Focus of New Regulation Should Be On Securitization

The election of Barack Obama as the presumptive 44th President of the United States promises to usher in an era of increased regulation of the financial markets pursuant to Obama’s platform of economic reform. So far, many commentaries on the financial crisis, including this blog, have focused on the fact that subprime and Alt-A loans were made in an economically irresponsible manner, resulting in a default rate much higher than anticipated. This would suggest that financial regulation aimed at preventing this problem from reoccurring should focus on curbing lending to those who are unlikely to be able to repay their loans.

While this may be a good idea in general, new evidence has emerged that the extent of the financial crisis is not adequately explained by a higher-than-expected default rate among subprime and Alt-A loans. This article from the Economic Times reports that while losses in the financial system from all loans (accounting for the potential snowball effect that defaults have on home prices) have amounted to $425 billion, the financial system has suffered additional losses of $945 billion on investment in securities.

The article further explains that the reason why this second category of losses has been so large is that the accounting treatment of securities is so different from that of loans. Traded securities must be valued at market prices for accounting purposes, whereas loans need not be “marked to market” and regulatory norms provide the basis for their value. It thus stands to reason that the evaporation of the mortgage-backed securities market would create a situation where these securities became essentially valueless for accounting purposes, thereby underrepresenting the true value of the securities if calculated based on the value of the loans backing them up.

A further cause of these losses, not mentioned in the Economic Times article, is the fact that many banks and other financial institutions were holding these securities on their books as reserves, which form the benchmark for how much money these banks could lend out. For every dollar in reserves held by a bank, it is allowed to lend ten dollars. Thus, when the value of the reserves shrinks by a dollar, the bank must call in ten dollars’ worth of outstanding loans (including loans made to other banks). One can then see how the sudden and complete evaporation of value of these securities would cause a spiraling liquidity crisis in the financial markets, as the money supply shrinks at an exponential rate.

Based on this evidence, Obama and legislators would be well-advised to focus their regulatory sights on the use and accounting of asset-backed securities in the financial markets, and not just on the irresponsible borrowing and lending that may have been the initial cause of this crisis.

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