Arnold Kling  

What's Wrong with the Financial Regulation White Paper

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I am reading this draft. Also of interest is this interview with President Obama.

Early on, the draft white paper says,


Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to out government's ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole.

I have to disagree with the last sentence. The Fed has always seen this as its job. It did when I worked there, and it did both before and during the crisis.

I also disagree with the tone of the first sentence, which makes it sound as though the problems were caused by unregulated firms. In my view, the problems were poor mortgage underwriting standards and too much credit risk held by institutions with too little capital. The holders of credit risk were regulated institutions, especially Freddie Mac, Fannie Mae, and the banks. They took on excessive risks right under the noses of their regulators. The regulators approved the use of AAA and AA ratings of mortgage securities to reduce bank capital. They approved the banks' use of off-balance sheet entities to reduce capital even further. They approved the entry of Freddie Mac and Fannie Mae into the business of purchasing subprime mortgage securities.

In football terms, the problem is not that regulators were in the wrong formation or fell for trick plays. The problem is that they did not tackle.

The white paper says,


First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times. Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed.

From the perspective of many insiders, including key officials as well as economist Gary Gorton, there was a liquidity crisis last year. AIG and other companies suffered from what amounted to bank runs. In my view, the real issue was more one of solvency. Banks and other firms genuinely lost enough money on bad mortgage loans to wipe out their capital. You can say that capital requirements were too low. But to me it looks more as though banks found ways to game the system of capital requirements, using techniques approved by regulators.

Two gaping holes in the white paper are housing policy and tax policy. On housing policy, a wide range of interest groups promotes leveraged purchases of houses. The net effects of this are the opposite of good public policy--private benefits for people in the real estate and mortgage industries with social costs in the form of paying for subsidies and cleaning up the mess.

In the interview, President Obama says,


I think you've got a broader structural problem in our economy in which our last two recoveries had been based on bubbles, and a massively overleveraged consumer, a massively overleveraged corporate sector, and a financial system that didn't have much restraint.

Both the President and the white paper blame this excess leverage on greed and faulty compensation structures. What about taxes and subsidies? Our high corporate tax rate, along with the deductibility of interest for corporations, encourages corporations to look for ways to minimize equity financing. For individuals, government-subsidized mortgages and the tax deductibility of mortgage interest help to encourage over-leveraging.

Overall, the white paper offers a highly skewed narrative of the financial crisis. All of the misbehavior took place in the private sector. No mention is made of government policies that contributed. Instead, the story is one of government that needed a better regulatory structure and more powers.

Intellectually, this is a very disappointing piece of work. But given political considerations, I cannot say that I am surprised.


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TRACKBACKS (2 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/1979
The author at Jim's Blog in a related article titled The universal government white paper: writes:
    In short, the white paper tells us: Politicians are of course entirely lily white and innocent, except that the other party allowed bad people in the private sector to do bad things. Some regulatory agencies failed to do enough. Solving the problem req... [Tracked on June 18, 2009 6:05 PM]
The author at Economics in a related article titled Kling on Financial Regulation writes:
    Arnold makes several good points , including this one: In the interview, President Obama says, I think [Tracked on June 19, 2009 6:16 AM]
COMMENTS (27 to date)
fundamentalist writes:

“First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times.”

All of that is very clear in hind sight. We should keep in mind that what in hind sight appears to have been risky was not viewed as risky at the time. I disagree that people knew they were taking huge risks in the past. That simply is not true. Very few people thought they were taking on risky investments or that they had a higher tolerance for risk.

Those investments appear risky now simply because the real estate market collapsed. Few people thought that the real estate market would collapse on a nation scale. It had never happened before, so why would they expect it to happen now? Real estate collapses were always a regional affair.

At the same time, you had every mainstream economist in the nation, including Nobel Prize winners, reassuring the nation that the Fed never causes any harm. The Fed can flood the nation with paper dollars and nothing bad will happen. As a result, a few people, but very few, saw the housing market as a bubble, but mainstream economists saw it just a higher level of equilibrium.

It’s irrational to attribute knowledge and perspective we have today to people in the past. The real question we should be asking is why businessmen, investors and regulators back then did not see the riskiness that is obvious today. The answer lies in bad macro theory and worse monetary theory.

I thought the five points of his solution were horrible:

1. Increase Gov't Power
2. Increase Gov't Power
3. Save Consumers and Investors From Themselves
4. Create Regime to Find Ways to Increase Gov't Power
5. Cooperate Internationally to Give Europe and China more of a say in our financial systems

I couldn't find anything intellectually or logically of worth in the paper either! Who could support this?

fundamentalist writes:

It's the same old tune played by socialists for the past 200 years and we're stupid enough to dance to it every time:

step 1: declare the present crisis to be the worst that mankind has faced since the last ice age.

step 2: round up the usual suspects--greedy businessmen, bankers and incompetent bureaucrats.

step 3: demand more power for the all-wise state to control everything and everyone.

step 4: cha-cha-cha

Isn't anyone getting tired of this old song and dance routine? Maybe I'm just getting too old.

funny da mentalist writes:

Too bad socialists don't follow the underpants gnomes' playbook.

