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Sunday, March 23, 2008

"A Coordinated Effort to Destroy Effective Regulation"

Fred Block, an economic sociologist at UC Davis, explains the political changes that led to the financial crisis:

Mortgage Meltdown for Dummies: Defining the Changes We Need, by Fred Block, Dissent: ...[T]he escalating crises of the housing and financial sectors have the potential to concentrate our minds on the specific reforms that our nation urgently needs. This requires understanding how our current problems are a direct result of the policies pushed by Republican Presidents from Ronald Reagan to George W. Bush.

The story begins with systematic efforts by Ronald Reagan to dramatically reduce the regulation of financial markets and facilitate a huge transfer of income and wealth to the highest income households. These policies were embraced and expanded by later Republican presidents and “succeeded” in producing a new era of income inequality and out-of-control financial activity. ...

Starting in 1981, Ronald Reagan set out to deliver on two major changes that he had promised his business supporters. He significantly rolled back government regulation of the financial sector... At the same time, Reagan cut taxes for the very rich, a policy initiative that was replicated by George W. Bush. Taken together, these steps facilitated a dramatic shift of income...

As the rich grew wealthier, they invested growing amounts in hedge funds that pursued risky strategies to earn annual returns that were far higher than those available for ordinary investments... The government never regulated these funds because they were closed to most people; one had to exceed a certain wealth threshold to play. The theory was that these already rich investors could cope if these highly speculative investments turned bad. ...

As hedge funds grew increasingly successful, they produced rate of return envy among established financial institutions. Pension funds, for example, wanted a piece of the higher return action and started putting some of their money into these unregulated funds. The big investment banks, similarly ... started imitating the strategies pioneered by the hedge funds. Many of them, like Bear Stearns, were even allowed to create their own hedge funds. ...

This is where the subprime mortgages come in. Starting in the 1990s, some independent mortgage brokers and mortgage firms figured out how to make money by lending to poor people who could not qualify for standard mortgages. The firms acted just like the local pawn shop, appealing to relatively desperate people who would be willing to pay substantially higher interest rates if only they could own a home. ...

Since housing prices, even in low income neighborhoods, were rising steadily, the lenders thought they faced little risk. Even if the borrower defaulted, the lender could always foreclose and sell the house for an even higher price... [B]ankers were eager to package large bundles of these mortgages and resell them to hedge funds and other investors. ... Hedge funds bought huge quantities..., usually using borrowed money..

This whole house of cards rested on the assumption that housing prices would continue the rise... But as subprime lending expanded, so too, inevitably did foreclosures, and as more foreclosed properties hit the market, prices started heading downward. ... By February 2008, almost nine million homeowners ... owed more on their mortgages than the house is worth, and that number is bound to rise...

[A] task for a new administration is to reverse the mistaken policies that created this mess. The right-wing experiment with free market orthodoxy has been a complete and total failure. It is time to repair the damage by driving the top 1 percent share of household’s income back down... We also need to restore effective regulation to all corners of the financial sector, especially hedge funds. ...

About that regulation:

Hiding behind the invisible hand, by Paul Krugman: Pretty good story on the coming fight over financial regulation. But it lets the Bushies off way too lightly, by suggesting that lack of coordination between agencies led to the awesome failure of regulators to take action against the bubble:

Except for the Federal Reserve, all of the federal bank agencies receive funding from fees paid by member institutions, and some specialists have long argued that the agencies competed with each other to woo institutions with lighter regulation.

“There was no federal coordinated oversight, and as a result there was a competition to reach the bottom, both in federal and state organizations,” said Brian C. McCormally, a former enforcement chief at the Office of the Comptroller of the Currency.

Actually, there was plenty of coordination — a coordinated effort to destroy effective regulation:

Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

The lack of oversight, in short, was no oversight: it was part of the plan.

Here's some of the "Pretty good story":

In Washington, a Split Over Regulation of Wall Street, NY Times: As Congress and the Bush administration struggle to contain the housing and credit crises ... a split is forming over how to strengthen oversight of financial institutions after decades of deregulation.

