To stop another crisis, everyone’s got to have a stake

Let’s start with the title. Why “Too Big to Save?’’

It’s obviously a pun on “too big to fail.’’ What I’m emphasizing is fixing the financial system. There’s so many books out there about what happened in the past. Almost none of them say what should we do to solve the problem going forward.

How did a US housing crash spiral into a global crisis?

The answer is loan securitization. Those securities were sold throughout the world, and when [former Federal Reserve chairman Alan] Greenspan held interest rates especially low, investors started to look for higher yields. In order to get higher yielding mortgage backed securities, you had to have subprime.

Who’s to blame for this?

I don’t think it’s useful to spend a lot of time allocating blame. But one of the most important lessons is that securitization is important for the growth of the economy. In 2006, we securitized, in the US alone, about $1.2 trillion in loans. Now, we have $30-$40 billion. When people ask why are businesses not getting enough loans, it’s got very little to do with banks. We need to get loan securitization going again.

Is it a matter of better regulation? Does the whole market have to be restructured?

Three main things have to be done. Everyone in the process has to have skin in the game. If you have a broker who can make a mortgage, sell 100 percent of it, and have no loss no matter what happens, that broker doesn’t have incentive to write a good mortgage. Second, we pooled these loans in very opaque entities, and it was very hard to tell what was happening. So we need transparency. Third, we need to have credit rating agencies we can believe in.

One of your proposals is eliminating the mortgage interest deduction.

I’m in favor of an interest deduction on your primary home, but don’t think we should go to second homes, third homes, and home equity loans. Home equity loans turned out to be another way to get consumer credit.

Was that a contributor to the housing bubble?

By the time you got to 2006, household debt exceeded household income by about 30 percent. People were over-borrowing, and home equity loans were a major contributor to that. It’s great as long as housing prices are rising. But when they start falling, it’s pretty bad.

Do we need a large scale overhaul of the financial regulatory system?

The sort of grandiose merger of regulatory agencies in the [Senator Christopher] Dodd bill will create the appearance of doing something as opposed to actually doing something. I am not for the wholesale reorganization of the financial regulatory system. We need to focus on the gaps, the main ones being regulation of financial derivatives and hedge funds. We need to strengthen the system we have.

On executive pay, should the federal government be involved?

We should have federal guidelines. But that’s very different than having a federal official approving pay packages. My approach is to get better boards of directors that should set executive pay subject to these broad guidelines.

Was there one key mistake in the crisis?

The most important was too little capital and too much leverage. The SEC in 2005 allowed investment banks to double their leverage ratio, so they only needed $1 in capital for every $30 of assets, and the other $29 were loans. What happens when you have losses, and your capital’s cut in half, you have to sell your assets. If everyone is selling their assets at the same time, that causes panic.

If there’s one change that you could get through Congress, what would it be?

The most important is regulating financial derivatives. Congress in 2000 effectively exempted credit default swaps and other fancy derivatives from both the Securities and Exchange Commission and Commodity Futures Trading Commission. If you want to predict the next possible problem, that sure is it. We really need to do this.

As far as readers go, is there a lesson you want them to take away?

The overarching message is it doesn’t help to spend a huge amount of time to go through the past. We know pretty well what happened. The challenge is to prepare ourselves for the next financial crisis.