1) Collect underpants
2) ?????
3) Profit

Would make about as much sense...

SaulOhio writes:

You have the method wrong.

1: See a minor problem and impose a thumbfingered solution.

2: Watch your solution cause more problems.

3: Blame these new problems on the free market.

4: Use the above as an excuse to impose more thumbfingered solutions.

Walter writes:

"In football terms, the problem is not that regulators were in the wrong formation or fell for trick plays. The problem is that they did not tackle."

Personally, my suspicion was that it the problem was more that they had down bets on the other team.

"It’s irrational to attribute knowledge and perspective we have today to people in the past. The real question we should be asking is why businessmen, investors and regulators back then did not see the riskiness that is obvious today. The answer lies in bad macro theory and worse monetary theory."

Bad macro theory, and bad monetary theory are clearly major contributors. But you are being very naive when you suggest the businessmen were not aware of the serious mispricing of risk that was going on.

There has been plenty of evidence that both the traders and the ratings agencies knew what they were selling was garbage, but the ratings agencies are paid by the seller, so there were and are clear and present incentive problems at play.

The investment banks knew they were playing with extreme risk, and they knew there was a bubble (but since their competitors were profiting off the bubble they had no choice but to play the game as well or lose customers). It wasn't that they weren't aware there was a bubble, it was that they thought they were hedged with their CDS positions.

The only company that's actions suggest they weren't aware of the bubble is AIG... They were either far and away the dumbest guy at the table, or the corruption and lack of ethics were Enronish at best.

Walter writes:

"No regulator saw its job as protecting the economy and financial system as a whole."

"I have to disagree with the last sentence. The Fed has always seen this as its job. It did when I worked there, and it did both before and during the crisis."

Sorry to double post, but I though of one other thing I wished I had responded to in my previous post.

From the outside looking in, it doesn't appear at all that the Fed considered that to be it's job. The statements from Mr Greenspan, and later Mr Bernanke consistently carried the message that the market was self-regulating... all we had to do was stay out of it's way and things would be fine.

mhodak writes:

"The statements from Mr Greenspan, and later Mr Bernanke consistently carried the message that the market was self-regulating"

Whatever one can deduce of Greenspan or Bernanke's personal philosophies, their JOB was to fix the price of credit in the U.S. This is hardly a laissez faire role.

mhodak writes:

I like these other lists, and will contribute my own, regarding what one could have predicted about any report written by political leaders:

1. No real blame would fall on the politicians
2. It was just a matter of who (outside of the relevant regulators or agencies) would be blamed.
3. The conclusions would center on "more power to the government"
4. The agencies that failed the worst would end up with the greatest increases in power and money.

fundamentalist writes:

Walter: "There has been plenty of evidence that both the traders and the ratings agencies knew what they were selling was garbage..."

There is plenty of evidence that many people claim that they knew what was going on, but little evidence that they are not lying. Who wants to admit that they were duped? How will you get a book deal or an appearance on CNBC by admitting you didn't see this crisis coming. Suddenly, everyone knew it was happening; they just went along to make money. To hear them tell it, no one was fooled. But a lot of smart people lost a lot of money.

And how is it that just the sellers of the junk knew it was junk? Were the buyers the only stupid people in the country? I just don't buy all of the wise johny-come-latelies.

fundamentalist writes:

The only people who saw the problem with the housing bubble and the coming crisis were a small handful of Austrian economists. Everyone else is lying.

Here is a challenge: first diagram out the new organizational structure described in the white paper. Now make a list of all the areas of concurrent jurisdiction created and interdependencies among these agencies.

The checks and balances built into this new regulatory regime are considerable. Remember that the "efficiency" of a more unified, laissez-faire regulatory scheme is what got us into this mess.

The tradeoffs are between divisions of labor between regulators and political checks & balances needed to ensure nothing gets missed. Perhaps we are well-beyond our economy of scale in regulating finance with this white paper. But that remains to be seen. I think some money will be attracted to the ethos of the white paper, which is quite different from the Atlas-Shrugged attitude of the previous administrations.

Walter writes:

"The only people who saw the problem with the housing bubble and the coming crisis were a small handful of Austrian economists. Everyone else is lying."

