GRACE CREEK MEDIA
"IIA ROBERT POZEN"
INTERVIEW WITH ROBERT POZEN
CORRESPONDENT:  JIM GLASSMAN

JIM GLASSMAN:
(MUSIC) Welcome to Ideas in Action, a television series about ideas and their consequences.  I'm Jim Glassman.  This week, now that the U.S. financial system has come back from the brink, what more should be done to restructure our banking system?  Joining me to explore this topic is Robert Pozen, author of "Too Big to Save:  How to Fix the U.S. Financial System," and Chairman Emeritus of MFS Investment Management.  The topic this week, "Prescriptions for a Healthier Financial System."  (MUSIC)
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JIM GLASSMAN:
In the aftermath of the financial crisis, Congress has enacted new rules that change how Wall Street does business.  The fear that the failure of a single institution could topple many others led the government to provide billions in bailout money to Wall Street firms.  A huge regulatory overhaul is the next phase of an unprecedented intervention in the way Wall Street does business.  But is the government vaccinating a patient that no longer is contagious?  What is the right prescription for America's financial system?  Bob Pozen, welcome to Ideas in Action.
ROBERT POZEN:
Glad to be here, Jim.
JIM GLASSMAN:
You know, one of the buzz phrases that emerged from the financial crisis we heard over and over again was too big to fail.  But you called your book, "Too Big to Save," what did you mean by that?
ROBERT POZEN:
Lots of people refer to too big to s-- fail as if this institution became bankrupt, the whole financial system would go kaput.  And I believe that we bailed out many too many institutions.  So that there are lots of institutions that are large, but we don't have to save them all.  And if we do try to save them all, we create a lot of moral hazard, meaning that we give incentives for people to take a lot of risk because they think they're always going to be bailed out.
JIM GLASSMAN:
So, specifically, do you think that we should have bailed out AIG?
ROBERT POZEN:
Well, I believe we should have started off by bailing out AIG in September.  But then we had about two months to figure out where all the counterparties were.  And we still decided to let all those counterparties be paid 100 cents on a dollar.  And in my view, that was the mistake.

In September, we didn't know what the lay of the land was.  But two months later, we did and those large financial institutions, including many in Europe, made a mistake.  They picked the wrong counterparty and they needed to take some haircut.
JIM GLASSMAN:
And when you say counterparty, these were banks that were relying on AIG in effect to insure them, and AIG wasn't, as it turned out, was not a very sturdy institution.  So, these banks, you say, should have borne the risk?
ROBERT POZEN:
Yeah.  These banks-- basically relied on AIG to insure them against the default of many mortgage-backed bonds.  And they picked-- a weak insurer, it turns out.  And we need to make sure that we give large banks an incentive to get good insurers.  And if they make a mistake, they need to pay a penalty.  Here, they paid no penalty.  Instead, they got 100 cents on a dollar, a total of $62 billion to some of the largest and most sophisticated investors in the world.
JIM GLASSMAN:
So-- and your point is that if you, in effect, reward or protect-- against failure, you are actually encouraging the kind of behavior that produces the failure in the first place?
ROBERT POZEN:
Absolutely.  We need to encourage all the investors, especially, the bondholders, to do due diligence, to understand who's on the other side of the deal.  And if they make a mistake, they need to bear a penalty.  If they feel they will always be bailed out, then they don't have an incentive to really care-- bondholders are effective monitors.

They bring to bear market discipline on financial institutions.  And so do people who buy insurance.  Because they're not going to buy insurance, they're not going to buy bonds, unless these institutions that are issuing the bonds or insurance are sound.  And they follow them over time.  But if we create the sense that no matter what happens, the government's going to bail you out, well, then we lose all that diligence.  We lose all that monitoring.
JIM GLASSMAN:
Let's go back to the beginning of the crisis itself.  What caused it?
ROBERT POZEN:
Well, there are lots of factors that caused it.  It's sort of-- you-- you could enumerate so many.  But, I mean, we'd probably have to start in the housing market to say that we had a bubble in the housing market.  And that was fed by investors around the world who wanted to get higher yielding securities.

Wall Street then came up with various types of mortgage-backed securities.  And that gave the incentives for the brokers to come up with sub-prime loans.  And they fed each other.  And, of course, that could only be done within a context where there was a lot of-- money sloshing around the world and where interest rates on treasuries were low.

