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Regulation Returns, Because Moral Hazard is Now Structural

Irwin Stelzer, writing in the Weekly Standard, discusses the implications of the Bear Stearns bailout and the regulatory reform proposal Treasury Secretary Paulson unveiled last weekend:

The investment banking industry as we knew it is no more. Change has been inevitable ever since the Bush administration and the Federal Reserve Board decided to use taxpayer money to back J.P. Morgan Chase's takeover of Bear Stearns. R.I.P. the deregulatory trend that has dominated policy towards America's financial institutions. Enter the lawyers, regulators, and politicians to reshape the nation's financial markets.

Investment bankers might moan, but when they created a system rife with conflicts of interest and too few incentives to good performance, followed by acceptance of billions of taxpayer money, they sold their deregulated birthright. When Fed chairman Ben Bernanke received permission from the White House and Treasury Secretary Hank Paulson to take almost $30 billion of Bear Stearns' paper onto the Federal Reserve Banks' balance sheet--and to open the discount window to other investment banks, to use the jargon of the trade--it put the taxpayer at risk.

Stelzer's language is not even condemnatory; if anything, it is reflective of a deep resignation, born of the knowledge that the wheel of history has turned, and that, given the actions of the participants, regulation of investment banks is simply a logical development. The bundling of collateralized debt instruments, and the sale of the same to third parties (and beyond) created a dense skein of interrelationships, increasing the likelihood of systemic failures, as opposed to isolated ones, and the fact that the entire architecture operated outside of the reserve requirements under which depository institutions operate, created a system of leverage that looked rather creaky once the black swans caused various asset classes to move in opposite directions, throwing the sophisticated mathematical formulae of the best and brightest into confusion.

In other words, the cowboys of financial innovation, always at least several steps beyond the reach of the regulatory agencies, created a system of financial relationships that was Too Big to Fail. And so the established powers are striving to move heaven and earth in order to ensure that it does not; meanwhile, the jury is still out deliberating over whether their efforts even can succeed.

The question that is always raised in connection with such bailouts is that of moral hazard: will such implicit guarantees - sometimes elevated to explicitness - encourage speculative and risky financial activity that, in other circumstances, and on any rational accounting, would appear imprudent? In the abstract, of course, the answer is obvious and affirmative. In reality, the answers quickly become more complicated; but the logic of the present crisis is that new regulation will be the inevitable price of government-backed salvation:

Wall Street had hoped to take the money and run. But Frank Sinatra had it right: like love and marriage, when it comes to bail-outs and regulation, "You can't have one without the other."

The ostensible logic of regulation is to create a series of mutually-reinforcing interests: the regulatory agencies of the state have an interest in avoiding bailouts, and the regulated entities have an interest in avoiding the risky behaviour that will necessitate bailouts - and penalties. That's the theory, anyway. Given both the pace of innovation in finance, and the mutual interpenetration of the parties, anything could happen.

It is imperative that it be appreciated, however, that moral hazard has not been a merely incidental bug in the system, one that manifests itself every now and again, as in the subprime fiasco. Rather, moral hazard has been intrinsic and systemic, a consequence of the dolorous combination of the Fed's loose, low-interest-rate monetary policy, which propped up two successive bubbles, a lax regulatory environment, a wave of financial innovation justified by a myth of self-regulation and created - in part - in order to evade regulation, a growing current accounts imbalance, both personal and national, and localized regulatory insanities, such as the so-called anti-redlining mandates. All of these factors are mutually-reinforcing, but the bottom line is that a loose monetary policy fueled a bubble of asset prices, which could not be sustained owing to the imprudence of lenders and borrowers (micro-level) and the overall indebtedness of American society, coupled with the inexorable pressures of globalization international labour arbitrage - the type of economy we now possess could not sustain both those asset valuations and the jobs people require to acquire such assets (macro-level). In other words, bad monetary and fiscal policy undertaken in the context of globalization's pressures was bound to produce both crises and the necessity of bailouts, which are merely another way of saying that gains are privatized, while costs are socialized. The monetary and regulatory policies of the financial establishment, from the Fed downward, were incongruous with the economic realities of the post-national, post-industrial American economy. Ergo, moral hazard was intrinsic to the system.

One issue remains outstanding, namely, the public perception of class-favouritism, of a socialism for the wealthy, who are Too Important to be subject to the same market forces as the rest of us:

...it is difficult for voters to understand why billions in their taxes can be used to enable one investment bank to acquire another, but not one cent can be devoted to preventing a family from being tossed out on the street. Even some conservative congressional Republicans are muttering that sauce for the Wall Street goose is sauce for the Main Street gander. It will be a brave politician indeed who goes through this election cycle chanting "The free market will solve this problem; intervention postpones the solution--and will in the end make the problem worse." Hillary Clinton and Barack Obama both want $30 billion of taxpayer money devoted to the relief of hard-pressed home owners--the same sum devoted to preserving at least some of the value of Bear's shares, worthless without the Fed's intervention, sold for around $10 with Fed backing of the J.P. Morgan takeover.

