Wall Street today is again proving William Faulkner’s line, “The past is never dead. It’s not even past.”
The causes and traumas of the credit bubble and crisis – and regrets for failing to arrest them -- have been burned into the minds of financial players and government officials. As a result, they continue to act in ways they wish they had eight or 10 years ago, fighting the last war before the threats grow dire.
Tuesday’s run of business headlines neatly captured this reality.
-The Justice Department has subpoenaed General Motors’ (GM) financing division as it looks into documentation related to subprime car loans.
-New York State financial regulators are pressing leading mortgage-servicing firm Ocwen Financial (OCN) over allegations that it improperly forced distressed homeowners to buy insurance from affiliated companies.
-Moody’s (MCO) downgraded its credit rating on the United Kingdom’s banking sector, in anticipation of regulations that would make a future government bailout less likely.
-Goldman Sachs (GS) is cutting some hedge-fund clients loose and tightening financing terms for others as it rationalizes its business in response to higher capital requirements imposed by regulators.
In each instance, a deeply ingrained lesson of the crisis years seems to inspire renewed acts of vigilance. Sketchily documented loans to high-risk borrowers in the first half of the 2000s were a core root cause of the subprime mortgage mess. Mortgage lenders abused customers with onerous and opaque loan provisions. Rating agencies willfully overlooked the systemic risks building up over the same period in an overleveraged banking system. And investment banks enabling concentrated risk-taking by hedge funds and exposing themselves to rapid client withdrawals brought about the implosion of Lehman Brothers.
An abundance of caution
None of these efforts address clear and present dangers to the economy or markets. While subprime auto loans have become a crucial enabler of strong car sales, they hardly represent the outsized risks that the former mortgage bubble did. And the Ocwen inquiry for now focuses on a narrow class of borrowers rather than an industry standard of over-aggressive tactics.
While U.K. banks are adjusting with difficulty to the new, restrictive regulatory scheme there, Moody’s downgrade seems both procedural and proactive rather than a response to imminent or foreseeable financial stresses.
And Goldman’s attempt to rework its hedge-fund relationships is part of an ongoing adaptation to higher capital requirements, narrower opportunities to trade for its own account and intense pressure from investors to raise risk-adjusted returns.
This is what we’d want to see, right? After a cataclysm involving a massive breakdown in risk-management discipline and failure of official oversight, leaders should learn from the shortfalls and vow to head off problems before they become too big, shouldn’t they?
Well, sure. Yet these logical responses will almost certainly bring unintended consequences of their own, while failing to create a reliable firebreak to contain a future market flare-up, whenever or wherever that might occur.
A building concern related to stricter capital requirements and tougher constraints on proprietary trading among big banks is that debt markets could lack proper liquidity should credit conditions worsen and lead to more urgent selling by investors who have gorged on trillions in high-yield and investment-grade corporate paper in recent years.
Bank dealers have record-low inventories of bonds, in part because they don’t want to hold expensive capital against them. Meantime, the amount of debt outstanding has ballooned and exchange-traded funds promising real-time liquidity, such as SPDR Barclays High Yield Bond (JNK) and iShares iBoxx High Yield Corporate Bond (HYG), have become big, foot-stomping players in the market.
Another inadvertent distortion created by post-crisis bank regulation: The debt of EU governments can often be treated by banks as carrying no credit risk. This creates incentives for them to buy bonds of even lower-rated euro issuers, which early this year saw their yields collapse, pulling global credit spreads lower with them.
On subprime auto lending, it seems unlikely that whatever scrutiny is being applied to marketing practices and documentation will choke off the heavy flow of cheap cash toward the new- and used-car market. Yet there remains the risk that regulators will see and treat this as a systemic threat, which it almost certainly is not.
Vigilance is better than neglect, for sure. It’s preferable to have overeager cops on the beat than wait for the forensics team to study chalk outlines. Yet none of it means the ultimate threats to this recovery cycle and bull market will be anticipated correctly.
In the years following the tech bubble collapse, regulators and Wall Street banks busied themselves by minimizing conflicts of interest among stock analysts and punishing abuses in the way technology IPOs were allocated. None of it was any help in anticipating -- or thwarting -- new financial excesses already underway.
Perhaps the clearest takeaway from all this re-fighting of the last campaign is that public psychology has yet to move on from a post-crisis mindset. We still think in terms of bubbles and crashes rather than normal market ebbs and flows, financial weapons of mass destruction versus typical buyer-seller gamesmanship.
Robert Shiller – the Yale professor, Nobel laureate and author of “Irrational Exuberance” in 2000 – has long maintained a set of “crash confidence indexes,” based on regular surveys. They measure investors’ level of confidence that there won’t be a stock market crash in the next six months.
During the current five-year surge in stocks, confidence that a crash isn’t likely has remained below 40% among individual investors. During the comparable span of 2004 to early 2007, confidence was never as low as 40%, and peaked near 50%.
“Twice bitten, thrice shy” seems to be the prevailing attitude, after the market was cut in half twice in eight years’ time. This persistent mood of suspicion probably creates its own check against too much giddiness infusing the markets too quickly. But it doesn’t provide much protection against a whole new, unexpected financial bug coming to bite us from a place we haven’t thought to look.