Despite what Alan Greenspan says, I believe that interest rates being low from 2001 to close to 2006 was an important factor.  Because when treasuries were very low, then all those dollars that were in the central banks of Japan, of China and Middle East, they wanted higher yield.  And so, they were pressing for higher yield.  That created the demand for these mortgage-backed securities.
JIM GLASSMAN:
So, they were chasing higher interest rates which meant that they were, would be taking on greater risk?
ROBERT POZEN:
Correct.
JIM GLASSMAN:
But what makes this kind of an unprecedent-- in a way, it was an unprecedented situation.  I mean, you know, a lot of people say this is the worst financial crisis since the Great Depression.  I mean, surely, interest rates have been too low, and you believe they were too low, that Greenspan set them too low.  But that's-- that's happened before?
ROBERT POZEN:
Sure.
JIM GLASSMAN:
In history-- why was it that housing prices spiked this time and all this-- all these other problems occurred?
ROBERT POZEN:
Well, I think one factor-- was securitization.  This is the first time in which we've had most of the mortgages were securitized.
JIM GLASSMAN:
And that means mortgages being put into a package and traded as though they were a stock or a bond?
ROBERT POZEN:
Correct.  We-- we had the originator of mortgages which would be a bank or a non-bank.  They would issue the mortgages and then sell them into the secondary market.  They were pooled and then tranches were sold around the world.  So, it's that mechanism of securitization that spread this financial crisis around the world.

The second factor is leverage.  We had a number of government agencies which explicitly decided that banks and investment banks could have very high leverage.  And when you have high leverage which means having a lot of debt relative to your capital, then a small loss can lead to a big desir-- big need to sell assets and get them down.

And so it creates a sort of rush to the exit door if you have high leverage.  If you're at a 30:1 leverage and you lose, say, half a million, then you've got to sell 15 of assets in order to get yourself back into compliance.  And if that happens to lots of people at the same time, then they're all running for the exit door.
JIM GLASSMAN:
You're very clear in your book that you think that the Fed left interest rates too low for too long?
ROBERT POZEN:
Absolutely.  I think that-- right after 9/11 in 2001, it was perfectly reasonable to keep interest rates low.  But by the time you got to 2003, now, the economy was recovering, the markets were recovering, and the Fed continued to keep interest rates very low for probably two or three years beyond what it should have.
JIM GLASSMAN:
And was that just a miscalculation or was it-- a response to political demands?  In other words, is there a problem with the way the Fed is set up to start with?  It's supposed to be insulated from politics, but politicians always like low interest rates.
ROBERT POZEN:
I agree.  Politicians do like-- low interest rates.  But here, I think it was more-- the faith, the faith that Greenspan had in a new economic concept.  It was almost a new ideology.  That there used to be these old rules in which-- certain norms would hold.  But he had such a faith in technology and in financial engineering that he felt that those old rules didn't need to apply.  And-- unfortunately, a lot of them still did apply.
JIM GLASSMAN:
And it's true, though, that for many years, there was at least when you look at metrics such as inflation or GDP growth or unem-- or unemployment, there was a-- a fair amount of stasis?  There wasn't a lot of ups and downs.
ROBERT POZEN:
Yeah.  For a while, it looked like it was a very successful new approach to economics.  But-- some of the old varieties reasserted themselves.
JIM GLASSMAN:
I just want to ask you about securitization, the packaging of these mortgages.  You know, if there had been no securitization as, for example, there was, there was not during the Depression, the Great Depression-- banks would have taken these mortgages and held them on their own books.  And they still would have suffered from the same kind of problem that people who owned the securities did and we would have had hundreds or thousands of bank failures.
ROBERT POZEN:
Well, if the scenario you paint happened, then we definitely would have had a lot of bank failures.  But there are two things.  One is that to the extent banks and non-banks knew they could initiate mortgages and then sell 100 percent of them to some New York City bank or some pool, then we reduced their incentive-- to-- to do a good job on those mortgages.  And I believe that a lot of the problems grew out of the fact that the mortgage originators didn't have enough skin in the game.  If the banks had held onto this for five or 10 years, they'd have more skin in the game.
JIM GLASSMAN:
Meaning, ha-- have had more responsibility--
ROBERT POZEN:
Yeah.
JIM GLASSMAN:
--For whether there, this was a good credit or not?
ROBERT POZEN:
Right.  More, and therefore, if they would take a lo-- big loss, if it wasn't a good credit, they would have done a better job.  And when you think about things like liar loans and no doc loans and these things, I mean, if you held a mortgage for ten years, would you, sort of, have a liar law, or no doc loan?  I don't think so.  But if you can take that loan and sell it quickly to a pool where it's sort of an anonymous part of a larger thing, well, then, unfortunately, it seems like people are willing to do it.

