 NS: Would you say that in this situation the government has no choice, it has to take an active role? JC: Yes. In fact, I think the government is being about as restrained as it can be. If you look at the actual bailout legislation, the warrant the government gets as compensation for bailing out financial institutions is a warrant that entitles the government to nonvoting shares. The government isn’t going to have voting control in the normal sense. At AIG, where the government owns nearly 80%, the government will appoint trustees who are experts in the field. The government won’t be actively managing. But as a creditor, the government may need to be able to force a change in management and to have some protection against golden parachutes. I doubt that we will see the government actively trying to manage the day-to-day decision making of financial institutions. Still, if the government does buy direct equity stakes in the major banks in order to avert their failure, it should at the least have the right when it disposes of its stake to sell voting common stock to others; that would increase its return and have an appropriate disciplinary effect. NS: So how will all of this impact the future of how these institutions do business? JC: I think the government is going to have to insist on reductions in leverage. When Goldman Sachs and Morgan Stanley switched under pressure from the Federal Reserve to become bank holding companies, they knew that they were entering a system in which the Federal Reserve would be likely to require a reduction in their leverage. At the time they converted, I think Morgan Stanley had a debt to ratio of 34 to 1, very different from the 12 to 1 ratio under the original net capital rule. Back in 2004, when the SEC gave the investment banks an alternative rule that permitted greater leverage, they quickly exploited it—moving to a 40-1 ratio in the case of Merrill Lynch. With that more leveraged capital structure, they became more exposed to an economic turndown. NS: What about determining the fair value of the assets? How can or should fair value be determined in light of the upheaval in the industry? JC: In the bailout bill, Congress specifically directed the SEC to reconsider the fair value rules. Now that does alarms me because Congress has no more legitimate role in legislating accounting rules than it has in modifying or repealing the law of gravity. Both are attempts at objective representation of reality. When Congress gets involved in these areas, things usually become more opaque. Still, there is a real problem with Basel II style mark-to-market accounting in that it is pro-cyclical. Ideally, in regulating financial institutions, you should generally adopt a counter-cyclical policy which makes the institution more able to survive downturns. What you ideally want is to have the institutions, in effect, generate some fat during the boom years and then be able to live off that fat during the lean years. That’s a counter-cyclical policy. Basel II does the reverse. Hopefully, the SEC and FASB can find some compromise. NS: You mentioned the Treasury Blueprint that can help de-Balkanize regulations. What other changes would you propose in terms of regulations? JC: Once, commercial banks were more closely regulated than other financial institutions because they had depositors. What we have really learned from this crisis is that the greater destabilizing prospect is not that the depositors will lose money (because they actually get FDIC insurance), but that counterparties could be left naked and exposed. That is more likely to cause the much feared cascade of falling dominoes. So, in the new world of over-the-counter derivatives, we must recognize that financial institutions are less too big to fail than they are too entangled to fail, because the failure of one doesn’t stand alone. It is likely to cause the failure of others. Given these chain-linked connections, there has to be common regulatory oversight, probably through the Federal Reserve. Also, the Federal Reserve simply has to force a common clearinghouse on the over-the-counter derivatives market. NS: I think we are going to be faced with a regulatory nightmare. JC: I think we have one core problem here. We should be most concerned about financial institutions becoming so leveraged that they are likely to fail again the next time the business cycle turns down. This rush to high leverage is the product of an executive compensation system that makes CEOs focus on the short run and stock market pressure. For the future, we can’t only regulate the commercial banks on the outdated rationale that they have depositors; we need to regulate the capital of other major financial institutions, or at least their leverage ratios, because they can destabilize our financial system through damage to counterparties. Beyond leverage, we have to recognize that there are classes of instruments, most notably credit default swaps, that just can’t continue to be exempt from adult supervision. NS: Any other comments you’d like to make? JC: I’d like to close with a few mixed words about the SEC. I have the greatest respect for the SEC as an agency committed to disclosure, consumer protection and anti-fraud enforcement, but the SEC did fail. It wasn’t just that it failed over the last six months since Bear Stearns. Reviewing the SEC Inspector General’s report on Bear Stearns, I note that it shows that Bear Stearns was at all times in compliance with the alternative net capital rule. Because Bear Stearns did not violate that rule, it was the rule, itself, that failed. This suggests that, while the SEC is good at disclosure, consumer protection and anti-fraud enforcement, it has been less successful as a supervisor of capital adequacy or safety and soundness. You have to recognize that the comparative advantage there belongs with institutions like the Federal Reserve. Page: 2 of 2 pages for this article < 1 2
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