One man in this picture did his job properly.
Three months into the financial collapse, much of the debate is centering around the role of regulation in the crisis. Democrats are claiming the deregulatory atmosphere in Washington over the last 8 years caused much of the fraud and other criminal behavior that’s come to light. Republicans are arguing that the push for low-income home ownership and the expansion of Fannie Mae and Freddie Mac caused the subprime housing bubble. In the balance lies the layout of whatever eventual fiscal stimulus should pass: Will it be a market-centric solution, focusing on tax breaks and consumer spending, or an infrastructure-centric solution, focused on government spending and programs?
Ultimately, though, regulation was never the cause of the crisis. The question of “too much” or “too little” is moot – Nobody was enforcing the regulations left on the books. The three biggest culprits in the fiasco are the SEC, the Federal Reserve, and the Ratings Agencies.
Certainly, there are others guilty of malfeasance. Subprime lenders lent to anyone dumb or greedy enough to sign their name to a contract, creating loans specifically designed not to blow up soon enough to wind up back with the originators. Investment Banks bought, packaged, and sold these loans with no questions asked, and frequently, with questions specifically avoided. Larger banks issued Credit Default Swaps against these instruments without worrying whether or not they had the capital to cover. Pension plans, hedge funds, and insurance pools invested in CDOs and instruments they didn’t understand, putting their investor’s money at stake. Investors took outsize returns without asking any questions. The money was too good for too long, and nobody was willing to look behind the curtain.
Egregious though this may seem, all of this is par for the course. Wall Street runs on greed – it always has. It’s the job of investors, banks, and funds to seek outsize returns, and the speculators taking out Option ARMs on McMansions were following the same instinct. So why was it different this time?
The worst possible case for Wall St. is unenforced regulation.
In a case of heavy regulation, innovation may be stifled to the detriment of the economy at large. Subprime, for all the villany the phrase now embodies, has helped millions of dedicated, honest individuals into houses who otherwise might not have been able to get a mortgage. Stated income loans are invaluable for individuals with highly variable loans. CDOs, CDSs, and the rest of the alphabet soup of financial innovations are not, by themselves, bad. When investors fully understand the structure of these arrangements and the risks involved and are able to charge for that risk accordingly, these instruments can help spread capital more efficiently. To paraphrase another social movement, there’s no good reason to stop two consenting adults from knowingly engaging in any relationship they deem fit.
For this reason, a fully unregulated market is not by definition a bad thing. In an unregulated market, investors are required to do their own research, assess their own risk, and price accordingly. No doubt, many an investor will lose big, and the overall volume of investment will be much lower. The safety net of regulation cuts a good deal of risk out of the markets, making wider participation more attractive to more investors. Still, savvy investors can make money in an unregulated market, or simply hold their cash, and it’s hard to shed too many tears for greedy suckers. Left solely to their own devices, investors have nobody but themselves to blame for losses.
The worst case, however, is when investors Think they have a safety net that they do not, and that’s exactly what happened with the subprime crisis. The three critical regulatory bodies failed in their duties, and the economy is showing the consequences.
The first failure was that of the ratings agencies. These companies were chartered and endorsed as the standard bearers of risk assessment. It was their job to give unbiased ratings to the various securities, including bonds and even CDOs. At some point (around 1996 for Moody’s), these companies stopped focusing on the investors and started focusing on culling relationships with the issuers of these securities. The ratings started gravitating upwards, and somewhere along the way, piles of subprime mortgages lent with nearly no oversight started earning investment-grade ratings. The AAA ratings were crucial to the explosion of subprime – without the clean bill of health, pension plans, insurance companies, and many other large investment pools would have been unable to buy these investments, and many other investors would have shied away from these instruments. The high ratings gave investors an undue sense of security, one purchased with decades of brand equity from the big three ratings agencies.
The Federal Reserve under Alan Greenspan committed itself to a conscious policy of lax regulation, espousing Greenspan’s own libertarian ideals. The list of mistakes is significant, but the problems started with historically low interest rates over the last five years. The flood of cash flowed straight into the housing market. Greenspan refused to regulate, or even investigate, the new CDO vehicles, nor would the fed investigate numerous reports of fraudulent lending among mortgage originators. Because the Fed stayed so far behind the curve, they were blindsided by the extent of the damage from the subprime collapse. When Bear Stearns collapsed, federal regulators were so shocked by the extent and scale of the shadow banking system they were forced to give a $20Bn company to JP Morgan for $2Bn to prevent the kind of carnage that Lehman Brothers eventually caused. Bernanke has since acted swiftly to stop a complete meltdown, and if he succeeds, I’ll forgive his earlier errors, but when a regulatory body is caught as far behind the curve as the Fed was, their negligence borders on malicious.
Finally, the SEC under Christopher Cox have been the finest group of keystone cops this century. Bernie Madoff’s $50Bn Christmas present shined one hell of a bright light on the laissez-faire attitude the agency chartered to watch after the markets has taken to its job. Madoff was egregious, but the SEC was complicit in the rating agencies’ slide into malaise as well. Numerous regulators and enforcers have commented on the SEC’s reluctance to pursue clear and obvious cases of fraud. But the biggest black mark against the agency is the 2004 decision to allow the Big 5 to lever up to 40:1, well more than double their previous limit and approaching hedge-fund territory. Finally, the SEC’s ban on short-selling was a painfully transparent bit of handout to the banks, investment firms, and whoever else managed to get themselves on the list (which included such noteable financial firms as GE and IBM).
In all three cases, there was either existing regulation, or the organization had the charter to create the regulation, to prevent the buildup that led to the financial collapse. In all three cases, the regulations were unenforced and the groups stayed willfully unaware of the changes in the markets they were charged to protect.
The depth of their complicity, however, was unknown to most investors. Market players were still acting as though they were in a regulated market, assuming the information and the ratings they were receiving were legitimate and the cops were still on duty. This led every participant to engage in behavior far riskier than warranted by the facts, and that nobody got bagged for violating the rules just led to more morally dubious behavior. It’s dangerous to have no regulation, but it’s even more dangerous when nobody knows the regulation isn’t there. Investors have been assuming a safety net that wasn’t in place, and now they’re seeing the level of risk they’ve actually been exposed to.
Unfortunately, the damage is going to take a long time to undo. We can’t just implement new regulation – we’ve had plenty of regulation all along. Even banks, already heavily regulated and forced into onerous disclosures, don’t have enough faith in the legitimacy of their peers’ disclosures to lend appropriately. We need to show the market that we’re committed to transparency, equity, and full disclosure, and that we’re willing to enforce the rules. Only then can investors and lenders re-enter the market with any confidence, and only then can we hope to fully restart our economy.
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