Plan to Repair U.S. Banking System Unveiled by Former Hedge Fund Manager
By Shah Gilani
Contributing Editor
Money Morning/The Money Map Report
The economic house of the United States is ready to collapse upon itself, leaving us exposed and defenseless against the next Great Depression. Bureaucratic handymen with a staple gun and a trillion-dollar roll can’t paper over holes in bank balance sheets or fill in the others created by plunging consumer spending.
It won’t work.
What is needed – and what would arrest the slide in U.S. housing prices – is a renewed general confidence in protective regulations, and tax incentives for investors to buy troubled assets and to make equity investments in banks.
Understanding just what brought the economies of the United States, as well as the rest of the world, to the brink of depression is important. But even more important is the realization that the regulations that could have prevented this have been systematically dismantled, such that none of the regulatory bodies charged with safeguarding the public, the capital markets or the systems and institutions we rely on were adequately empowered, properly managed or diligent enough to do their jobs.
Just this month, the U.S. Chamber of Commerce’s Center for Capital Markets report highlighted a number of places the recently much-maligned U.S. Securities and Exchange Commission (SEC) came up short during the crisis.
While the report is enlightening in detailing problems and in proposing practical solutions to internal operations and procedures, the study doesn’t go far enough. An extreme makeover of our economic house requires a brand new regulatory foundation.
As a 30-year veteran of Wall Street, having owned an exchange seat and a broker/dealer and having run my own hedge funds, I know a great deal about regulation; including what works and what doesn’t. Trading derivatives, stocks, futures, bonds and pooled-securities also gives me a unique perspective. The good folks follow the path, but I’ve seen plenty who look at the path and look for ways around it. Why? Because they know "thar’s gold in them thar hills."
And, in the words of Pink Floyd: "We’ve got to keep the loonies on the path."
The Four Point Regulatory Turnaround Plan
Believing that simple solutions are often the most powerful, here is a four-point plan for restoring the regulatory protections that largely shielded investors from harm, and that would rebuild needed confidence in our capital markets:
- First, throw out all the old regulatory guards; they weren’t watching the henhouse.
- Second, merge the hodgepodge of existing regulatory agencies into one body – not just for budgetary reasons, but also to make sure there is no more "regulatory arbitrage, turf wars, or cracks in the foundation.
- Third, create a performance-based "civil service" to oversee and enforce rules and regulations promulgated by a transparent management structure that includes public and private citizens.
- Fourth, and last, create a national council responsible for watching over the regulators.
In order to regulate the regulators, first create and establish "The United States Economic Council" under the federal government’s Executive branch. The Economic Council would oversee and have approval and veto power over all rules and regulations established by a new single regulatory agency, "The United States Capital Markets Commission." The U.S. Economic Council would represent the U.S. in global regulatory agreements and disputes. The U.S. Economic Council would represent the United States in global regulatory agreements and disputes and be comprised of the following members:
The United States Economic Council:
- U.S. Treasury Secretary (Chairman of the Council).
- Chairman of the U.S. Federal Reserve Board.
- President of the New York Federal Reserve Bank.
- Comptroller of the Currency.
- Chairman of the Federal Deposit Insurance Corp. (FDIC).
- Chairman of the National Association of Insurance Commissioners.
- Chairman of the U.S. Capital Markets Commission.
By forming the The United States Capital Markets Commission, the country gains a single effective regulatory body. This commission would simply consolidates the offices, personnel and resources of the U.S. Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange and Nasdaq Regulation.
Together, these organizations already employ more than 7,000 officers and staff. The Capital Markets Commission would have regional offices run by career-oriented regulatory professionals. Commission personnel holding an executive post – or a position with the ability to make or influence findings of guilt or innocence, or to levy fines or penalties – would be ineligible to be hired or compensated by any company or individual subject to commission oversight for two years subsequent to their commission employment.
The Capital Markets Commission would derive its budget from charges levied upon regulated companies, markets, transactions and licensed professionals.