---

Internal agency documents released last month as part of an investigation by Rep. Henry Waxman's House Oversight and Government Reform Committee show that at least some ratings analysts were aware that their ratings were more about increasing their company's bottom line than accurately gauging the value of the securities at issue.

Here's one IM exchange from April 2007, between two S&P analysts, reported last month by the Wall Street Journal --:

Rahul Dilip Shah: btw -- that deal is ridiculous.
Shannon Mooney: I know right ... model def does not capture half of the risk
Shah: we should not be rating it.
Mooney: it could be structured by cows and we would rate it.

And in a 2007 presentation to directors, Moody's CEO Raymond McDaniel wrote:

Analysts and MDs [managing directors] are continually 'pitched' by bankers, issuers, investors -- all with reasonable arguments -- whose views can color credit judgment, sometimes improving it, other times degrading it (we 'drink the kool-aid'). Coupled with strong internal emphasis on market share & margin focus, this does constitute a 'risk' to ratings quality.

At a hearing he held on the issue, Waxman himself quoted another S&P analyst asserting:

Rating agencies continue to create an ever-bigger monster, the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters.

PassingShot writes:

I you make the assumption that housing values will always rise on a national basis, you can justify a lot of risky behavior. For example, unqualified borrowers can always refinance, or at worse sell their homes for a handsome profit. By conventional metrics, many knew that housing was way overpriced, but no one wanted to stop the partying. Even the rating agencies joined the dancing. Many were making easy money by purchasing sub-prime loan products with short-term loans. This is now the hangover from being so intoxicated. Partying behavior seems so reasonable while the dancing and drinking are going on.

fundamentalist writes:

Walter: "at least some ratings analysts were aware that their ratings were more about increasing their company's bottom line than accurately gauging the value of the securities at issue..."

Ratings were a very small part of the picture, and a few analysts within that small picture saw that they were doing a poor job of rating. Most people disagreed with them, including their bosses. That a few cynical analysts happened to be right, like a broken clock, doesn't mean that the understood the crisis that would develop. The fact that they didn't warn anyone demonstrates how little they understood about the implications of what they were doing. They certainly didn't see the current crisis. At best, they saw that they were doing a lousy job of rating the credit of some companies and that could come back to haunt them personally. Did those guys really know something or were they just being cynical. It's easy to be cynical and accidently be right. What about the hundreds of analysts who thought they were doing a good job? Is there any evidence that the majority of analysts felt the same way as those highlighted?

Methinks writes:

If risk were so easy to calculate and control a regulator could do it, we wouldn't be in this pickle in the first place.


Walter & Fundamentalist, interesting debate. Anecdotaly, I know that to swim against the tide as an analyst can be career suicide. If you're wrong or your timing is off (collapse occurs after a period of time in which people managed to forget your report) or you are written off as a nag. If you're right AND your timing is impeccable, you win but you don't win nearly as much as you lose if you're wrong and/or have bad timing. Thus, there's a bias toward optimism among analysts. Walter points out there were people who thought we had reached irrational heights in the housing market. Many we don't hear from either stayed out or made a lot of money from the collapse - notably, John Paulson. He also points out that some ratings analysts didn't think that their risk models (which assumed ever increasing housing prices - good lord) adequately captured risk. Still, as fundamentalist points out, there's a big difference between KNOWING what was going on and what it would lead to and simply making predictions based on assumptions about the future. The sellers of this junk didn't think it was junk. If they did, they wouldn't have underwritten it in the manner in which they did and they wouldn't have kept any for themselves either. Gentlemen, I don't see your arguments as mutually exclusive. All of those things happened. The industry didn't broadly see this coming but some in the industry became uncomfortable with the situation. Nobody had or can ever have enough information about what's going on in the entire system to know what would happen and even if they did, they couldn't predict the exact outcome.

marginallyEmployed writes:

Does this work?
You have traders in a boxcar. There is room for signaling and exchange. There is concern for the train running off the tracks but everyone forgets about the flu. Trader gets on and has flu. Quickly everyone has the flu. Collapse.
Government steps in by loading the boxcar with more regulators, enough that signaling and exchange is reduced, lowering efficiencies. Regulator gets on with flu. Otra vez.
There seem to be many fun plays on this metaphor. Some are ugly.

Niccolo writes:

From the outside looking in, it doesn't appear at all that the Fed considered that to be it's job. The statements from Mr Greenspan, and later Mr Bernanke consistently carried the message that the market was self-regulating... all we had to do was stay out of it's way and things would be fine.

Walter, I have a friend who worked at the Chicago federal reserve as a financial markets consultant, and I can't remark upon how false it seems your statement is in regards to what people working at the federal reserve regarded their responsibilities to be.

