Toward a Modest Proposal about the Mortgage Mess

Bernanke speaks:

the mortgage market has become more like the frictionless financial market of the textbook, with fewer institutional or regulatory barriers to efficient operation. In one important respect, however, that characterization is not entirely accurate. A key function of efficient capital markets is to overcome problems of information and incentives in the extension of credit. The traditional model of mortgage markets, based on portfolio lending, solved these problems in a straightforward way: Because banks and thrifts kept the loans they made on their own books, they had strong incentives to underwrite carefully and to invest in gathering information about borrowers and communities. In contrast, when most loans are securitized and originators have little financial or reputational capital at risk, the danger exists that the originators of loans will be less diligent.

And this holds even more for derivatives.

The big financial houses that make big money from peddling toxic financial waste as portfolio vitamins don't want regulation--but if they must endure regulation, they want a lot of it because the costs will overburden their nascent competitors. (To rectify the financial system and economy, more lawyers should get paid more money...yeah, that'll do it.)

If sunlight is the best disinfectant, the first thing to do is to get all these instruments into the sunlight. After they are assessed, society can assess how the markets should be regulated in order to keep them reasonably free and efficient.

A very rough thought follows. For starters every piece of US-traded paper--CDO, CMO, OTC derivative, etc.--should be posted on a publicly accessible central database together with the most recent transaction price and rating. Confidentiality of buyers and sellers should be respected, but the rating agency/agencies should be revealed[1].

Let this data be swarmed over by think tanks and legions of rabid dissertation-seeking finance graduate students and tenure-hungry junior faculty. Even with modern computer processing, that's going to take time. Only after an overall picture emerges should regulation be structured.

Formatting requirements should be kept simple to minimize the reporting burden. The USA should take the lead--the mess is primarily due to the negative consequences of our financial innovation--, but we might wish to team internationally.

The danger is that such regulation will drive business offshore and, like Sarbanes-Oxley is said to have done, further erode American leadership of global financial markets. A way to offset that is to maximize transparency and minimize complexity. The goal is that listing in the database, by creating confidence, will add value to an instrument relative to a similar one that is unlisted offshore. Ideally, once the system is in place, participants will recognize its value and its mandatory nature will almost be beside the point; I'd like to say that it could eventually be relaxed, but, given the proclivities of Wall Street wise guys, I hesitate to do so.

Clarification. This post was begun in September 2007 but not published until late January 2008. I wanted to develop a more cogent formulation, but finally realized that

It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.

[1] Update May 12, 2008: During an interview, George Soros proposed something similar.