Reform of the Regulatory System

As I reflect upon the regulatory system, or lack thereof, which has partly contributed to today’s economic challenges, I have reexamined my view of the mission of banks in this complex world. Not surprisingly, it hasn’t changed.

A bank’s mission is to make loans that can be repaid, gather low cost deposits, maintain liquidity, acquire sound investments, establish appropriate reserves, and preserve adequate capital. This mission may seem rather mundane when described this way, but, if done right, shareholders will prosper over the long haul. The bank will survive and prosper as well. It is when these fundamentals are compromised by greed, ignorance, technological complexity, manipulation, and/or unintended consequences from ill-conceived regulations and legislation that banks and banking systems begin to stress. This is where we find ourselves today.

The Whitney, with approximately $12.5 billion, is 125 years old, well capitalized, and is predominantly a commercial enterprise. Domiciled in New Orleans, its footprint stretches from Houston to Tampa. While it has experienced the bottomless valuation phenomena prevalent in the state of Florida, and is experiencing the repercussions of a distressed economy, it is important to take note that the Whitney did not participate in the creation or accumulation of subprime, exotics, or no-documented instruments, and has avoided executing, purchasing, or retaining complex or synthetic derivatives. Nor has it invested in hedge funds or been a party to credit default swaps. I would speculate that, in regards to these factors, it matches the profile of in excess of 80 percent of all banks regulated by the OCC and the Fed (not 80 percent by size, of course, but rather by number). Today, all of us are the victims of a great paint brush which equates the actions of a few to the whole. Hopefully, we can and will avoid future repetition.

To that end I would suggest that as we infuse significant funding into our economy, we take the time to critically analyze the regulatory system and determine if it meets the challenges presented by this new world.

There seems to be little doubt that the root cause of our malaise is real estate—the abnormal increase in the number of mortgages and the proliferation of non-traditional underwriting standards. It is evident that a significant percentage of those lenders that prepared and executed these mortgages had little or no understanding of the fundamental principles of lending; or worse, they were driven by greed with full recognition that, because they had no skin in the game, they had little concern for the inherent train wreck that would ultimately overwhelm the system. These individuals and, in certain instances, unsupervised or under-supervised financial companies, violated the implicit principle that loans are underwritten with the expectation that the borrower can repay. Two and 28, three and 27, no docs, and similar loan terms clearly violate that principle.

Bringing this segment of the industry under the tent through regulation can begin the process of avoiding similar results in the future. At the same time, it is apparent that one or more regulating federal or state agencies utilized different standards of review for institutions under their domain, which allowed for the execution and proliferation of identically flawed mortgages. Uniformity of standards is essential.

A significant portion of these ill-conceived mortgages were sold upstream to investment houses and other institutions and ultimately bundled and securitized into what we now refer to as “toxic assets.” The method by which they were classified as something other than toxic—so as to facilitate their sale—was the imprimatur of approval rendered by one or more of our esteemed rating agencies. Without delving into the various reasons, these bundled instruments received ratings bearing little relationship to the quality of the securities themselves. Suffice it to say that by virtue of that seal of excellence, the holder was then able to sell the bundle to financial companies and others throughout the world. Regardless of whether the alleged seal of excellence was a byproduct of ignorance, conflicts of interest, or worse, the rating system has been called into question and it must be fixed. Accountability on the part of the acquirer to inspect what he is purchasing is also critical and should be required to the end that the purchasers assume some responsibility for at least trying to understand the quality of the acquired assets.

The third leg on this stool may present the ultimate conundrum. Complex derivatives, synthetic derivatives, hedge funds, and credit default swaps are difficult enough to understand individually but when we begin to think of them as trillions of dollars of on- and off-balance sheet obligations, is it not almost beyond our capability to assess risk? At the Whitney we chose not to deal in these instrument types as no one understood them. Some might suggest that this speaks to a lack of sophistication. Maybe so, but then you might want to question how many members of the boards of directors or, more succinctly, the management of WAMU, Countrywide, Merrill Lynch, Bank of America, Citibank, Lehman, Bear Stearns, AIG, and others had any idea of what was, or for that matter, is still in their portfolio and the risk associated with those portfolios? I suspect we all know the answer—not a clue. So when faced with such massive portfolios aided in large measure by complex technology, how can we be reasonably assure that we have gotten our hands around the problem? As you consider the possible solution you might also juxtapose the whole idea of “too big to fail.” Maybe a partial answer lies in posing the question, are they too big to regulate?

The accumulated impacts from these three issues ultimately accelerated the arrival of the long-anticipated recession. As the number of foreclosures increased and the value of the underlying assets of homes and commercial real estate decreased, other policies and regulations were also called into question. While there are others that might be the subject of a discourse, in this instance I speak particularly of the role of market value accounting and the inability of financial institutions to apply judgment in establishing reserves. These two policies fail as their application are counterintuitive and have contributed to the fundamental weaknesses.

Mark-to-market accounting was eliminated during the Great Depression as the very concept required institutions to reevaluate assets under conditions with no comparables. It resulted in irrational write-downs and diminished capital. Sound familiar? The SEC in the early 90s unilaterally reinstated the rule. The observations of the 1930s hold true today, when there is no connectivity between the ground condition relative to the valuation of assets, and the fundamental predicate forming the stated basis for mark-to-market, applying mark-to-market accounting is not just counterproductive, but damaging as well. If you question this, focus upon the happenings in Florida, California, and Nevada. The application of mark value accounting should be suspended.

Additionally, restricting banks from using rational judgment in establishing reserves is also counterintuitive. Today, established reserves are based primarily upon known losses, which results in banks diminishing their reserves in good times, prohibits adding reserves when economic clouds begin to appear, and results in having inadequate reserves upon the arrival of the downturn. As a result, rather than rationally establishing reserves in good times for the purpose of securing safety and soundness, banks generally exhibit unsustainable higher earnings which have little bearing upon the long-term strength and stability of the institution. When a severe economic downturn begins, the immediate reaction is to quickly supplement reserves at the same time as the bank’s revenue stream is compromised— all of which results in the impairment of the most critical of assets, capital. Thus the fundamental requirement to maintain every element of safety and soundness becomes compromised at this most critical juncture. The SEC might feel comfortable with this result but I suggest no one else should. It requires total re-examination.

As in the past, we are witnessing the fragility of our financial system. Its maintenance depends upon regulations that support strength and stability and appreciate the nuances required not only to meet different risks in different geographic localities, but also the vagaries of changing economic conditions. Strict arbitrary rules which impede the ability to anticipate changing conditions cause uncertainty and impact credibility. Ultimately this situation can severely impact reputation which, under certain circumstances, foreshadows closure.

Mr. Milling previously served as the President of Whitney Holding Corp. and its subsidiary, Whitney National Bank from 1984 to March 2007. He is retired from the Bank as of December 2008. This article is adopted from a speech he presented on February 19, 2009.