November 24, 2009
J.W. Verret on Robert Pozen's "Too Big to Save? How to Fix the U.S. Financial System"
Posted by J.W. Verret

I am pleased to return to the Conglomerate today to host another in the successful line of Conglomerate Book Clubs.  Today we will be taking a look at Too Big to Save?  How To Fix the U.S. Financial System by Robert Pozen.  I will also be joined by Satya Thallam, Director of the Mercatus Center Financial Markets Working Group.

Bob's book is a fascinating read, and it is informed by his wealth of experience in financial markets.  Bob was the President of Fidelity Investments and presided over an unprecedented era of growth for Fidelity. From the non-partisan, clear cut compromises the book develops for fixing the financial system, we also get the sense that the book is informed by Bob's work on a number of bi-partisan projects, from the Social Security Blue Ribbon Commission to Chairing the SEC Advisory Committee on Financial Reporting.  For example, the book provides an excellent play by play of the Treasury Department's TARP program to inject capital into failing banks and provides a useful running critique of the Bush administration's approach.  Yet it also runs counter to many of the reform initiatives in the current Dodd Bill.  It is a breath of fresh air to read an analysis of financial regulatory reform that isn't motivated by partisanship or regulatory turf wars.

One appealing feature of the book is its accessibility.  The novice will find in it a concise summary of the events leading up to the financial crisis of 2008-2009 and a clear explanation of some very complicated financial engineering.  The book really hits its stride in the chapter on Credit Default Swaps, where it first made me question my understanding of instruments I thought I understood, and then resolved each of my questions in turn.  Each chapter also closes with a short list of recommendations for solving the regulatory challenges that the chapter addresses.  

I found I agreed with probably 2/3 of the recommendations in the book.  For instance, incorporating liquidity risk into financial models in a more conservative way seems like a great idea, and regulation designed around a "comply or explain" format for banks incorporating liquidity risk into their reserve requirements is something I can support.  But I also found that some of Bob's recommendations ran counter to my views.  For instance, I don't think that breaking the credit ratings oligopoly by allowing more competition for ratings will lead to forum shopping for ratings.  I think reputational effects will mitigate forum shopping.  So I thought that most of his ideas were brilliant, and many of them made me uncomfortable, but I suspect that this is what bi-partisan compromise feels like when it actually occurs.

Bob picks his battles carefully.  In his analysis of Fannie, Freddie, and the Federal Housing Administration, he doesn't take much of a position on the larger question of how much the government should subsidize housing.  He does recommend, however, that housing subsidies take place on the federal budget, rather than continuing the smoke and mirrors game of implicit (but unrecognized for budget purposes) government backing for mortgage intermediaries.  He also gets into the weeds to offer some useful mechanical solutions, like limiting tax credits to half the down payment on a house and requiring hard down payments (not tax credits or exemptions) for FHA housing.

One of Bob's conclusions that I think could be better supported is found in the chapter on hedge funds. Bob is suspicious of over-leveraged and unregistered hedge funds, but his recommendation that hedge funds register with the SEC isn't well supported.  Many hedge funds voluntarily registered with the SEC, hoping to use registration as a selling point to clients, have complained that the Commission doesn't have the resources to conduct many compliance audits.  Let's not also forget that Madoff was a registered investment adviser. 

The book does a masterful job of considering the banking regulators and provides some well supported recommendations in that regard.  Most importantly, Bob notes that the Fed needs to adopt an explicit inflation target to help minimize the specter of inflation on the horizon.  He also argues that the Fed should stick to what it does best, monetary policy, and get out of the business of regulating consumer protection or financing the purchase of corporate assets.  With respect to the FDIC, Bob argues that charging the same insurance premiums to all banks and thrifts regardless of their risk doesn't make any sense, and he's right. 

The book also signs on to the new Consumer Financial Protection Agency, but doesn't acknowledge that there is a growing debate over whether it will be effective in achieving its objective (for more on the debate see
Zywicki and Wright).  Regulators didn't do a very good job in predicting problem spots in this crisis.  Bob mentions that OFHEO ruled Fannie and Freddie's books "accurate and reliable" just days before a scathing audit report.  The PCAOB is criticized for mark-to-market accounting, and the SEC takes a hit for its Consolidated Supervised Entity program overseeing the investment banks.  One is left to wonder whether new agencies are going to offer much benefit.

Bob's book is a must read, not only because it presents a clear picture of how we got into this mess but also because it provides the most independent, non-biased roadmap available of how to get us out.  Buy your copy here.

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