G20 Should Hurry Up On Financial Reregulation

The two-day summit meeting of world leaders from the Group of Twenty (G20) kicked off yesterday in Pittsburgh. This is the third of such summit held since the the collapse of Lehman Brothers, the largest bankruptcy in U.S. history, a year ago. High on the summit’s agenda is the urgent need to reach agreement on financial reregulation, in order to prevent a repeat of the global financial crisis that pushed us to the very edge of the abyss not so long ago.

I doubt that this summit could accomplish much, given the record of previous G20 summits which were long on rhetorics but short on decisive action. Still, I really hope I’m proven wrong in the end for we need a new set of rules pronto before another bubble springs a surprise. Even as the G20 debate goes on, I think there are already evident “red flags” that regulators should be concerned about. Following is a quick survey:

Securitization of "Life Settlements"

Not surprisingly, Wall Street banks are busy concocting their next money-maker. New York Times’ Jenny Anderson recently reported on one of these up and coming products--the securitization of so-called “life settlements” or those life insurance policies that are sold for cash, mostly by ill and elderly people.

Actually, a small-scale life settlement industry has been around for years. Wall Street would effectively ramp this up by joining the fray, in a controversial business plagued by fraud. Under the scheme, banks would buy the life settlements, package the insurance policies into a security, then resell the bonds to investors. Bondholders receive the insurance payouts when the insured die. As Ms. Anderson puts it, it is a bet on “whether people will live longer than expected or die sooner than planned.” The earlier the insured dies, the bigger the return. The banks, on the other hand, make money via the fees earned from creating, reselling and, subsequently, trading the securities.

I have nothing against financial innovation. My only concern is Wall Street's intended use in this case of a discredited subprime securitization model. Scale is crucial to origination, so banks will need to buy large numbers of life insurance policies that they can securitize. How large is the population of policyholders who would be willing to sell their policies for cash? Will there be enough volume to sustain this securitization exercise over time?

I have no idea, but I figure that because of competition among banks later on, subprime life settlement policies might appear, as in the case of mortgages, and compromise the market again. Already, there have been reported instances of life settlement brokers and agents coercing the ill and elderly to take out policies which would be sold back to them.

As in the past, I'm sure there will be exotic mutations of this new financial product down the road, which could have unintended consequences still too early to forecast at this time. Herein lies the rub and this is what I'm afraid of.

The criticisms against life-insurance securitization is probably best summed up by Steven Weisbart, chief economist for the Insurance Information Institute: “...this defeats the idea of what life insurance is supposed to be. It’s not an investment product, a gambling product.”

Re-Remics

In an earlier post (click here), I blogged about re-securitization of real estate mortgage investment conduits or Re-remics for short. Re-remics are basically CDOs in a new guise (a diagram that shows how the repackaging is done can be found here). Critics call them recycled garbage, but that's too simplistic a view, as I have explained in my said post.

Banks are busy repackaging their distressed CDOs into higher-rated Re-remics. Now, lest we forget, the painful lessons from the subprime mess have not changed--that all the slicing and dicing does not make a mortgage pool less risky, and that a triple-A rating does not mean “risk-free”.

Predicting default risk involves probabilities. Unfortunately, while this can be modelled, as what rating agencies have done, the science involved is at best inexact. The undeniable fact is that the chance of default cannot be assigned a unique probability. In other words, risk is not totally absent, even for the highest rated bonds or securities.

Some $25 billion of Re-remics were created in 2007. I don't have the data for 2008, but for this year at least $30 billion in residential Re-remics have already been done, according to Morgan Stanley. Relative to the volume of toxic assets that choked the financial system a year ago, these amounts may appear measly. But then, financial risk has a way of growing unnoticed until it surprises all of us. That's a lesson we learned from recent history.

Credit Default Swaps (CDS)

Warren Buffet had rightly called them “weapons of financial mass destruction.” After all, CDS did nuke Wall Street, vaporizing Lehman Brothers and almost claiming AIG too, if not for the timely bailout done by the U.S. government using taxpayers' money. This notwithstanding, the sale of new CDS never really ceased despite calls from certain quarters to ban them in their current form.

As Mark Sunshine explained here:

Make no mistake about it, most credit default swaps are speculative and are a “zero sum” game. Money is transferred from one party to another but without any underlying economic activity or hedging of real risk. Speculative credit default swaps are like going to the craps tables. Either the shooter wins or the house wins. And, right now the shooter is playing with loaded dice.

Apparently displaying sensitivity to accusations that CDS aggravated the financial crisis, CDS market participants, including hedge funds, pension funds and others, had agreed on a new protocol--named the "Big Bang Protocol" by the International Swaps and Derivatives Association or ISDA--to make the contracts more transparent and easier to trade. This involves standardizing the terms of many of these insurance-like contracts to align them with the bonds they are tied to, and using a central counterparty clearinghouse operated by IntercontinentalExchange or ICE.

Should we rejoice over this development? Not so quick, for it is for the most part a preemptive move on the part of the industry. According to Greg Burns who wrote here:

By guaranteeing counterparties and providing a system for evaluating risk, clearing represents a major change for the shadowy swaps market. But it's well short of what regulators envisioned during the crisis -- as with much of the sweeping financial-reform agenda advanced by the White House.

There is no shortage of justifications for the continued use of CDS by financial players. However, I find more compelling what George Soros said about CDS during a meeting of the Institute of International Finance in June: "It's like buying life insurance on someone else's life and owning a license to kill." I agree, therefore, that CDS should be outlawed and not be allowed to be traded at all.

G20 Should Hurry Up

Commenting on Lehman's failure, Byron Wien, Blackstone Advisory Services vice chairman, said:

“There was a general feeling that an enormous amount of additional regulation should be put in place to prevent what happened that weekend from happening again. So far, we haven’t seen a lot of action.”

He's right and that's the sad part. Precious time is being wasted. With every day of delay in reforming the financial sector, the system grows riskier as the above survey illustrates. Who knows, the seeds of the next financial crisis may have been sown already.

The thing is this: It is easy to get the finance industry to accept regulatory changes at a time of crisis. But then, this global crisis is ebbing. Confidence has returned to banking and the world economy has weathered the recession.

Knowing this, U.S. Treasury Secretary Tim Geithner probably worried that complacency was setting in. In his speech during the meeting of G20 finance ministers and central bank governors in London early this month, he said:

Let me close by saying that, as we look toward the G-20 Summit in Pittsburgh, we need to bring the sense of common purpose and urgency that we demonstrated at the peak of the crisis to the challenges of restoring growth and to reforming the financial system. We have made a lot of progress, but we have a ways to go. We can’t let momentum for reform fade as the crisis recedes.

Well said, but will they act? Let's see...

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