An update on asymmetric information and corporate governance in bank bailouts

Last June I wrote a post on the topic of corporate governance that pointed to one of only two outcomes as the likely result of the bank bailouts. Outcome number one was bank prudence and low credit growth in the face of uncertainty. Outcome number two was a reckless heads I win, tails you lose mentality that permeated the 1980s leading to the S&L crisis. To date, we have mostly seen outcome number one, which (if you can believe it) is the thing you would like to see. But this necessarily means slow growth until the uncertainty about earnings and litigation passes.

Let me take this opportunity to update you on my thinking in the wake of the foreclosure crisis.

Regulatory forbearance means under-performance or excessive risk

What we have just witnessed over the past decade is a credit bubble in the financial sector, in the US and elsewhere. The epicentre of the bubble was housing in the US, the UK, Spain and Ireland. During the good times, no one asks any questions. In bubbles, all is well and risk appetite increases. But when the bust happens, many banks are forced into an undercapitalized position. The question for regulators is what to do about this. One could exercise regulatory forbearance, allowing the banks to earn their way out of trouble as the Japanese did. Or one could put the banks into receivership, recognize the bad assets, and move forward as the Scandinavians did. The U.S. has followed the Japanese path of bailouts, accounting changes and regulatory forbearance. And this means one of two outcomes are likely:

[Former Merrill Lynch strategist Richard] Bernstein believes that the government is attempting to keep the excess capacity in the financial sector alive. His basic point is that bubbles create overcapacity (think tech stocks). This is the case in finance. The sector must shrink. In my own, there are only two ways a sector in over-capacity can perform. They can have poor earnings (Bernstein’s first point) or they can seek heavy risk taking and reach for yield. One of these two outcomes in financial services is likely unless the sector is rationalized.

–Bernstein: What kind of recovery are we going to get?

In the 1980s, after US savings and loans were undercapitalized and regulators practiced regulatory forbearance, we got the second outcome as S&Ls loaded up on Junk Bonds in the days of the Predator’s Ball. The result was a wave of control frauds at S&Ls and eventually a wave of bank failures followed by prosecution and conviction of fraudsters.

Today, we are in a period just after the forbearance has begun as FASB relaxed accounting standards early in 2009 to allow insolvent institutions not to mark mortgage-backed securities to market. Clearly, bank insiders are more aware than we are of the discrepancy between the marks on their books and the market value of these assets. They are therefore in a better position to discern what level of prudence is necessary. This gives them more information than either we in the general public or the regulators can have. Looking forward in June 2009, I wrote about a hypothetical bank CEO Phil:

Phil was caught unawares when the credit crisis hit. His bank, where he had been CEO for a decade, had been growing prodigiously at relatively low risk according to internal risk metrics. The return on capital was top quintile. But, the financial crisis and recession had not been kind to the bank. Big Bank had taken massive credit writedowns and was forced to take on TARP money and issue FDIC insured bonds in order to demonstrate its safety as a bank. As a consequence, the share price was crushed, falling 80% peak to trough. All of Phil’s stock options were underwater.

But, the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital. In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.

There was one problem, however, and Phil knew it. You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit. The company had done a significant amount of work to get to grips with likely credit exposure. And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios. What should Phil do?

Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base.

–Asymmetric information and corporate governance in bank bailouts

Control Fraud may be the issue

Now, remember, if a bank is deeply insolvent, the temptation is to bet the farm on a high risk strategy to eliminate the insolvency during the period of forbearance. This sets tax payers up for large losses down the line. Regulators in the U.S. learned this the hard way during the S&L crisis due to the numerous control frauds that popped up in the 1980s. As a result, now bank regulators are forced by law to seize an insolvent institution using prompt corrective action – something they have failed to do. Randy Wray’s bank holiday suggestion must be motivated by this. The subtext of his writing must be a belief that some systemically important banks are deeply insolvent and that they have decided to defraud homeowners in foreclosure to keep this from coming to light. That’s my interpretation of his post "Bank Holiday is Best Solution for Epidemic of Mortgage Fraud."