The mandate of the commission would be to establish market efficiencies and opportunities enforced by rules and regulations for transparency in product creation, ratings integrity, public protection, fair and orderly markets, and systemic risk mitigation.
The Capital Markets Commission would exercise its mandates by empowering eight committees:
- A Transparency-and-Accounting Committee.
- A Products Committee.
- A Ratings Committee.
- A Licensed Persons Committee.
- A Public-Trust Committee.
- A Fair-and-Orderly Markets Committee.
- A Systemic Risk Oversight Committee.
- And an International Regulatory Coordinating Committee.
Each committee’s rules, regulations, findings and determinations would be subject to peer-committee review and comment, and publicly posted on the Commission’s website. A department that we might call the "Division of Compliance, Examination and Investigation" would act as the commission’s executive and judicial branches.
Six commissioners would govern the Capital Markets Commission. Five commissioners would be industry professionals with demonstrable records and an expertise in their respective market segments. Industry commissioners would be elected by a vote of registered individuals licensed to transact business in their markets. Industry commissioners would serve two-year terms, and their service time would be capped at two terms. These commissioners would execute their duties as unpaid public servants.
The chairman of the Capital Markets Commission would be an established-and-recognized "academic," and would be elected by a vote of the U.S. Economic Council.
The Capital Markets Commission chairman would serve a four-year term and could serve no more than three terms. The chairman’s compensation would be market-based.
The membership of The U.S. Capital Markets Commission would look like this:
The U.S. Capital Markets Commission:
- Chairman of the Capital Markets Commission.
- Equity Markets Commissioner.
- Credit Markets Commissioner.
- Commodities Markets Commissioner.
- Derivatives Markets Commissioner.
- Currency Markets Commissioner.
Unlocking the Credit Crisis
While working on a transparent-and-effective regulatory foundation, we must simultaneously address the framework of banking institutions and credit facilitation. As I noted in Money Morning earlier this month, the new bank-rescue plan outlined by U.S. Treasury Secretary Timothy F. Geithner is flawed from the outset, for it essentially relies on some of the same ingredients that caused the financial crisis in the first place – and it lacks the details that a plan must have to succeed.
The credit crisis is not simply a matter of getting banks to lend again. The actual credit-creation algorithm incorporates a greater than 50% reliance on securitization and the sale to receptive investors of pooled packages of residential and commercial mortgages, credit-card receivables, car loans, student loans, small business loans and many other pooled debts.
When investors buy these security pools, the purchase price they pay to become the recipients of the "pass-through" cash flows from the underlying borrowers, goes back to the originators of all these loans, who then have more money to make more loans. If investors aren’t willing to buy these packaged pools of consumer and institutional debts, banks and loan originators have to keep these loans on their books and set aside "reserve requirements," the result is they have less money to make future loans.
Better regulation over the creation and structure of investment products, greater efficacy in the ratings that new and old products are assigned, and more-effective protections for investors willing to buy packaged pools of debts (both old and new) is the only way to fix the securitization side of the equation.
If investors were willing to buy mortgage pools again, banks could start making mortgages to homebuyers, a change that would undoubtedly firm up falling prices,. It’s high time that U.S. banks adopted the European "covered bond" model for securitizing and selling mortgage bonds and other asset-backed pools.
With a covered bond, the bank continues to hold the underlying mortgages, but gets to sell the "pass-through" cash flow. It’s safer for investors because the underlying mortgages are "ring-fenced" on the balance sheets of issuing banks; thus, if anything happens to the bank, the mortgages actually serve as investors’ collateral. In the meantime, banks get to "borrow" cheaply by selling the cash flow, and can make more loans with the borrowed money. Under this model, banks retain skin in the game and would be far more inclined to exercise greater diligence in originating mortgages and loans.
Eight Steps to a Better Banking Plan
Fixing the banking system will be infinitely easier if banks’ securitization efforts are actually backstopped by their repaired balance sheets.
