level in the banking sector. Financial institutions will no longer be able to hold insufficient capital for an MBS (or ABS) and hide behind a credit rating agencies incorrect AAA analysis of a high-risk MBS security. In addition, Dodd-Frank's elimination of the NRSRO oligopoly has substantially increased the number of competitive credit rating firms.

The NRSRO changes in Dodd-Frank will force banks to increase their capital for higher risk MBS and ABS holdings. These changes will also eliminate the power of undeserved AAA ratings and naïve investors looking for only AAA ratings will no longer find themselves mistakenly holding high risk securities mislabeled as safe.

Skin in the game is a no win situation. It turns off bank credit to a whole class of borrowers. Some portion of these borrowers will turn to other sources of credit and others will go without.

Skin in the game constrains some of the Fed's macro-economic control of lending and the money supply.

Skin in the game constricts a bank's risk control and diversification ability.

Elimination of the NSRSO oligopoly and power over setting an asset's capital requirements solves many, if not most, of the problems associated with excessive high-risk MBS (ABS) securitization.

As the mentioned study shows, higher risk MBS's had higher yields than lower risk MBS's. The securitization market worked as expected and priced the risk. The credit rating agencies failed to accurately rate higher risk securitizations leading some investors to misperceive the risk of their holdings. Financial institutions failed to hold adequate capital for the higher risk MBS's due to the incorrect high credit ratings for the investment.

Dodd-Frank fixed the problems that occurred from high-risk mortgage lending securitizations through changes to NSRSO role and status. Skin in the game adds problems for institutions, borrowers and the Fed without any benefit.

Congress should modify Dodd-Frank to eliminate skin in the game requirements.

Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.