In a Wall Street Journal op-ed, Paul Singer, chairman of the Manhattan Institute, suggests that “there is an urgent need for a new global regulatory initiative” to address the causes of the worldwide financial collapse and that even those who appreciate the qualities of free markets should welcome the new and different regulations he proposes (April 3). Singer’s good intentions notwithstanding, his position is based on two crucial mistakes. One concerns the fundamental causes of the crash. The other concerns the nature of regulation of any kind.
Singer proposes “three fundamental tests” for the new “regulatory infrastructure”: 1) assess and measure risks accurately, including the compounded risks of herding; 2) impose significant margin requirements on all exposures; and 3) bring all investors and traders–regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual, or government agency–under the regulatory umbrella.
These are not trivial or piecemeal steps. The last especially implies a substantial expansion of government reach into all parts of the investment environment. That alone would give free marketeers extreme pause, especially since Singer wants “a global mandate.”
Perhaps his boldest assertion, however, is that “The private sector, not the public sector, is where the biggest mistakes were made.”
By saying this Singer joins the chorus that attributes the financial collapse to the “excesses” of the free market–to the lack of regulation that characterized the pre-crash environment. The Orwellian nature of this position is a source of painful–though not unpredictable–frustration for those who understand that the true cause of our current problems is, and continues to be, massive government regulation that prevented markets from working and pushed resources into investments that could not be sustained. Those who understand this also understand that if government is the problem, it cannot be the solution.
The crash of 2008 will be hotly debated for a long time to come, and the precise nature of its causes will be the subject of much historical research. Matters now somewhat obscure will emerge with greater clarity as time goes by. We do know enough right now, however, to identify with great certainty three fundamental causative factors: easy money, “innovations” in mortgage lending, and misleading credit rating. Disagreement about the precise role of easy money probably will continue. (It is not easy to know if the crash would have occurred had the Fed not been so accommodating.) But there is a compelling case about the other two.
First, what does “innovative” mortgage lending mean? According to Professor Stan Liebowitz’s in-depth examination of the mortgage industry, “[I]n an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of government undertook an attack on underwriting standards starting in the early 1990s” (“Anatomy of a Train Wreck: Causes of the Mortgage Meltdown”).
The huge consumer leverage in residential real estate that ensued was in fact the brainchild of those persistent and self-righteous legislators (chief among them Barney Frank), aided and abetted by progressive journalists and academics. Their much-touted agenda to increase homeownership in America, particularly among minority low-income earners, succeeded spectacularly. And it is precisely these new homeowners who have featured most prominently in the meltdown that home foreclosures triggered. These legislators and their cheering section in the press and academia have a lot to answer for in having precipitated a world financial crisis. Would that they were at least aware of their culpability.
Gold (Plated) Standards
In the meantime, of course, the run-up in housing prices attracted investors from other parts of the financial sector and encouraged experimentation with new types of financial instruments and insurance based on these high-performing mortgage assets. Absent the systematic and massive intentional degrading of mortgage-lending standards, it is hard to see how this could have occurred. Still, it is clear that the three existing credit-rating agencies systematically misread and underestimated the riskiness of these assets and misled the entire market in the process. Notably, all three agencies (Moody’s, Standard and Poor’s, and Fitch) earn their incomes from the companies whose assets they rate. They all made substantial profits from rating mortgage-backed securities. There are no independent agencies because those three are “government approved” to rate assets in which government-created financial institutions can invest. These agencies were in effect protected from competition and subject to serious conflicts of interest. The positive glow generated by their consistently high ratings, fueled in part by implicit government guarantees, obscured the darker warning signs emanating from less prominent sources.
Against this backdrop Singer’s reasoning is difficult to understand. On what basis can he possibly claim that the biggest mistakes were made by the private sector? What mistake could be bigger than the willful encouragement–even mandating–of irresponsible lending by private-sector institutions that otherwise would have continued to adhere to their time-tested standards for assessing the reliability of mortgage borrowers? In the absence of this legislative abuse, the margin requirements for which Singer calls would not be necessary because the underlying assets would be more reliably valued. And surely, in the absence of government protection, independent rating competitors would have had a much better chance of bringing some sanity to bear on the market.
The Nature of Regulation
Singer seems to misunderstand the nature of regulation itself. He calls for regulators (with the aid of the private institutions in the pay of the regulators!) to “accurately assess” risks, including the risks of herding (psychological contagion that causes markets to tank), and to use this assessment as the basis for new and enlightened regulations. We might as well pray for the Messiah to come next Thursday.
Regulators are fallible human beings whose knowledge of the present and ability to predict the future–including the future consequences of their actions–are seriously limited. The future is and will always be unpredictable. One might wonder whence even dedicated public servants are to come up with such “accurate assessments” when such assessments depend on events beyond their ability to foresee. Why should they do better than the market in this respect? After all, it is not even their own money they are regulating.
Successful regulation is rare. Market successes, on the other hand, are abundant. Bubbles may be unavoidable, but in the absence of clumsy government pushing and shoving, they are likely to be small, short-lived, and confined in scope. The housing monster-balloon is a creature of the most egregious regulation. How can we expect more regulation to be the solution?