The U.S. Treasury Department and the U.S. Federal Reserve have been juggling all the pieces necessary to fix the crisis. They simply need to stop juggling the pieces separately and embrace a total solution. If the government is going to nationalize some banks, which it says it doesn’t want to do, or if it is going to buy troubled assets, which it says it wants to do, it’s going to take more money. Even then we won’t know which banks are dead or alive. There’s an easier way to manage the crisis that has the potential of being far less costly and far more efficient. To do that, the government needs to:
- Create classes of "eligible securities" that constitute troubled assets. Leave all such eligible securities on the books of existing holders.
- Create a new accounting domain where eligible securities can reside, segregating them from institutions’ healthy assets.
- Have the Fed establish and manage transparent pricing models for eligible securities based on actual cash flow measures and model specific criteria.
- Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, using the Fed’s pricing models.
- Create demand for eligible securities by offering public and private investors who buy eligible securities tax advantages on gains and losses.
- Arrange three consecutive quarterly auctions. In the first auction, give investors a five-year grace period with no capital gains tax due on any appreciation, and an indefinite loss carry forward, with no limit on yearly deductions. In the second auction, reduce the grace period to three years; and in the third auction reduce the grace period to 18 months.
- Have the Fed and Treasury determine, on a pro-rata basis, which banks’ eligible securities are sold to investors. No banks that have received bailout money, or whom the Fed, Treasury and FDIC determine are at risk after being "stress-tested," would be allowed to opt out of inventory liquidation. After the third auction, determine a liquidation or receivership outcome for remaining eligible securities holders suffering from insolvency.
- Immediately, after each auction, have the Fed disclose which banks’ troubled inventories have been reduced and by how much and allow all banks to sell equity capital to investors. Make dividends to all equity holders exempt from any tax for five years for all holders of record as of the first equity sale date; for three years for any equity holders of record on the second allowable equity sale date; and 18 months for holders of record on the third equity sale date.
By encouraging investors to shoulder the risk of banks’ troubled assets, we would forsake some potential tax revenue on the appreciation of those assets. However, we would be infinitely better off encouraging private investment as opposed to the continuing threat of nationalization and even more taxpayer money being wasted. And, if by encouraging private investment in bank equity we recapitalize our banks quickly and efficiently, wouldn’t the byproduct of stimulating credit and rewarding risk-taking investors be worth the forsaken tax receipts on dividends that otherwise would never have been possible?
There are, of course, more details to be vetted, including not allowing banks to borrow to pay dividends and making sure that reserve requirements and other stress tests are met before dividends are authorized. Additionally, there should be mutual-fund-like pools created for small investors to participate in this potentially lucrative economic fix.
And if in the process shareholders become more active and boards held to higher standards, we will be farther along on the road to recovery and prosperity than slogging it out at our current pace. It’s high time we began building a better home for ourselves, let’s start now.
[Editor's Note: Money Morning Contributing Editor Shah Gilani is a retired hedge fund manager and an internationally recognized expert on credit and financial crises that continue to sweep the globe. More than 2 million readers have perused his analyses of deregulation, problems with the debt-rating process, and the bailout and stimulus plans put forth by the Bush and Obama administrations. Indeed, just last month, in an open letter to President Barack Obama, Gilani detailed a regulatory plan that he believes would go a long way toward restoring the investor confidence that most experts say is needed if the crisis is to be brought to a close.
Gilani is also the editor of The Trigger Event Strategist, which identifies profit plays that continue to be created by "aftershocks" from the financial crisis. Uncertainty will continue to be the watchword for at least the first part of the New Year. Little wonder, as the global financial crisis continues to whipsaw the U.S. financial markets in a manner that hasn't been seen since the Great Depression. It's almost enough to make you surrender and give up the investment game forever.
But what if you knew - ahead of time - what marketplace changes to expect? Then you'd be in the driver's seat right? You'd know what to anticipate, could craft a profit strategy to follow, and could then just sit back, watching and waiting and finally profiting from the very marketplace events you anticipated.
