Banking, Opacity and Financial Securities

Earlier this month, MaxedOutMama and I debated whether the repeal of the Glass-Steagall Act of 1933 contributed to the current financial crisis and whether its return would help prevent another. Under G-S, commercial and investment banking were separated; the 1999 Gramm-Leach-Bliley Act allowed companies (and affiliates) to do both (subject to some limits).

At last take, M_O_M (to some extent) and I agree that the economy became too dependent on financial sector profits (and capital gains) instead of income (or GDP, which is the same thing). I see less need to re-impose line-of-business restrictions on investment banks or insurance companies--not, in theory, insured by the government--though the fact that we bailed out some IBs and insurers because of the risk to counterparties worries M_O_M (due to the potential moral hazard). But, I conceded that the existence of taxpayer-guaranteed deposit insurance make the risk-taking--and thus scope of activities--of commercial banks (and CB affiliates) a legitimate regulatory concern. And M_O_M sometimes seems to say that risk taking, in the age of modern securitized paper, is difficult to value or insure--though it should have spread, and thus minimized, the risk.

I'm not smart enough to be certain on the last point. But I read someone who is: Peruvian economist Hernando De Soto, who someday will win an Economics Nobel; he addressed the question in Wednesday's Wall Street Journal:

The Obama administration has finally come up with a plan to deal with the real cause of the credit crunch: the infamous "toxic assets" on bank balance sheets that have scared off investors and borrowers, clogging credit markets around the world. But if Treasury Secretary Timothy Geithner hopes to prevent a repeat of this global economic crisis, his rescue plan must recognize that the real problem is not the bad loans, but the debasement of the paper they are printed on.

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it.¹ The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.

According to De Soto, modern free markets "only work if the paper is reliable." So De Soto recommends systems for recordation, standardization and disclosure of such "new derivatives," akin to perfecting a security interest in assets used as collateral for loans.²

Recently, I read an argument--perhaps from MaxedOutMama herself, though couldn't quickly find it--that the current crisis was a function of divergence of the holders of securitized debt obligations from the underlying assets, and the consequential inability of the holder of the paper to assess the underlying risk of default (for non-recourse debt). If so, De Soto's proposal would seem to help.

Question: Assume mortgage-backed securities, collateralized debt obligations, credit default swaps, etc., are standardized, recorded and transparent, as De Soto suggests. What would be the minimum prohibitions necessary to impose on commercial banks to stop the financial system from, as M_O_M says, "privatiz[ing] profits and nationaliz[ing] losses"? Note that I understand that limiting commercial banks to the traditional "business of banking" (e.g., by re-imposing Glass-Steagall) would accomplish M_O_M's objective; I'm posing a more narrow question leading, I hope, to a less invasive rule.
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¹ As M_O_M has explained, the current crisis isn't limited to sub-prime mortgages, but includes Alt-A, other commercial mortgages, consumer credit, etc.

² For personal property, that's accomplished by filing what lawyers call a UCC-1; the acronym is pronounced "you-see-see." Folks like me, who hated the law school "Secured Transactions" course, call it the "uck." I refused to study that topic for the bar, and merely guessed at most such answers on the bar exam. I've expanded my understanding in the subsequent decades.