All Commentary
Wednesday, August 25, 2010

Financial Regulation Snake Oil

Recent turmoil set off by the threat of Greek insolvency shows how fast markets change. Fear about the inability of European governments to pay their debts caused the 2010 turbulence. By contrast, the 2008–2009 havoc was rooted in the collapse of property values. The next crisis will be about something else, possibly another government’s debt.

Meanwhile, Congress put the finishing touches on a mammoth regulatory bill called the Restoring American Financial Stability Act of 2010. (Editor’s note: It was passed and signed in mid-July.) As I write there is no way to know what final shape it will take. But considering how it was shaping up, what are the probable effects?

The rationale for this vast expansion of government oversight is to prevent, or at least reduce, financial instability, as the bill’s title declares. Therefore it is useful to remind ourselves of why and how markets became so unstable in the first place.

There are two fundamental reasons why markets gyrate. One is human emotion, in particular a penchant for over-optimism about financial prospects, which turns into panic once things go downhill—a pattern known colloquially as greed and fear. Business cycles are unavoidable to the extent they’re rooted in human behavior. On top of this, governments have caused normal cycles to become extreme and destructive with a multiplicity of interventions and their own financial woes—as with Greek sovereign debt.

Thus the boom in the American housing market was set off by optimism that property prices would keep rising and the bust initiated by the panic that ensued when prices faltered. But the cycle became monstrous because the Federal Reserve kept money creation too loose in 2001–2004. To make matters worse, Congress pushed the two government-created entities, mortgage buyers Fannie Mae and Freddie Mac, to go easy on less creditworthy loans.

As a result of these policies, taking out a mortgage became child’s play. People who might have otherwise been more prudent mortgaged up to the hilt, and enormous piles of mortgages became available to be bunched together and turned into securities—a lucrative activity that drew the attention of Wall Street, but was done largely by Fannie Mae and Freddie Mac.

When real estate turned, it took down banks that lent heavily to developers, homeowners who borrowed beyond their means, and financial companies that held or insured mortgage-backed securities. As for Fannie and Freddie, they continue to suck down billions of dollars of taxpayer money every month, with no end in sight.

Human nature has not changed, and the government is becoming more interventionist, not less so. So the conditions that produced the dramatic bubble-and-bust remain in place. How, then, will the Financial Stability Act prevent crises?

Since it is not practical to analyze all the disparate elements that constitute a 2,300-page grab bag of a bill, I will focus on the centerpieces that were most likely to become law. These are from the version of the bill introduced April 15, sponsored by Sen. Christopher Dodd.

The first is the creation of a supra-bureaucracy called the Financial Stability Oversight Council, with nine voting members who are to make decisions by majority vote. Among them are the Treasury secretary, the Federal Reserve chairman, the Securities and Exchange Commission chairman, the director of the Federal Housing Finance Agency, and an independent member appointed by the president.

Almost all council members are heads of departments and agencies that have been around for decades and shown not the slightest ability to prevent risky behavior by financial firms, the population at large, or for that matter themselves and fellow government entities. Somehow, they are supposed to do together what they don’t do on their own.

The act also adds a new bureaucracy, the Office of Financial Research, with responsibility to collect and process data and conduct studies for the council. This newly created apparatus of the council and research office is to work as “an early warning system to detect and address emerging threats to financial stability and the economy,” according to a congressional committee report.

The research office would get the power to subpoena information from any financial company. It is “to develop and maintain metrics and reporting systems for risks to the financial stability of the United States” and “monitor, investigate, and report on changes in system-wide risk levels and patterns.”

If you ask what the systemwide risks are, you won’t find an answer in the act. The director of the office, appointed by the president for a six-year term, “shall have sole discretion in the manner in which” he or she exercises the authority provided by the bill. Indeed, the wide discretion the bill provides to future bureaucrats is remarkable. What they’re going to do to promote stability is about as clear as how snake oil was supposed to cure cancer, bunions, and lovesickness.