That's just what Gilani, a nationally known expert on the U.S. credit crisis, attempts to do with the Trigger Event Strategist. He has predicted five key "aftershocks" of the financial crisis that he says will create substantial profit opportunities for investors who know just what to look for, and how to play the. In the Trigger Event Strategist, Gilani uses these "trigger events" as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, check out our latest report.]
News and Related Story Links:
- U.S. Chamber of Commerce/Center for Capital Markets Effectiveness (Report):
Examining the Efficiency and Effectiveness of the U.S. Securities and Exchange Commission (February 2009). - Whitehouse.gov:
Executive Branch. - Wikipedia:
Securitization. - Money Morning Profiting from the Aftershocks Series:
The New Banking Bailout Plan Reconstitutes Some of the Same Ingredients That Touched Off the Financial Crisis. - Money Morning Analysis:
Only Tighter Regulation Will Stem this Crisis of Confidence. - Money Morning Analysis:
How Deregulation Eviscerated the Banking Sector Safety Net and Spawned the U.S. Financial Crisis. - NASAA.org:
NASAA’s Core Principles for Regulatory Reform in Financial Services. - Money Morning News Analysis:
With Government Talking to Citi About a Larger Stake, Bank Nationalization Still Off the Table. - Money Morning News Analysis:
By Relaxing "Mark-to-Market" Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System? - Wikipedia:
Stress-Testing. - Bank for International Settlements:
The Covered Bond Model.
Comment by John Lounsbury on 25 February 2009:
Very well thought out proposal. It is aimed at quickly achieving asset value discovery, future transparency in markets and a new effective regulatory structure. I can imagine that some purists will object to interference with free markets and expanding government; I would argue that your proposals are aimed at reducing market manipulation and establishing needed government involvement.
Comment by Pat Mack on 25 February 2009:
Forget the conjecture…the banks must help those in desperate, true need of financial help. Those laid off that want to keep their homes. Not those working who just want a cut in their mortage.
Billions of dollars have put forth to help this ugly situation…put this money where it will truly help. Cover the monthly mortgage payments until the laid off person gets called back to work or finds another job…or let the laid off person refinance his/her home to an affordable monthly mortgage rate.
Comment by Phil Gloggner on 25 February 2009:
Get this to Obama, Geithner, and the rest of the Cabinet, so we can get back to consumer confidence, and prosperity.
Comment by Guillermo Melville on 25 February 2009:
Your proposals, in the long run, would damage an economy based on individual rights, where people earn money taking
risks, that has been the base structured by the Founding Fathers. The Founding Fathers also had in mind the mechanics of Chapter ll: Banckrpucies. You would eventually arrive to a system very similar to the one used in Europe, where the American dream is unobtainable and people migrate to the US or underdeveloped countries where people have better chances and opportunities for them and their families.
Your proposals would bring along more government intervention and a passive economy of burocrats that never
make good decisions and are more theory oriented and are
not practical people, something similar to the ex Soviet Union,
with it’s famous “Gossplan”. A centralized economy innundated
with “regulations to protect the people” ended with a situation that triggered the fall of the Soviet Union due to
a big shortage of basic consumer goods. (Something like
Cuba, where you can’t even buy yourself a coke ! )
The United States would not be and won’t be a prosperous country following your government burocratic propousals.
Sincerely,
Guillermo Melville
Comment by Matt Hobson on 25 February 2009:
I agree 100% with the plan presented here today, but I would take it a step further and integrate this final piece into the framework. I’m all in favor of using Government’s power to intervene in times of great turmoil to bring about much needed economic stability, but Secretary Geithner’s plan as it stands today, is nothing but a desperate scheme to save certain bondholders from insolvency. He and the President are simply throwing good money after bad. The only real solution is to restructure crippling debt and until we come to that conclusion then we may as well do nothing.
So far all of the bank bailout plans we’ve seen rely far too heavily on taxpayer dollars, and an outright refusal for insolvent banks to shed toxic assets at market prices. Until we come up with a solution that would allow mortgagees to service their debts with current income levels, then we solve absolutely nothing. The spread between debt and income is just too immense and is getting more severe by the day.