The second thing is once we pooled these mortgages-- we then divided them into tranches.  And-- I always say this is like medieval alchemy.  We took some sub-prime mortgages, we put a few derivatives, we mixed them all up, and somehow we got Triple A bonds.
JIM GLASSMAN:
Right, tranches are little slices of a big pie of mortgages?
ROBERT POZEN:
Right.  Slice-- tranches are the slices of the pools that are sold.  So, people got an interest in these pools.  And so, we also created the illusion that some of the-- the products of these pools were much better than the pools themselves.  And to some degree, you could benefit from diversification.  You know, but-- you can't go that far as to take a whole group of sub-prime mortgages and wind up with 60 percent Triple A bonds.  It's just not possible.
JIM GLASSMAN:
So-- so-- so, I wanted to ask you about Fannie Mae and Freddie Mac.
ROBERT POZEN:
Right.
JIM GLASSMAN:
Because a lot of people think that they were a major cause of the financial disaster.  And yet, Washington doesn't seem to want to deal with them?
ROBERT POZEN:
Well, Fannie and Freddie were significant factors because Congress over the years required them to have more and more low income or sub-par mortgages.  And by the time we got to 2006 to 2007, their obligation was over 50 percent.  And so, they became the biggest buyers of these sub-prime mortgages.  And if you have government entities that can finance cheaply and are standing there ready and in a sense required to buy these mortgages, you're creating a huge demand for them.
JIM GLASSMAN:
And-- and just to make it clear what their role was, a bank ma-- or other institution makes a loan, and then sells it to Fannie or Freddie, correct?
ROBERT POZEN:
Yes, correct.  It's like it's a government-backed securitization.  We, before we were talking about privatization in the sense of mortgages being sold to a New York City bank that does a pool-- Feddie-- Freddie and Fannie were government sponsored securitization.  And they had an obligation to buy a certain percentage of low-income or sub-prime mortgages.  And so, they created another huge demand for these mortgages and, again, people weren't that careful-- at the origination stage because they knew they had a built-in buyer.
JIM GLASSMAN:
So, what should happen to Fannie and Freddie now?
ROBERT POZEN:
Well, in my book, I argue we need to-- divide the world in two.  There are-- certain mortgages and certain families that we want to help.  They're, mainly, should be in the low-income area.  And if we want to help those people buy homes and reduce the cost of their mortgages, we ought to subsidize that directly through the federal government through HUD or an agency like that.

But we don't want to subsidize $500,000 mortgages or $700,000 mortgages, or mortgages for high-income families.  And we also don't want to subsidize anything through Freddie and Fannie because lots of studies showed that of the federal subsidy, most of it went to shareholders of Feddie-- Freddie and Fannie, and very little went to home owners.

So, in my view, once we get out of that defined target area that we decide we want to help, the rest of that ought to be served by the private market.  And there'll be some market price that will be set for it.  There'll be a securitization mechanism.  And-- those will go off at a market price.
JIM GLASSMAN:
Many people, including my colleague when I was at the American Enterprise Institute, Peter Wallison-- people in the administration, the Bush administration, warned that Freddie and Fannie were disasters waiting to happen.  But Congress didn't do anything.  And now, there's been money that's been pumped into Feddi-- Freddie and Fannie, taxpayer money, but still, nothing's happened.  How can you explain that?
ROBERT POZEN:
I agree.  Freddie and Fannie are the-- the large black holes of the universe, of the housing universe.  There's something like $6 trillion of mortgages there.  And we actually have very little idea of how big the losses are.  We know they're big.  But we don't know exactly how big.