The act says certain bank companies may be required to have a “risk committee” with “at least one risk management expert having experience in identifying, assessing, and managing risk exposures of large, complex firms.” That is like requiring water to flow downhill. Almost every financial business already has risk control people. Even hedge funds have risk managers.

Risk management is a well-established discipline with an ever-increasing number of practitioners who spend their time trying to measure and reduce future hazards. In finance the number of risk management experts has grown tremendously in past years—without any legal mandate. These specialists have been notably unsuccessful in preventing occasional crises, as the past several years demonstrated.

Risk experts constructed the mathematical models that gave misleadingly benign views of the dangers in mortgage-related complex instruments. The models will improve over time, but will occasionally be mistaken regardless of legal requirements. It is not the case that financial companies want to lose money.

The basic reason they sometimes do lose money is that making money requires some risk. This is no different from many other activities, such as drilling for oil. Yes, you can end up with a nasty spill, but no risk, no oil. Similarly, no financial risk, no financial gain.

The object is not to avoid risk but rather to keep it under control, and that has always been a most delicate task. The early twentieth-century economist Frank Knight made a distinction between risky situations, where the possible outcomes and their odds can be estimated, and uncertainty, where there is no meaningful way to know the probabilities. There are known unknowns and then there are unknown unknowns.

Throwing dice exemplifies risk with known odds. By contrast, Fannie Mae (which, along with Freddie Mac, is unaddressed in the new law) is a source of uncertainty; the consequences of its creation were unexpected, and its future is an unknown unknown at this time. It stands as a shadowy but colossal monument to man’s ability to create monsters in the name of doing good.

Dealing with risk is hard enough; we’re lost dealing with uncertainty. This shows up especially with rare but big events—known as the tail risk of a bell-shaped probability distribution. More vividly, Nassim Nicholas Taleb, a trenchant critic of financial industry practices, has dubbed them black swans.

As long as an event like the real estate slump has not yet happened, people make money by ignoring it. Therefore risk managers “play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning [them],” to quote from an earlier book by Taleb, Fooled by Randomness, published a decade ago—when risk managers were already recognized players.

Same Goes for Government

This criticism applies no less to government agents. Nobody has a reliable way to predict rare events, and human nature is all for ignoring them. Regulators don’t do any better—from the chairman of the Federal Reserve on down, officials issue vague warnings but don’t stop risk-taking. After all, they are subject to the same behavioral biases and face similar incentives. Just as shareholders are displeased when a bank does not make money, voters are displeased when a government imposes economic hardship.

Therefore, like banks, governments keep dancing as long as the music lasts. It is hard to imagine that changing. So preventing future crises is the least likely outcome of the Stability Act. But might it have some other benefit?

Emergency measures used by the U.S. Treasury and the Federal Reserve to prop up companies in 2008–2009 left in their wake the absurd problem of too-big-to-fail—taxpayers appear to be on the hook for any large financial concern whose failure might have far-reaching impact. Given that taxpayers also ended up with the vast pension liabilities of General Motors, the problem of bailouts is not really confined to financial companies, though it is widely described as such.

Nobody wants a repeat of the widespread panic and losses caused by the bankruptcy of Lehman Brothers in September 2008. That failure resulted in market chaos in large part because the assets of Lehman clients got tied up in bankruptcy courts, not just in the United States but in the United Kingdom. With their capital frozen in years-long litigation, the clients sold securities to raise money, with the predictable catastrophic effect on prices.

So instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would both reduce the impact of failures and get rid of the notion that investment banks need to be bailed out. Expeditious, orderly, and internationally coordinated winding down of failed companies is an obvious solution for the too-big-to-fail problem.

The act gives the Treasury, in conjunction with judges from the U.S. Bankruptcy Court for the District of Delaware and other agencies, broad powers to take control of a financial business perceived as a threat to the system and turn it over to the Federal Deposit Insurance Corporation (FDIC) for liquidation. The FDIC, which unwinds failed commercial banks, is to do the same for other financial businesses.

