There has been no shortage of public pronouncements, oral or written, by members of the global financial community on the causes of the financial crisis. But only a few in the financial industry have been prepared to propose a comprehensive package of specific actions that should be taken to prevent another such crisis occurring. Among the handful who have, no one has been more clear or far-reaching in prescribing practical solutions, or has more experience and credentials to back them up, than Robert Pozen, chairman of MFS Investment Management and former vice-chairman and president of Fidelity Investments. He has recently authored Too Big To Save? – How to Fix the U.S. Financial System; this is in addition to numerous other books and papers published during an illustrious career in the financial, legal and academic worlds. He recently presented his outspoken views, including some words of praise for the Canadian financial system, at a luncheon seminar hosted by Toronto CFA Society.

Mr. Pozen traced the origins of the U.S. financial crisis to the growth in America’s current account deficit and to the U.S. Federal Reserve’s prolonged actions to reduce interest rates in the wake of the bursting of the technology stock bubble in 2000. These events together drove strong global demand for high-yielding U.S. bonds in 2001-2006, which in turn led to reckless mortgage lending practices and irresponsible securitization, thus creating the supply of high-yielding, mortgage-backed securities to satisfy that demand.

The largest source of the U.S. current account deficit, China, is now being urged by the U.S. government to allow its currency to appreciate and to stimulate local consumer demand for imported goods in order to address this trading imbalance. However, Mr. Pozen contends that the solution does not lie in currency appreciation (his estimates suggest a 20 percent gain in the renminbi versus the dollar would reduce the U.S. current account deficit by no more than 5 percent) or in more direct economic stimulus (China is already stimulating its economy more than any other country in the world). Rather, he argues, China’s extremely high personal savings rate (20 -30 percent) stems from its inadequate public pension and healthcare systems. He maintains that only by creating a better social safety net can the Chinese government give its citizens the confidence to spend more of their incomes and in the process bring down the country’s current account surplus.

Mr. Pozen is very critical of the typical model for mortgage securitization—as it incorporates no retained risk by the originator or securitizing firm, and it consists of a multi-layer structure with a credit rating secured under conditions fraught with conflicts of interest. Instead, he suggests a new model with a minimum of 5 percent retained risk exposure by the origination/securitization firm, a simple structure of improved and ongoing disclosure, and a rating supplied by an independently-chosen rating agency.

Mr. Pozen also proposes a new model for the boards of large financial institutions, which would reduce the number of directors to 5-7 “super-directors”, all of whom should be well-experienced in the financial industry. The new model would replace the current board, which typically consists of 12-18 directors, drawn from a wide range of backgrounds. He suggests that the “super-directors” should meet for two to three days per month, compared to a current standard of six days per year, and that each “super-director” have no more than one other corporate board position so as to limit any potentially distracting commitments.

At the seminar Mr. Pozen praised Canadian financial institutions for their relatively strong capital ratios and mortgage financing practices – namely prudent income-screening; substantial down payment requirements (most commonly 20 percent); full lender recourse to a borrower’s other assets (in contrast with U.S.-style “NINJA” (No income, No Jobs) loans and a general lack of U.S. lender recourse beyond the property); and no tax deductibility of interest to fuel speculation with excessive borrowing. He noted that even though U.S. lending practices were loosened partly to encourage wide homeownership for social reasons, the percentage of the population that owns a home in the U.S. is no greater than it is in Canada.

Mr. Pozen expressed sympathy for the view among Canadian banks and the Canadian government that a new global bank tax would unjustly penalize those financial institutions that had been prudent in the past. He suggested that perhaps in the context of reaching a new international agreement, Canada should offer to implement higher capital requirements for its banks as a substitute for a bank tax.

Robert Pozen promotes his recently published book Too Big to Save?

Mr. Pozen offered additional solutions in person and in his book on issues ranging from better systemic risk monitoring, to the establishment of a new clearinghouse for credit default swaps, widely acknowledged as a prime culprit in the credit crisis. Among his specific ideas and proposals:

• A prohibition on negative amortization loans (except in special circumstances such as imminent foreclosure)
• New rules codifying standards of practice for underwriting, servicing, and advertising mortgages
• Interest subsidies in place of no-down payment loans to assist low-income homebuyers
• Limit interest deductibility to a taxpayer’s primary residence only
• Reinstate the uptick rule for short selling
• Raise margin requirements in futures markets to discourage speculators
• Implement systemic risk monitoring of large hedge funds by the SEC and Federal Reserve
• Create new federal charters for large U.S.-based global life insurance companies to improve systemic risk controls
• Require more anti-cyclical capital and reserve requirements to cope with excessive leverage
• Limit executive compensation by establishing low base salaries, adopting extended periods for measuring performance-based remuneration, incorporating downside risk in incentive packages, adjusting stock option exercise prices for movements in relative stock prices indices, and limiting the amounts of severance and pension payments
• De-linking fair market value accounting from capital standards
• Deferring the costly adoption of International Financial Reporting Standards (IFRS) until key differences between U.S. GAAP principles and IFRS are resolved

Mr. Pozen suggested that the US Federal Reserve, by participating in the bailouts of more than 600 financial institutions to date, crossed the line from a monetary to fiscal authority and now holds only 30 percent of its assets in U.S. Treasury securities, compared to a more normal 90 percent. He urged the Federal Reserve to return to being a pure monetary authority again in order to protect its independence.

Moreover, Mr. Pozen criticized the poor terms received by the U.S. government for its massive bailout of financial institutions compared to private sector suppliers of capital (calling it a form of “one-way capitalism”). The U.S. government received warrants to buy only 15 percent of the amount of its preferred stock, while Warren Buffett received warrants to buy 100 percent of his preferred stock in Goldman Sachs.

However, despite considerable popular support for reinstatement of Glass-Steagall Act he suggested no changes to the universal banking model now in place. Such action he said, would simply drive financial business abroad in the context of a global financial world. In addition, he pointed out that neither securities underwriting nor proprietary trading by banks was a significant cause of the financial crisis. Unfortunately, he concluded, U.S. banks simply made fundamental mistakes in extending loans and acquiring bonds. In other words, they failed in their core business of commercial banking.