My own view is that most banks must believe they can earn their way out of any undercapitalization. That means being very cautious about lending standards. Even the ones which are well-capitalized like US Bancorp are exercising caution in lending. Large banks like JPMorgan Chase have not reinstated a normal dividend despite decreasing loan loss provisions and credit write-ups. If we avoid a double dip, this is certainly the right way of seeing things.

But the fraud issue that Randy points to is a big problem. First, you have the issues that Felix Salmon has raised about putbacks, whereby investors could sue the investment banks to require them to take mortgage bonds back on to their balance sheets. There is no guarantee the suits will proceed or win. But, an overlooked facet in this is that putbacks would increase leverage at the banks which must reduce asset size. That has to constrain asset growth elsewhere – and will be a drag on the economy. Moreover, these bonds will be put back at par and there is every reason to believe, their real value is well below par given the record number of mortgage defaults in the US. This issue could be taken in stride because litigation will occur over a number of months and years and because the banks will not have to mark to market. In any event, Simon Johnson thinks we could see up to $100 billion in losses in a baseline scenario and suggests another round of stress tests and capital raising to prevent another systemic crisis.

That is worrisome enough. But then there is the robo-signer issue which is separate from the mortgage putback and bank capital issue. When talking about robo-signers, you have to mention control fraud. Bill Black, a veteran regulator of the S&L era, calls control fraud:

Frauds in which the CEO or head of state uses the entity as a "weapon." Control frauds cause greater financial losses than all other forms of property crime combined.

The problem with the robo-signing is how it increases the preponderance of evidence that fraud was endemic throughout the system. For example, the FBI warned as far back as 2004 of an epidemic of fraud during the origination of loans. So we know that lenders and borrowers were committing fraud on a grand scale. The key to connecting this to the robo-signing and control fraud is that the banks had to process the fraudulent origination documents through the entire mortgage backed security chain.

For example, the MBS originators used Clayton Holdings to sample mortgages for the mortgage bonds, uncovering upwards of 30% were problematic. The banks threw out the problem loans and proceeded forward. Yet, when banks got this high figure of problem loans, they did not test the whole loan pool to throw out all of the fraudulent mortgages as they should have. Black attests that 80% of the teaser-rate, interest-only, no-doc and NINJA loans that he saw were tested and revealed to show fraud. This is what has Black Rock and PIMCO, Fannie and Freddie, and even the NY Fed looking for put backs.

Then you have the whole foreclosure mess. I should point out that income for servicing mortgages is reduced when a homeowner is delinquent. And there is little incentive for servicers to actually modify a loan given the four sources of servicer income. Moreover, if you were a lender, you would want to resist any principal reduction you could. The key is to modify a loan’s terms so as to decrease the interest rate and cost to the borrower but not the principal. I recall Jamie Dimon saying something to this effect in an earnings conference call earlier this year. That makes foreclosure more likely.

Regarding foreclosure, the MERS issue is a legal minefield for what I would call ‘technical’ reasons. The long and short of the MERS problem has to do with who can foreclose using what specific documentation. The necessary documentation was often sloppy/missing. This is a headache but imminently fixable. Nevertheless, in the context of the robo-signing and control fraud, it is a problem because it is now apparent that "foreclosure mills" were cutting corners and creating fraudulent documents in order to foreclose on homeowners. A number of embarrassing cases have come to light in which this resulted in lenders foreclosing on the wrong property or breaking into homes in order to foreclose.

So you probably have fraud during origination, fraud during packaging, and fraud during foreclosure. That certainly gets you back to thinking about Bill Black’s control fraud definition and how to resolve this issue. My point is that most of these pieces are ‘fixable’ in isolation. But you can’t look at any of these pieces in isolation; they are all connected and given the fraud that seems to be endemic throughout, it is clear that regulators need to look at the books to determine what level of fraud actually exists. I hope they can do so as quickly and as thoroughly as possible and prosecute where necessary, so we can clear this mess once and for all. Had we opted to recognize the losses and take prompt corrective action in the first place, we wouldn’t be in this situation to begin with.