Unfortunately, I think, Congress is afraid to touch them now.  They're afraid to touch them because the housing market is still fragile and they don't want to rock the boat at any point now.  Maybe, a year or two from now, they'll be willing to deal with the situation.
JIM GLASSMAN:
What do you propose that will help prevent the kind of melt-down that we've seen from happening again?
ROBERT POZEN:
Well, I think the first thing, and most important thing is we should have lower leverage in financial institutions.  They should have more capital relative to their liabilities.  Capital is sort of the cushion by which you absorb these things.

I think second of all, we had lots of activities that occurred off balance sheet in special purpose entities where we really didn't know very much about them.  And not only was the disclosure bad, but we didn't have much capital that supported them.  And some of the worst abuses occurred in these special purpose entities.

Third of all, I believe, that everybody ought to have skin in the game.  And so, when we have originators of mortgages, they ought to retain even a little bit, three percent, five percent risk of loss if they decide to sell them, whether it's to a government-sponsored entity or to the private market.  So that they retain the incentive to do the job right.
JIM GLASSMAN:
So, you're not against securitization or selling to Freddie or Fannie or whatever there would be as a successor to them, but you want to make sure the banks have some-- or and other mortgage originators have some kind of skin in the game, as you call it?
ROBERT POZEN:
Right.  We need to have, make sure they have incentives.  In fact, I think the revival of securitization is critical to the revival of the economy.  In 2006, the U.S. in private securitization did about $1.2 trillion.  Last year, we did about $180 billion.  That difference is a huge difference in loan volume.

So, when we hear people complaining, small businesses and consumers, that they're not getting enough loans, a lot of the real culprit there is the falling apart of securitization.  We used to have a very vibrant securitization-- program.  It was abused, but we need to get back a vibrant securitization program, but on much stronger lines.
JIM GLASSMAN:
Do you see the-- this financial disaster at all as a failure of professional or personal responsibility?  Is there a moral element?
ROBERT POZEN:
I think there is a moral element because when you look at these various financial institutions, people were on yearly bonuses and were prepared to do things that got them huge bonuses, even though they must have known that these were going to blow up in several years.  Now, in part, you can say, that's a structural problem.
JIM GLASSMAN:
Right.
ROBERT POZEN:
It's a structural problem of incentives.  And I believe strongly, and in the financial institutions that I've been involved with, we've always tried to base bonuses on three-year performance, not on one-year performance.  So, we should move toward more of a three-year performance basis.

But there's also an element of moral or personal responsibility.  I've always felt that I wouldn't sell a financial product unless I, myself, would invest in it.  And it's clear that lots of people were selling products that they really didn't have any confidence in.  And they were selling products to investors and at the same time, we now know, bad-mouthing them among their friends.
JIM GLASSMAN:
And some of those products you're talking about are, were complex derivatives?
ROBERT POZEN:
Right.
JIM GLASSMAN:
Do you believe that derivatives should be traded on an exchange the way that stocks are?
ROBERT POZEN:
I believe deri-- the key thing for derivatives is to have a clearing corporation, as we have a clearing corporation behind all exchanges in all over-the-counter markets.  We could then have standardized contracts, futures contracts, derivative contracts, traded on exchanges.  We can also have, to some degree, customized contracts that are done in the over-the-counter market.  As long as they're cleared through the same clearing mechanism, and as along as there's some disclosure about it.
JIM GLASSMAN:
What do you think about the so-called Volcker Rule which would limit the activities of commercial banks and-- and prevent them, in many cases, from-- from proprietary trading from trading on their own account?
ROBERT POZEN:
Whatever rule we set up, this type of trading will be done somewhere.  And if we are saying, "Okay, it shouldn't be done in banks," then it's going to be done in non-banks.  And those actually, we have much less regulatory control over.  So, if we push all of the very risky activity out of the banks, we'll essentially be recreating a Bear-Stearns.