The administration and Democratic lawmakers in Congress agree that the meltdown in credit markets exposed weaknesses in the nation’s tangled web of federal and state regulators...

But the two sides strongly disagree about whether, after decades of a freewheeling encouragement of exotic new services and new players like hedge funds, the pendulum should swing back to tighter control. ...

Given the philosophical differences about the value of government regulations, some experts were skeptical that Congress and the Bush administration would agree on more than cosmetic changes.

“There is a political will, but I’m not certain that it can overcome longstanding philosophic objections to dealing with free markets in a crisis environment,” said Arthur Levitt Jr., the chairman of the Securities and Exchange Commission under President Bill Clinton. ...

Regulations can make markets work better, so it's not clear to me why those who believe in the power of markets have such a knee jerk reaction against any kind of regulatory oversight.

One way regulation can help markets function efficiently is to require that full and truthful information be made available to all market participants. We see regulations like this so much that we take many of them for granted, e.g. weights and measures regulations, truth in advertising and labeling, full disclosure rules in housing markets, and so on. Without government to enforce these rules, markets can break down or lose efficiency.

One aspect of the problems in financial markets is exactly like this, information is incomplete or asymmetric, and these problems are pervasive. For example, complicated financial instruments are difficult to evaluate because they lack transparency. Currently, with all the financial turmoil, nobody is sure what they are worth, market participants don't have the information they need to make that determination, and many markets have broken down entirely. Similarly, there are also information problems in real estate markets, with real estate agents and mortgage brokers much better informed about the variety, eligibility, and terms of loan products than their customers. This made it easy for real estate agents and mortgage brokers to steer customers into loans that were profitable, but not always in the best interest of their customers. On the other side, customers don't always reveal truthful information about their situations, e.g. their income, debts, etc., and this can also lead to inefficiencies (and sometimes both sides work together to fool the next person in the chain).

There are many other regulations that are needed besides those intended to increase available information, one example is increasing capital requirements, and different regulations address different market failures. Not only do we have information problems in these markets, we also have moral hazard issues of the type that occur when people do not have enough of their own money at stake when taking on risky investments using other people's money (borrowed or deposited). Capital requirements will likely encounter more resistance than measures to increase transparency, but it is a means of reducing excessive risk taking and the options need to be fully explored.

There's a lot more to do, redefining what a bank is, and then bringing all banks under a consistent and central regulatory authority, rethinking the discount window (we are likely headed to a channel/corridor system anyway, so it's a good time to rethink the whole operation, what assets can be traded, with whom, etc.), but to emphasize the information aspect more, here's Tyler Cowen:

It’s Hard to Thaw a Frozen Market, by Tyler Cowen, Economic Scene, NY Times: Real estate bubbles have burst before, without bringing such trouble to the financial system. What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values. ... The results have been a form of financial gridlock.

If you think that traders have been well informed of late, take another look at the wild path of Bear Stearns shares: A year ago, the stock was selling for $170 a share. At the close on March 14, just before the deal by which Bear Stearns was to be bought by JPMorgan Chase, Bear had a book value of $80 a share — and a share price of $30. The JPMorgan transaction, arranged two days later, valued the company at about $2 a share. Since then, the shares have been trading above $2, which in part reflects the possibility of the deal breaking up.

Every step of the way, the pricing of the stock has surprised the market — and yet Bear Stearns is a firm with a lengthy history, not an Internet start-up or a biotech whose value is based on a new but untried wonder drug.

To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.

The subsequent poor performance of planned economies bore out his point. ... The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. ...

Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.

The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined. Who wants to lend to the institutions holding them? No wonder there is a credit crisis and a general attitude of wait and see. ...

So what now? Regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions. This will limit dangerous leverage, contain contagion effects and make the system less dependent on the steady flow of good information. ...

