To Regulate or Not?

Wednesday, October 15, 2008 | 07:10 AM

I am working on something for The Economist -- its an Oxford style debate on the current crisis.  The proposition being discussed is: "This house believes that it would be a mistake to regulate the financial system heavily after the crisis."

Any comments you may have on this would be appreciated -- my final version is due later today.

My biggest problem is trying to cover a lot of ground in just 500 words . . .

DRAFT:

Over the past 30 years, the United States has moved from an environment of excessive regulation to excessive deregulation. This philosophical shift was taken to irrational extremes, and it is the heart of the current financial crisis.

A brief history: Post War World II, the global economy expanded dramatically. By the late 1960s, the U.S. had an expansive bureaucracy. Regulatory oversight had become time-consuming, complex, and expensive. Eliminating this excess regulation started with President Jimmy Carter, and dramatically accelerated under Ronald Reagan. Originally, only the most expensive and onerous provisions were targeted. But eventually, deregulation became a religion, and effective and necessary safeguards were removed along with the costly ones.

Free-market deregulation became a misguided rallying cry of conservative ideologues. The U.S. moved from a state of excess regulation to radical de-regulation.

In 1999, the Glass-Steagall Act was repealed, allowing insurers, banks and brokerage firms to merge. In 2000, Derivatives were exempted from all regulatory, supervisory or reserve requirements by the Commodity Futures Modernization Act.

During the early 2000s, the Federal Reserve, under Alan Greenspan Fed elected against supervising new mortgage lending firms. This act of nonfeasance, based upon Mr. Greenspan’s free market philosophy, had enormous repercussions.

The final act of deregulatory zeal were the net capitalizations exemptions granted by the SEC to five firms. This exemption allowed firms to exceed rules limiting debt-to-net capital ratio to a modest 12-to-1 ratio. After the 2004 exemption, firms levered up as much as 40 to 1. Not surprising, the five brokers that received this exemption – Goldman Sachs, Merrill, Lehman Brothers, Bear Stearns, and Morgan Stanley – are no longer in existence; they either failed, merged, or changed into depository banks.

~~~

To show the impact of deregulation, consider the underlying premise of all credit transactions – loans, mortgages, and all debt instruments. Over the entire history of human finance, the borrower's ability to repay the loan has been the paramount factor in all lending. With mortgage, this included elements such as employment history, income, down payment, credit rating, other assets, loan-to-value ratio of the property, debt servicing ability, etc.

Greenspan’s decision to not supervise mortgage lenders led to a brand new lending standard. During a five year period (2002-07), the basis for making mortgages was NOT the borrowers ability to pay – rather, it was the lender's ability to sell a mortgage to firms that securitized them.

This represented an enormous change from the past.

These new unregulated mortgage brokers no longer cared about a standard 30 year mortgage being repaid over time. In the new world of repackaged loans, all that mattered was that the loan did not come back to the originator. By contract, this was typically 90 or 180 days. As long as the borrower did not default in that period of time, it could not be put back to the originator.

It turned out that the best way to do that – to put people in houses that would not default in 90 days – were 2/28 ARM mortgages. Cheap teaser rates for 24 months, with an eventual large reset.

This monumental, unprecedented change in lending standards led directly to the key to the current crisis. It also shows what happens when we remove supervision from the financial sector. Most of these mortgage originators – nearly 300 – have since filed for bankruptcy.

~~~

Why do we have referees in professional sports? All intense competition leads to rules of the game getting tested. Refs are on the field to prevent the game from spiraling into something unrecognizable to fans.

In business, the profit incentive leads to similar behavior. We push the envelope, tap dance close to that line, and then blow past it.

Deregulation took the referees off of the field, allowed speculative excesses to flourish, and reckless short-term incentives to distort behavior.

That is Human Nature – we are competitive creatures, and we require reasonable boundaries to protect ourselves from our own worst instincts. When left to our own devices, we push the envelope, cut corners, even work against our own best interests in the pursuit of profits. Every financial scandal over the past decade – corrupt analysts, fraudulent accounting, over-stating profits, predatory lending, conflicts of interests, option backdating – are the result of a legitimate business operation pushed up to the legal boundaries, and then going far beyond them.

That is the risk deregulation brings: It encourages behavior that leads to systemic risk. In the present case, the global credit markets have frozen, threatening a worldwide recession. The total cleanup costs are scaling up towards $10 trillion dollars.
All due to an excess of deregulatory zeal . . .

Wednesday, October 15, 2008 | 07:10 AM | Permalink | Comments (105) | TrackBack (0)
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Comments

The Austrians have it right... the need for regulation arises from a system based on fractional reserve lending and a fiat currency.

Posted by: dash | Oct 15, 2008 7:20:38 AM

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