Emerging from the vast literature generated by the recent financial crisis are two competing narratives attempting to identify the root cause of the crisis. One, emanating from the more conservative side of the political spectrum, emphasizes the role played by governmental policies encouraging and subsidizing the expansion of home ownership among middle and low income households. The other side focuses on the extent to which a free market philosophy came to dominate governmental thinking and led to deregulation and hence catastrophe. Although it will be crucial, from a policy perspective, to eventually ascertain just exactly what were the main drivers of the crisis, due to entrenched partisan and dogmatic differences, it may not be possible to do so until we have achieved some historical perspective. However, what does appear to be common to both narratives is that governmental actions, or, perhaps more precisely, their unintended consequences, were in some way heavily implicated.
Apart from anything else, what the foregoing might suggest is that governments should be cautious about its interventions in the market place. Rather than grand, sweeping reforms, the long-term effects of which governments have notoriously unable to accurately anticipate, what may be called for are more surgical, incremental reforms, which, if necessary, can be revisited and adjusted from time to time as their effects become manifest.
Nevertheless, and at the risk of setting up a straw man, the position taken by U.S. regulators in respect of the ABS market appears to be that, while the last crisis may well have occurred as a result of problems specific to the real estate sector, as no one can predict the source of the next contagion, it is best to take vigorous prophylactic measures across the board now. Accordingly, they have been widely accused of, and abused for, taking a “one-size-fits all” approach pursuant to which they have crafted rules of universal application.
This approach has attracted vociferous criticism the main line of which generally goes as follows: The financial crisis occurred as a result of poor asset quality due to the application of the originate-to-distribute model characteristic of the RMBS/CMBS sector. The other, non-mortgage-backed sectors, do not use this model and investors in these sectors experienced no spike in losses during the crisis. To apply a solution crafted to address the unique problems of the RMBS/CMBS sectors to these other sectors is both unfair and unnecessary and will lead to the suffocation of those markets.
Despite sympathy for the foregoing, I am not quite sure that it entirely responds to the regulatory position, which is not to say that that position is justified. Perhaps the issue can be better approached from a slightly different angle, one that is based on the proposition that the crisis was symptomatic of a series of faulty credit decisions which made up a chain of events, each link of which was comprised of an aggregation of credit decisions each of which in turn was characterized by a fundamental lack of prudence.
The first link was comprised of decisions made by mortgage originators who advanced loans to borrowers based, in the most extreme cases, on little or no down payment, no documentation, no proof of income and, ultimately, fraud. Whatever the ultimate root-cause of these decisions, it is clear to most, including the regulators, that what stoked them was the enormous demand for product, any product, by investors. Hence, the motivation to originate for the sole purpose of distribution. By not retaining any of the risk, by not keeping any skin in the game, the originators were incentivized to worry less (or not at all) about product quality and more (or entirely) about product quantity, knowing they could pass any losses on.
The next link was characterized by the credit decisions made by purchasers of the mortgages and the issuers of securities backed by the mortgages. The fault with these decisions lay in the lack of proper due diligence on underwriting standards being applied by originators and thus the quality of the purchased mortgages as well as a failure to adequately disclose to purchasers of the securities the problematic underwriting standards and poor asset quality. Their level of imprudence may also in large part be attributable to a belief that they could also pass any problems on to investors. (It has always been a source of some wonder to me that some of the biggest players were nevertheless caught with an enormous amount of these assets/securities when the crisis arose . I am inclined to believe that this was a result of bad timing more than anything else.)
The last link in the credit chain was inhabited by investors in MBS who failed to ensure that they understood the product in which they were investing and their true exposure to faulty underwriting standards, relying too heavily on the credit analysis provided by rating agencies which have subsequently been accused of being hired enablers rather than reliable gate-keepers.
The regulators have consistently maintained that their goals in crafting the ABS proposals were two-fold: to protect investors while at the same time recognizing the importance of maintaining the securitization industry in order not to compromise the availability of credit to consumers. They have been accused, however, of paying little more than lip service to the latter and the solutions evidenced by their proposals would seem to support this accusation.
Accordingly, they have chosen to mandate prudence at each link in the chain. First, they impose prudence on originators by requiring them to have skin-in-the-game and by devising complex and expensive mechanisms to police the accuracy of representations and warranties. Second, they impose prudence on purchasers/issuers by requiring burdensome asset level disclosure and asset reviews. Third, they attempt to impose prudence on investors by attempting to dislodge their reliance on the credit analysis provided by the rating agencies and substituting therefore requirements of doubtful utility or value such as waterfall computer programs and cash-flow certification.
It should, however, have been apparent that the crisis would never have occurred unless each link in the chain of credit decisions leading to it had been faulty. In other words, without all three levels of imprudent credit decisions there would have been no crisis and the final two links are rooted in and totally derivative of (albeit compounding) the original set of credit decisions involving the failure to apply prudent underwriting standards. What necessarily follows from this is that regulators should have been able to achieve their goal of protecting investors by causing a break in the “chain of imprudence” at any single link rather than by taking a shotgun approach which will necessarily involve extensive collateral damage.
For instance, in those sectors, such as autos and credit cards, in which there is no historical evidence of the imprudent application of less than rigorous underwriting standards, and which have historically had both corporate and structural incentives to the exercise of appropriate levels of prudence in the origination of loans, there is no justification at all for imposing further costs and burdens by the application of rules which have been specifically crafted to address a model and to correct abuses not shared by these sectors. The evil at which the rules are aimed simply did not and does not exist in these sectors. The application of these rules will create no further benefits and will entail only further costs, which should perhaps be viewed as a bright line test for regulatory overkill. Only if and when these other sectors were to evolve in the direction of the RMBS/CMBS sector would the application of similar rules to them be justifiable.
Once the issue of imprudent underwriting standards is satisfied either, in the case of autos and credit cards, by finding no evidence of the application of such imprudent standards, or, in the case of RMBS/CBMS, by application of the new rules (assuming for present purposes that such rules are adequate and effective for such purposes) the chain of imprudence will have been effectively broken and there is no justification for the imposition of further burdens down the credit chain for the same reason: they will bring no extra benefit but will entail heavy costs. This is especially true for such artificial constructs as the proposed waterfall computer program and cash-flow certification. (While it may be argued that mandating adequate disclosure (the second link in the chain) should thus be sufficient in the case of RMBS/CMBS, there may be other reasons why it is preferable to instead regulate at the origination link given the levels of malfeasance in the form of predatory lending which seem to have been all too common during the heyday of the crisis.)
Perhaps a medical analogy is the most fitting conclusion: The regulators have it within their means to neutralize the cancer by the simple excision of an identifiable tumour; but instead they seem to be insistent upon extensive radioactive and chemical therapy which, while it will certainly eliminate the tumour, may well kill the patient.