Arnold is not the first person with banker experience that I've heard who said that it is a general tendency for people in the federal reserve to believe their responsibilities are to regulate the market. The few puff pieces of Greenspan and Bernanke on the wonders of the free market seem to me to be more of ideological phrases than job descriptions.

Walter writes:

"They certainly didn't see the current crisis. At best, they saw that they were doing a lousy job of rating the credit of some companies and that could come back to haunt them personally."

I'm not suggesting that they knew how big the implosion would be. I'm saying you are incorrect in saying that the business people involved had no idea that the risks were playing with out sized and understated. The games they were playing with accounting were all about being able to increase the risk (and therefor the reward) without it being visible to the world at large.

In my opinion the simplistic assumption that housing values would always go up was actually less a factor (and probably less universal than it's being bandied about as, and more a convenient excuse imo) than the assumption that CDSs spread and diffused risk.

"The few puff pieces of Greenspan and Bernanke on the wonders of the free market seem to me to be more of ideological phrases than job descriptions."

Ideological phrases are a large part of how leaders set the philosophical direction for the organizations they lead. You can say they are meaningless, but we will have to agree to disagree on that subject.

fundamentalist writes:

"I'm saying you are incorrect in saying that the business people involved had no idea that the risks were playing with out sized and understated."

I agree with methinks. A few people were concerned, mostly lower level analysts. Most were not. Why not? Why did the majority think they were doing the prudent thing? And risk wasn't there only concern. They had to consider profits and balance the risk/reward trade off.

My main point, however, was that no one saw the crisis coming except a handful of Austrian economists. Sure some analysts were concerned about their particular job, but not about a crisis in the entire financial system and the subsequent depression.

Niccolo writes:

Walter,

Recently - and in previous quotes - George W. Bush has spoken favorably of free markets, certainly as favorably as Alan Greenspan or Benjamin Bernanke.


How did his government react when given the opportunity to show how well his ideology guided the philosophy of the US government?

Walter writes:

The federal government is by design (in order to prevent tyranny) very inefficient and every decision and directive is is resisted by near half the government.

It's a weak comparison.

SINE NOMINE writes:

Sadly, I agree that it isn't surprising. Protect your interests, and so forth.

Reminds me of something you wrote before, Mr. Kling:

http://www.cato-at-liberty.org/2006/05/03/medicare/

Power corrupts, absolute power corrupts absolutely, and private-public partnerships absolutely corrupt the private sector.

We have reached the point in [__________________] policy where government is like the ten-year-old boy who starts fires so that he can be lauded as a hero for helping to put them out.

John writes:

If the rating agencies were free to give an unbiased analysis of an offering, then perhaps their rating would be more reliable. As long as they are chosen and their fees are paid by those whose offerings they are rating, there will be tendency to rate favorably. What if agencies were assigned randomly from a list of agencies certified by the SEC for particular specialties? Baseball teams don't get to pick their umpires. Students don't get to pick their proctors. I would think the key to keeping political influence out of it would be for the certification criteria to be transparent and the assignment to be random.

Sine Nomine writes:

Niccolo,

He showed it before - freetheworld.com shows USA dropping from a rank of 8.6/10 to 8.0/10 from 2000-2006.

http://www.freetheworld.com/cgi-bin/freetheworld/getinfo.cgi

Sine Nomine writes:

Sadly, I agree that it isn't surprising. Protect your interests, and so forth.

Reminds me of something you wrote before, Mr. Kling:

http://www.cato-at-liberty.org/2006/05/03/medicare/

Power corrupts, absolute power corrupts absolutely, and private-public partnerships absolutely corrupt the private sector.

We have reached the point in [__________________] policy where government is like the ten-year-old boy who starts fires so that he can be lauded as a hero for helping to put them out.

Baris Atak writes:

Is that all?

I will say only this. The US Congress sooner or later will have to seperate the economic legislation from the political one.

As long as The US Congress does not initiate the formation of Economic Legislative Body, politics will continue to be the most fundamental obstacle to the current Economic System both locally and globally.

Economic system, unlike political system, requires day to day survailance of the overall performance of the economy as a whole.

How can a political system which reincarnates every 4 years for public showdown be on such a par with such daily executed economic performance ?

This economy needs daily legislative maintanence. not half-measures inacted every four years. If the economic system does not have any spontaneous legislative flexibility to correct its course when the wrong turn is taken, the economic system ends up accumulating problems which are only dealt with when the politically fancied solutions starts parading every four years in the persona of political canditates.


Add to this the facts that the economy depends on cash-flow rather than market-battles in which killing of business by business is considered to be a corporate-virtue, and handicapped monetary policies with fiscal-aloofness to the savage-market forces, The US congress should be even more innovative in bringing a fundamental economic-order out of market-induced chaos! All the rules and the laws they need are in the cash-flow of the system.

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