Update: More on the need for regulation, and on the need to consolidate regulation under a single authority:

U.S. Financial Regulation 2008, by John Tepper Marlin: In late 1999, the bulwark bank regulation of 1933, the Glass-Steagall Act - the wall between investment banks and commercial banks - was torn down. This was a great victory for creative bankers, who had found the wall irksome and restrictive.

The teardown opened the way for the Bankers Panic of 2008.

Senator Carter Glass, who was a leader in the creation of the Federal Reserve System in 1913, saw how the deposits of correspondent banks flowed to New York City where the big banks were tempted to speculate with the funds and he was determined to keep the investment-banking foxes out of the commercial-banking chicken coop. A wall was created around the banking system to prevent bank deposits being used for speculation by investment banks.

When the wall came down in 1999 with the Financial Modernization (Gramm-Leach-Bliley) Act, what was outside the wall should have been brought under expanded regulatory responsibilities of the Federal Reserve or the SEC, or both. ...

I was an economist at the Federal Reserve Board and the FDIC during the William McChesney Martin era at the Fed, and I vividly remember a long-time staff member of the FDIC, a southerner with an amazingly large-brimmed floppy hat, telling me more than once that if you hadn't lived through the Depression you couldn't know how much damage is caused when bank credit dries up and how important it was to keep commercial bank assets from being used for speculation.

Back then, in 1999, the Economist Magazine wondered why the wall between banks and investment banks was taken down without regulatory reform. Two years before, the Brits consolidated their regulatory system. The reason for the persistence of the multiple financial regulatory authorities in Washington (and the states) was given as follows by John D. Hawke, Jr., Comptroller of the Currency ... in 2000: "Regulatory competition has stimulated innovation and efficiency. Competition keeps all of us on our toes, and provides incentives to add real value to our supervision. While the system unquestionably provides opportunities for regulatory arbitrage, there is little evidence that it has stimulated the competition in laxity that former Federal Reserve Chairman Arthur Burns discussed 30 years ago."

Today, competition in laxity and regulatory arbitrage seem good descriptions of what has occurred in financial markets since 1999, at an accelerating pace. The worst possible situation for an institution seeking to avoid regulation is a single regulator. A large number of regulators creates the impression for the consumer that the system is tightly controlled, while creating ample opportunity for innovators to do what they want. Could mortgage bankers have succeeded in processing so many subprime mortgages if borrowers weren't fooled by the paperwork into thinking that the process was under some kind of regulation? Could so many CDOs have been sold if investors in the United States and overseas weren't reassured by the many bank regulators and the SEC and the monoline insurers and the rating agencies that the securities they were buying were as advertised?

If we really want to modernize the American financial system, we need a single government entity in Washington to oversee it. This entity - perhaps a Treasury-Fed-SEC Regulatory Commission - might seek to impose and enforce capital adequacy requirements proportional to risk on all financial institutions and address issues such as moral hazard and disclosure across the entire range of players.

The Economist was right in 1999 to recommend that modernization of the American financial system be accompanied by regulatory reform. On March 19 ("What Went Wrong") the Economist now argues that the financial industry "is unlikely to grow as it did in the 1980s and 1990s. If finance is foolishly reregulated, it will fare even worse." This wobbly sentence needs to be parsed: ...If the sentence means that any new regulations would be foolish, the Economist is pre-judging what the Congress might come up with. New regulations are going to happen. - If the Economist means that new regulations should not be adopted if they are foolish, then who could argue with that?

Update: See Paul Krugman Doesn't Need My Help, by Robert Waldmann

The ... problem is not, say, that commercial banks which were allowed to own common stock gambled and lost. The way in which the Glass-Steagal act would have been relevant is if the investment banks had taken deposits. They didn't. The crisis is based on commercial banks being irrelevant, not on their being allowed to do things they couldn't do before. ...

    Posted by on Sunday, March 23, 2008 at 02:43 AM in Economics, Financial System, Market Failure, Regulation | Permalink  TrackBack (0)  Comments (68)

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