ROBERT J SHILLER ROBERT POZEN CHAIRMAN OF MFS INVESTMENT MANAGEMENT ® F O R E W O R D B Y Y Y Y A A L L E U N I V E R S I T Y TOO TOO BIGBIG TOTO SAVE?SAVE? HOW TO FIX THE U.S. FINANCIAL SYSTEM Additional Praise for Too Big to Save? “Americans need to understand the fi nancial crisis shaking this country. Bob Pozen offers a great guide to inner workings gone wrong and a clear agenda for getting the system right again. Read this book and understand.” —Tom Ashbrook, Host of NPR’s On Point “Bob Pozen is among the most knowledgeable and thoughtful commentators on America’s fi nancial system today. Based on decades of practical experience and years of penetrating analysis, his book Too Big to Save? presents new ideas that should be essential reading for laymen and experts alike, especially our top policy makers.” —Jeffrey E. Garten, Juan Trippe Professor of International Finance and Trade, Yale School of Management; Former Undersecretary of Commerce, Clinton Administration “America’s fi nancial system is sorely in need of fundamental reform, and the after- math of the recent crisis represents a historic opportunity to do something about it. Too Big To Save? is full of the kind of knowledge-based common sense that only someone with Bob Pozen’s rich background of experience in the securities industry is likely to bring to today’s debate about what to do and who should do it. The country will stand a better chance of getting these reforms right if every- one pays attention to his thinking.” —Benjamin M. Friedman, William Joseph Maier Professor of Political Economy, Harvard University; Author, The Moral Consequences of Economic Growth “There will be many books written about the fi nancial crisis of 2007–2009. But if you want to read just one, read this book. Bob Pozen’s account of what went wrong and how to prevent future crises is a tour de force, clearly written for the nonexpert and powerfully argued.” —Robert E. Litan, Vice President for Research and Policy, The Kauffman Foundation; Senior Fellow, The Brookings Institution “Bob Pozen reviews some extremely complex concepts in a straightforward, easy- to-read manner for people to digest the sheer quantity of coverage about all the elements of the credit crisis. Using charts and summaries, he helps nonexperts understand what happened and gives them the tools needed to evaluate the most critical fi nancial issues.” —Peter Lynch, Former Portfolio Manager, Fidelity Magellan Fun d To my wife Liz, who has patiently endured months of obsessive writing, and from whom I have learned so much about life and love. Too Big to Save? How to Fix the U.S. Financial System Robert Pozen John Wiley & Sons, Inc. Copyright © 2010 by Robert Pozen. All rights reserved. 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HG181.P67 2010 332.10973—dc22 2009032794 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 v Contents Foreword vii Acknowledgments ix The Financial Crisis: A Parable xi Part I: The U.S. Housing Slump and the Global Financial Crisis 1 Chapter 1 The Rise and Fall of U.S. Housing Prices 7 Chapter 2 Fannie and Freddie 27 Chapter 3 Mortgage Securitization in the Private Sector 47 Chapter 4 Credit Default Swaps and Mathematical Models 69 Appendix to Chapter 4 95 Part II: Impact on Stock and Bond Markets 97 Chapter 5 Short Selling, Hedge Funds, and Leverage 101 Chapter 6 Capital Requirements at Brokers and Banks 129 Chapter 7 Impact on Short-Term Lending 153 Chapter 8 Insuring Deposits and Money Market Funds 179 vi contents Part III: Evaluating the Bailout Act of 2008 201 Chapter 9 Why and How Treasury Recapitalized So Many Banks 205 Chapter 10 Increasing Lending Volumes and Removing Toxic Assets 235 Chapter 11 Limiting Executive Compensation and Improving Boards of Directors 263 Chapter 12 Were Accounting Rules an Important Factor Contributing to the Financial Crisis? 295 Part IV: The Future of the American Financial System 319 Chapter 13 The International Implications of the Financial Crisis for the United States 321 Appendix to Chapter 13 353 Chapter 14 The New Structure of U.S. Financial Regulation 355 Notes 393 Glossary 435 About the Author 445 Index 447 vii Foreword E very time there is a major fi nancial crisis, and there have been quite a number of them in history, we fi nd that there are many who are ready to dwell on blaming people and institutions; and only very few who offer really serious and constructive new proposals for improvements in our fi nancial system that can repair the damage and reduce the impact of future crises. It is much harder to do the latter, as it requires coming to an understanding of the real origins of the crisis. The causes of the crisis are typically multiple, and understanding them requires extensive knowledge of the real nature of fi nancial arrangements as they appear at this point in history, of the laws and conventions that regulate them, and of the kinds of human failures that underlie their mis- application. Constructive solutions require also an analytical framework that allows us to use basic economic theory to evaluate government responses. Too Big to Save? provides us with just such an understanding and analytical framework. The policy proposals offered here should be taken seriously. The review of the crisis that is provided here is a pleasure to read. First, it brings together a strong list of relevant facts in connection with viii foreword an illuminating interpretation. For example, Bob documents how very low interest rates created a demand for mortgage - backed securities with high yields — which could be met due to the weak regulation of mortgage lendings and the eagerness of the credit rating agencies to hand out AAA ratings. He provides a wealth of information that can enable the reader to assess his argument. Second, Bob develops several principles for evaluating the govern- ment ’ s bailout efforts. He criticizes the Treasury ’ s peculiar reliance on pre- ferred stock as an instance of one - way capitalism — where taxpayers bear almost all the