If one solution is to simply inject more cash into the system and allow banks to continue to hold toxic assets, in time we will all be right back at the same table asking for trillions more of bailout dollars. We will ask ourselves how come these consumers aren’t paying their bills—well, they don’t have the income, and furthermore the forecast for the income levels needed to service this debt is nonexistent and would potentially only be available in a hugely inflated economy. A large increase in “bailout” inflation can only come from huge government debt and further devaluation of the dollar.
In conjunction with Shah Gilani’s improved regulatory oversight we need a massive and uniform nationwide plan to write down mortgage principal amounts to affordable levels based on today’s real income data. This would give us a realistic price discovery for real estate values virtually overnight and put a floor under housing and commercial properties. It would also realign consumer debt to incomes ratios that would allow normal discretionary spending to resume quickly.
In exchange for this service, any individual, married couple, business group, etc. that takes a principal write-down has to carry with them a “future real estate appreciation” lien on their Social Security numbers. The lien would be proportioned out to anyone whose name is signed on the bottom line. At any time in the future that they sell any real estate, and there is a realized gain, then those funds would be used to pay off the outstanding real estate lien. Heck let’s even make those “pay down gains” tax-free if you want. This could even provide incentive for someone with a lien to go out and find a property, now priced correctly for the current market, fix it up and sell for appreciation gains to pay off old debts. Since financial institutions are equally culpable, they should absorb half of any mortgage principal write-downs upfront.
At the same time that we are writing down the loans to a new principal level, we should extract additional equity principal from the owner to finance upfront a term-life insurance escrow pool (assuming they don’t have cash in hand). This life insurance pool would pay for those individuals who carry an “appreciation warrant” but who might choose to never buy real estate again, and thus not have future property gains, and/or protect against those that might die before they had a chance to pay back the lien. It could also eventually pay for any final debt outstanding for some person or business that had any remaining partial unpaid lien balance. There would be no need for medical underwriting, as we could reasonably assume that this population would be a good cross-section of society and any individual lien should not be “too large.” The insurance is strictly only for lien payoffs.
The final part of this idea solves two huge problems (as Gilani points out that securitization is necessary) that we are currently faced with under any current proposals on the table. I suggest we could take these “real estate appreciation liens,” package them up, securitize them and sell them off to private (perhaps some public money if needed) investors. Government is the only entity that could bring back all the scattered pieces of securitized mortgages now in the marketplace back together to allow this to happen.
Bond holders of these units are virtually assured that they will be paid back, as we have now reset real estate levels to a new, sustainable level. We can’t predict the future, but I’m pretty certain that if we reset our real estate values to sane levels today, then we should have normal appreciation going forward. In the event that real estate goes negative or sideways for a very long time, well, at least all lien designees have a life insurance policy against this debt that would ultimately pay off. A bit morbid and perhaps draconian, but true. In the meantime cash flows go to into a pooled fund that pays out a proportional amount relative to the original new bonds sold.
I believe that this repackaged debt to be sold by the current holders of mortgages (banks and others) would generate a far higher price than “fire selling current toxic debt.” While the greedy vultures sitting on the sidelines ready to pounce and become wealthy with the help of taxpayers might be very disappointed, I think these new bonds might easily sell for $0.80 on the dollar or even higher. The currently compromised (insolvent) banks would be freed up of a large percentage of bad debt, generate large new cash amounts from the sale of the bonds and keep cash flow coming from the newly established mortgage levels of existing mortgage holders. Little or no taxpayer cash involved!
Those whom might cry, “I played by the rules, but got screwed anyway” might be stroked by getting a one-time bonus for good behavior. Perhaps those whom hold a mortgage and never takes a write-down could get a tax write-off in any given year of their choice. Find something, even if it is a token gesture, to assuage their rightful anger.
The basic question that has to be answered is, “Who is going to pay for the losses and get our economy moving again?” We obviously have lots of villains we could point fingers toward, but at the end of the day folks who put their name on the dotted line and the risk crazy bankers should be responsible for the bulk of the payoff.
