Collateral-Backed Lending Led to Economic Crisis: FDIC Chair

Over-reliance on collateral values instead of evaluating borrower or counter-party capacity to perform; over-reliance on short-term funding, frequently to fund longer term assets and excessive leverage, and other factors led to the ongoing financial crisis, FDIC chair Sheila Bair told bankers late last week at the Federal Reserve Bank of Chicago’s annual conference on bank structure and competition.

The above factors led to a buildup of excess risk exposures in financial institutions and severely limited regulatory-response options once those risk exposures were realized, Bair said, adding that the weaknesses could be traced to regulatory loopholes.

“The current crisis was spawned by an unfounded faith in the safety of collateral-based lending – even if the borrower could not afford the loan,” Bair said. “‘Liar’ loans and 50 percent debt-service burdens only made sense to lenders and investors if they believed that the collateral backing the loan would continue to rise in value. Why assess a customer’s ability to repay a loan when collateral could always cover the balance?”

Consumers couldn’t afford homes that were accelerating in price faster than incomes could keep pace, so they were drawn to option adjustable rate mortgages and hybrid ARMs. Consumers theorized they could afford these loans because home prices would keep going up.

The OTC derivatives markets – particularly Credit Default Swaps – also suffered from a blind faith in collateral protection, Bair added. When major players in that market started experiencing difficulties last year, the rush to seize and liquidate collateral by their counterparties contributed mightily to the liquidity crisis.

“Massive government intervention was necessary to stabilize the system. The safety net and liquidity facilities traditionally available only to regulated depository institutions were expanded and made available to large parts of the shadow banking  (i.e., hedge funds, private equity) sector,” Bair said.

Bair said she agrees with those who are calling for a systematic risk regulator. But regulators missed the current crisis because many of the causes lay outside the purview of the different regulatory agencies.

“We could create a Systemic Risk Council as some have proposed,” Bair said. “The council would have a mandate to monitor developments throughout the financial system, and the authority to take action to mitigate systemic risk.”

Such a council should have the authority to establish consistent capital standards throughout the system to prevent excessive leverage and the painful de-leveraging that follows, according to Bair.

“The council should also have the ability to check over-reliance on collateral, and to instill greater discipline on the underwriting process by placing limits on the use of collateral to mitigate potential loss,” Bair said. “It could also require systemically important institutions to provide greater stability in their funding base. For instance, the council could require banks to issue: 1) commercial paper that automatically converts into a long-term unsecured liability when a distress event is realized, and to issue unsecured debt or preferred shares that convert automatically into common equity when a "distress trigger" – such as a ratings downgrade– occurs.”

To monitor risk, the council should also have the authority to demand better information from financial entities and to ensure that information is shared more readily, according to Bair. “During this crisis, as we contemplated actions necessary to preserve financial stability in the face of a possible failure, it was very difficult to get complete and timely information, particularly regarding holders of unsecured debt or credit default swap exposures. The lack of information can force a policy response that may be more blunt-edged than surgical.”

Bair also called for a credible resolution regime for systemically important financial firms to complement enhanced regulation.