downside losses of bank failures with little upside if a trou- bled bank is rehabilitated. Ironically, federal offi cials appear to have chosen to use preferred stock rather than common stock in part because they wanted to keep the appearance of capitalism (not nationalizing the banks) more than its substance. This is a book about the real substance of our capitalist economy. He also articulates specifi c tests for justifying bailouts and then shows why many recent bailouts do not meet these tests. We need to view bail- outs in terms of our economic theory as well as we can, for only then can we have any semblance of an economic justifi cation for these last - minute measures—rule changes in the midst of the game. Third, Bob presents an integrated view of how U.S. fi nancial regu- lation should be structured in the future. He puts meat on the bones of systemic risks — with the Federal Reserve as the monitor of such risks and the functional regulators implementing remedial measures. Since government guarantees have become so broad, he argues for a different type of board of directors to help regulators monitor the fi nancial con- dition of mega banks. Of course, not everyone will agree with all his proposals since the book includes so many. This is not a book with a lengthy discus- sion of the past plus a few future - looking proposals outlined in the last few pages. It is a thoughtful account on nearly every page. It keeps its momentum going, bringing us to a position where we can really evalu- ate how we ought to proceed from here and how our fi nancial econ- omy should evolve over the coming years. — Robert J. Shiller [...]... Treasuries (e.g., one week to three months), which declined to almost 1 percent at the end of 2002 The Fed then held the short-term rate close to 1 percent until the middle of 2004 Concerned about the fragility of the economic recovery, the Fed held interest rates too low for too long Only toward the very end of 2006 did the Fed bring the short-term interest rate back to normal levels.7 To see how far the... But Greenspan again refused to utilize the Federal Reserve’s authority to restrict mortgage lending practices.14 Lending Rules :Too Little ,Too Late Gramlich’s concerns turned out to be well-founded The default rate on subprime mortgages began to climb—from 10.8 percent in 2005 to 15.6 percent by 2007 In comparison, the default rate on prime mortgages went from 2.3 percent to 2.9 percent for the same... their capital to buy houses financed with mortgages from banks or nonbank lenders At the next level, public companies outside of the financial sector as well as banks sell their stocks and bonds to institutional investors and sometimes directly to individual savers Banks and nonbank lenders also sell mortgages to specialized entities, securitizers in the diagram, which turn these mortgages into mortgage-backed... mortgage to Fannie Mae or Freddie Mac, which finances the purchase by selling bonds to investors Alternatively, the lender may sell the mortgage to a special purpose entity (SPE), a shell corporation formed by a Wall Street firm to gather mortgages into a pool An SPE raises money to buy these mortgages by selling to investors various types of bonds that are backed by (the B in MBS) the monthly payments... should take to help prevent future financial crises, we should try to find the least burdensome regulatory strategy with the best chance of resolving the most critical issues Because financial crises tend to spread across the world, in theory the international community should develop a global solution to a global problem In practice, no country is prepared to cede its sovereignty to global regulators Some... poured into unregulated hedge funds, which often took out large loans to pursue aggressive trading strategies As long as the music was playing, everyone kept dancing But when the music stopped in late 2006, all the dancers ran for the exits at the same time, crushing each other in the panic As prices of housing and mortgage-backed securities plummeted, many investors tried to sell assets to raise cash... securities (the S in MBS) As the total residential mortgage debt in the United States more than doubled from 2000–2007, so did the total amount of MBS that were sold to investors throughout the world The total residential mortgage debt in the United States skyrocketed—from approximately $5 trillion in 2000 to over $11 trillion in 2007—as U.S home prices soared In parallel, the total amount of MBS doubled... obtain cash to make The Financial Crisis: A Parable xvii more loans Loan securitization also provided investors with an easy way to diversify into securities based on payments from mortgages American and foreign investors could choose among various types of mortgagebacked securities with conservative to risky credit ratings However, when the mortgages underlying these securities began to default, losses... unfair to American taxpayers For example, after investing $45 billion of capital in Bank of America, the Treasury owns mainly the Bank’s preferred stock and only 6 percent of its voting common shares To gain the upside as well as the downside, the Treasury should own the majority (but not 100 percent) of the voting common shares of a troubled mega bank bailed out because it was deemed too big to fail... the fast pace of financial innovation and the growing complexity of transactions, regulatory officials will be hard pressed to monitor a mega bank’s activities Given the increase in moral hazard and the decline in competitive constraints, the regulators should seek help from the directors of a mega bank in holding its top executives accountable for generating consistent earnings without taking excessive . MANAGEMENT ® F O R E W O R D B Y Y Y Y A A L L E U N I V E R S I T Y TOO TOO BIGBIG TOTO SAVE? SAVE? HOW TO FIX THE U.S. FINANCIAL SYSTEM . in to the xii too big to save? excitement of upgrading to a new home, so she and John signed all the papers that Spencer slid in front of them to make