“Once a failing financial company is placed under this authority, liquidation is the only option; the failing financial company may not be kept open or rehabilitated,” says a Senate committee report.

That may sound like a way to prevent bailouts, but the government is given such open-ended discretion that perverse outcomes are possible. To go this liquidation route a company does not need to be actually in default as long as the Treasury determines that it is a sufficiently serious threat. On first read, my primary concern was that companies that were not going to fail might be liquidated.

On second thought, it is just as possible that those which are failing will be bailed out instead of being liquidated. This could happen if there are politically powerful interests behind a company. Think of the unions that came out on top in the government’s handling of GM. In effect, we’re asked to trust politicians and bureaucrats. No doubt they will make politically advantageous decisions, with goodies for the politically favored and sticks for the politically vulnerable.

A better alternative to the creation of this extensive authority would be to streamline bankruptcy to make it simpler and faster. The act calls for studies of bankruptcy and international coordination, the latter of which is necessary because large investment banks are global entities—but the possibility of bankruptcy reform is remote. That could reduce legal fees, not something that a Democratic Congress will allow. Lawyers are a major constituency for the Democrats. They will be among the big winners of the regulatory onslaught, which is bound to increase the demand for legal services.

More Of The Same

It is ironic that the act expands the government’s domain in the name of stability, since public policies have increased instability, public functionaries have been clueless in foreseeing threats, and politicians have created uncertainty—with Fannie Mae, for instance.

One of the members of the Stability Council, the Federal Housing Finance Agency, was set up by a 2008 law to be the successor to the Office of Federal Housing Enterprise Oversight. The latter, the overseer of Fannie and Freddie, presided over debacle after debacle, year after year, from accounting shenanigans to endless taxpayer bailouts. Congress obviously wanted an agency with a different name.

But the new bureaucracy is simply the old one merged with another entity. So the same bureaucrats that did so well ensuring the safety and soundness of Fannie and Freddie are supposed to ensure financial soundness on a wider stage in the new setup! If that does not inspire confidence, neither do other members of the council.

The Securities and Exchange Commission let Bernard Madoff continue his Ponzi scheme year after year despite repeated complaints from a whistleblower and even news stories about the fraud. More recently another astounding SEC failure came to light.

In 2009 Texas resident Robert Allen Stanford was nabbed for an $8 billion fraud—Stanford International Bank had for years sold certificates of deposit promising unachievable returns. An investigation found that the SEC Fort Worth office had known since 1997 that Stanford was likely operating a scheme. Despite examinations indicating this, the enforcement division chose not to take action.

The preferred excuse for numerous government debacles is that the bureaucracies lacked authority, personnel, or information. Yet the SEC in fact repeatedly examined Stanford and had the power to stop his activities.

Here is the punch line to the Stanford affair. In a dramatic instance of the revolving door for former regulators, the SEC lawyer who made enforcement decisions at Fort Worth left and represented Stanford—before he was told that this was improper. That’s how regulation works in reality.

Expanded Crony System

The vast new powers given to regulators will no doubt enhance the fees and salaries that former bureaucrats like this SEC lawyer command. They will have greater opportunities to sell their protection and expertise to the regulated and will also, of course, benefit from enlarged budgets while in public employment. Politicians and political staffers, too, will be able to extract more money from the regulated and get lucrative jobs in the financial industry.

This is already an established trend, with President Obama’s former White House counsel moving to Goldman Sachs and a former aide to Rep. Barney Frank on the House Financial Services Committee taking a job with a derivatives exchange. Such crossovers will no doubt become even more common as firms look to protect themselves while government agents get a broad mandate to intervene and decide which companies to liquidate and which to bail out—who’s a systemic risk and who’s not.

Even as they go “tsk-tsk” chiding business lobbies, the President and Congress are laying the groundwork for an infinite growth in the crony system intermingling government with private interests. The rest of us will pay for the resources that will be redistributed in favor of bureaucrats, politicians, lawyers, and the politically favored. The impact of the act on financial stability is uncertain at best, but its corrupting influence on the Republic is a sure thing.