And then some people say, "Well, we won't let the non-banks do it.  We won't let the banks do it, we won't let the non-banks do it."  Well, that will be the best-- economic-- help that we can give to Frankfurt, Dubai, London, Canada-- because these-- these contracts are going to be done someplace.
JIM GLASSMAN:
They'll do it, right.
ROBERT POZEN:
And people don't realize that Glass-Steagall, the old Glass-Steagall Act.
JIM GLASSMAN:
Which separated commercial banks from investment banks?
ROBERT POZEN:
Right, it never applied to U.S. banks with respect to their activities overseas.
JIM GLASSMAN:
And you're not in favor of resurrecting Glass-Steagall--
ROBERT POZEN:
No.
JIM GLASSMAN:
--As some people want to?
ROBERT POZEN:
Correct, I'm not.  Because I really think that it's-- it's, in a globalized economy, it's not-- globalized financial market, it's not realistic.
JIM GLASSMAN:
Now, one of the things that-- I know you agree about, you said in your book-- that Paul Volcker has proposed is increasing capital requirements for banks in good times-- that seems to be counterintuitive.  I mean, don't they need the capital more in bad times?
ROBERT POZEN:
Well, in bad times, they don't have the capital and in bad times, if they try to go out and raise the capital, it's hard to do.  So, it's what we mean by counter-cyclical is, in good times, let you have higher capital requirements, higher reserve requirements, and you're building up-- a cushion for a rainy day.  And that rainy day will come and then you can draw upon that cushion.  If you wait till the bad times and then try to impose higher requirements-- people don't have it.  They don't have the money to put up at that point.
JIM GLASSMAN:
And I guess the other reason for doing it in good times is that during good times, we kind of forget, that the bad loans are made.  And that's, that's one of the lessons here?
ROBERT POZEN:
You know, that's an important point because people get a little-- carried away and over-optimistic about every loan.  So, if people start to feel, well, the spiral is going up, they can get carried away and if they have a little higher capital requirements, it might make them think-- a few times before putting on a loan that really is-- questionable.
JIM GLASSMAN:
Do you think that-- we are as vulnerable as we were two years ago to the same kind of financial crisis?
ROBERT POZEN:
I think we're less vulnerable now just because all this stuff is very close-- we've reduced-- the leverage, the ability of the major investment banks to have leverage-- we're looking at capital requirements a lot more closely.  And I think-- the whole idea of risk management and compliance has become much more front and center.  Having said all this, it would be deluding ourselves to believe that we can, in advance, predict every financial crisis.

There's some people who feel like if we just have a systemic risk monitor, then we'll be able to figure out this all in advance.  Well, in hindsight, we always know what's a financial bubble and w-- why it broke down.  But-- in advance, it's pretty hard to tell what some of these things are really going to become.

You could say China now has a real estate bubble.  Well, it may just be an increase in prices that will work it's way out, or it might be a terrible financial bubble.  We won't really know for another few years.
JIM GLASSMAN:
And every financial crisis, it seems anyway, seems to have a different kind of trigger.  I mean, in some cases, it's-- you know, it's Asian currency.  In some cases, it's loans to Latin America.  This one's real estate.  But so, it's hard to predict?
ROBERT POZEN:
Yeah.  There-- each time, it is different, though there are certain themes.  One is countries that have fixed currencies are vulnerable to financial crisis because the fixing of the currency, if it's fixed to another currency, makes it a little inflexible.  The second area that I point out in my book is if you have real estate prices going up and it's fueled by foreign money that historically has been a trigger for a financial crisis because that foreign money leaves very quickly.

Third of all, high leverage.  Again, if you allow people to have little capital and lots of assets, then you've reduced the cushion.  So, we know that.  And fourth is mismatches.  If you allow financial institutions to have, take long assets and finance them with short liabilities, what was that, that was the S&L crisis.  

You have 15-year mortgages, and on the other side, you have daily deposits or 60-day commercial paper.  So, we don't know the specifics of each crisis.  But we actually do know that there are certain, sort of, danger signs.  And so, we had ought to at least, sort of, focus on those danger signs.
JIM GLASSMAN:
And that's a good place to end it.  Thank you so much, Bob Pozen.
ROBERT POZEN:
Thank you.
JIM GLASSMAN:
Before we go, I want to remind viewers that you can watch Ideas in Action whenever and wherever you want.  Just go to our website to watch complete episodes or download podcasts to your mp3 player through the iTunes Store.  Wherever you watch, be sure to join us next time.  That's it for this episode.  For Ideas in Action, I'm Jim Glassman.  (MUSIC)
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