The level of trust that we have in our government and our institutions is at a major low point in our history. We need a workable plan to rise to the challenge we face—to bring the power of our systems back to the people. If Congress and the president don’t succeed, I’m afraid an entire generation, or more, of voters and taxpayers will be disenfranchised, and that will weaken our country further for years to come.
Comment by A. Pearsall on 25 February 2009:
Look, this is a great plan, thoughtful and carefully worked out, just as I would expect from Shah Gilani–but it’s a pity if only us schmoes who read this blog (no offense to any of us schmoes or to the bloggers!) will ever see it. Hopefully Mr. Gilani or his associates know someone, or know someone who knows someone else, who can actually take a list of suggestions like this and put them into play where the decisions are actually made!
Comment by conor lawson on 25 February 2009:
Would it be a solution if the U.S Gov. was to issue, say 10 year Zero Coupon Bonds in exchange for the toxic assets of the banks. The banks would have to hold Bonds until maturity and would of course not be tradable and thus would not have to be “marked to market”. The toxic assets would be put into a ” Bad Bank” and could be worked out during the 10 yr. period of the Zero Coupon Bonds. The gov. would not have to pay out any funds until the Zero Coupon Bonds matured and the banks would accrue the income on the Zero Coupon Bond over the 10 years. With their Balance Sheets cleaned up the banks would be able to attract funds and deposits and thus build up their balance Sheets again. Give that the “Bad Bank” toxic assets could be worked on over a 10 year period there is a chance that the economy could have recovered somewhat, and as a result some portion of the toxic assets will have come good and thus be available to pay down the 10 year Zero Coupon Bonds
Comment by conor lawson on 26 February 2009:
Hi Shah,
Could the U.S Gov. issue say 10 year Zero Coupon Bonds for the Toxic assets in the banks which would be put into a “Bad Bank”. The banks would not be able to trade the bonds, so the would not have to “mark to market” but would accrue the income in the normal way. The government would not actually have to part with any tax payers cash and would have a 10 year period to work out the toxic assets in the Bad Banks. Hopefully during the ensuing 10 years the economy will recover and lead to some of the toxic assets coming good. The funds in the “Bad Bank” when recovered could be used to part pay down the 10 year Zero Coupon Bonds at maturity.
Given that the banks would be rid of their “Toxic Assets” they would be in a better position to start building their balance sheets and be in a position to attract deposits and business once again.
Comment by chris erickson on 26 February 2009:
I agree as to the basics ; but what should have been done from the outset & still should be is to take all the existing loans I don’t care if it is for a $100 K or $1 mil convert them to a fixed rate of 4% , keep the rate this low for about 2 years till the market sorts it self out the let it float; this would most likely stop all if not most of the foreclosures , 2nd
any company that out sources , ships their jobs/ production over seas should be taxed at a higher rate & give those that do provide jods here & tax break … raise the Federal gas tax
to a dollar a gal , also raise the achaol tax which hasn’t been done in how many years …
Comment by Ken Davies on 26 February 2009:
Why should the government adopt regulatory measures to “firm up” house prices? If house prices fall to affordable levels in line with the long-term ratio of price to income, people will be able to buy houses. They will be able to put aside a regular sum from their income in what is called a “savings account” (they still have this in many other countries). This builds into a sizeable deposit, then the buyer makes his/her purchase and the regular sum becomes the monthly mortgage payment. No need for foreclosure.
Comment by Rod Williams on 2 March 2009:
Efficient regulation is to be applauded. However it does not address the primary problem of an industry of paper shufflers who, in the main, have a negative contribution to the world economy. What % of activity is directed at primary versus secondary investments? The investing of funds “in funds” sets up the market for a misallocation of capital and develops a casino mentality especially when short term returns are the mantra. Direct investment at real R&D, production and services and maybe the economy can revive. “Gamblers ruin” maybe a concept worth understanding.
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