Any politician who went through the present election season reciting that mantra about the free market would be shellacked, and rightly so; for the entire architecture of the system that failed represented a distortion of the market forces that would have obtained in the absence of bad policies - such a politician would be doing nothing more than granting political cover to a Federal Reserve system that failed, and to a banking system that articulated imprudent degrees of leverage. One cannot coherently present a distortion of a market system as the essence of the market itself, as was done in all of the delirious talk about the Anglo-American financial model, then act as though that entire sector of the market is now non-market, such that only individual mortgage-holders, who ought to have known better, remain in the market. One cannot be so arbitrary with the borders of the market, deeming some interventions permissible and others forbidden, particularly when the latter are but a pittance by comparison to the former. Swallow the one, and you may as well swallow the other, for illusions' sake. If you do opt to act arbitrarily in this fashion, the message communicated infallibly will be that the system will act to protect the interests of the powerful, while the little people can eat cake, or live in tents. A democratic society cannot endure if the elites are permitted, openly, a separate peace, an alternative set of favourable rules accessible only by themselves. Intervention is intervention; and if it is necessary in the case of the financial establishment (which it seems to be, as policy errors create a self-reinforcing logic) in order to prevent collapse, it is necessary in the case of the small homeowners in order to preserve some semblance of legitimacy, or at least the fiction thereof.

Comments (7)

Hard to imagine the creative, high-priced talent of Wall Street won' be able to circumvent whatever rules the market monitors establish. More troubling is the lack of transparency and accountability, the necessary essentials for trust, missing from the Fed's response to this crisis. So, who will regulate the regulators?

30% of Bear-Sterns is owned by employees who are mightily pissed of by
$2/share price granted to JP Morgan. There are suits in preparation as well as rumored (fact?) plan by Morgan to increase price to $10/share.

All of which flatly contradicts the main points of the posting.
Way too much emotion and too little knowledge, facts and analysis.

The bundling of collateralized debt instruments, and the sale of the same to third parties (and beyond) created a dense skein of interrelationships, increasing the likelihood of systemic failures, as opposed to isolated ones

What does it mean? Bunch of long words with no particular meaning?

All of which flatly contradicts the main points of the posting.

Not unless the truly 'innovative' aspect of the bailout is undone: the Fed's assumption of nearly $30 billion in suspect financial instruments, so that JP Morgan could be enticed into the acquisition. Morgan could increase the offer, but it would still remain a rather interesting bailout if the Fed and the taxpayer assumed most of the liabilities.

Morgan could increase the offer, but it would still remain a rather interesting bailout if the Fed and the taxpayer assumed most of the liabilities.

I agree with that part.

Analysis of the causes of the crisis is flawed.
Out and out fraud in obtaining mortgages did exists, of course. How could it not, what with all that "rich diversity" in moral and ethical norms of conduct we have now.
I did not see data on fraud, but I believe that it played a relatively small role (less than 10% of all mortgages?).

Lax lending standards very likely played larger role, but still were not overriding factor.

What created crisis was a systemic miss-pricing of risks of CMOs.
That and the fact that no one understood behaviour of CMOs in some circumstances.

Both these factors were probably created by people who were trying to do what is best for themselves and their investors.
It is not sexy, even boring explanation, but it is more likely to be true than other theories.

The difficulties involved in pricing such risks owes to the complexity and arcana of the instruments themselves, the abstruse nature of the mathematical models employed to assess them, the concomitant difficulty of applying the models, the partiality of any such modeling (any model, however complicated and recondite, will simplify at some level, and so exclude some factors, by omission or otherwise), and the interests many of the parties had in obscuring or blurring what could be known or presumed about the instruments. All such considerations were factors. But the substructure of the failure was the collapse in the valuation of the basic collateral - in the case of securities backed by mortgages, of the housing stock itself - which collapse resulted from the inability of many (nominal) homeowners to make their payments. And, to account for that, one must factor in the financial health of the homeowners, something which obtains at the intersection of personal responsibility and macroeconomic conditions, these latter inclusive of the Fed's de facto inflationary monetary policy, which fueled the abnormal increase in asset valuations, and the overall economic health/policies of the nation. Given the financial condition of many homeowners, which encompasses everything from personal indebtedness to the nature of the jobs available in a so-called "new economy", the credit expansion and the resultant appreciation in housing were unsustainable. It is a case of 'too much financial superstructure, too little macro-economic base'. While the two are obviously interconnected in innumerable ways, they are also distinct.

This all needs to be shaken out with minimal government control.

Treasury Secretary Henry Paulson’s proposal to consoldiate various financial regulatory agencies is uninspired and likely will prove useless. This proposal rests on the unquestioned assumption that bad economic results should never occur, and, if they do on a large enough scale, should be bailed out. If they should be bailed out by the federal government, then the federal government rightly acquires some interest in preventing them. But consolidation alone won’t do the trick, even if these flawed assumptions about economic regulation are accepted.

Without new rules and expanded authority–which Paulson has renounced–it’s unlikely any consolidation of the SEC, CFTC, OCC, and other regulatory agencies can yield better results than today. This is the same logic behind joining various agencies under the Department of Homeland Security, which can accomplish little more than these agencies could in the past without broader authority, racial profiling, and increased border infrastructure. The case for consolidation is even less compelling in the case of finanical regulators, as poor inter-agency communication is widely reputed to be one factor in the unsuccessful prevention of the 9/11 attacks. By contrast, no one thinks that the current mortgage crisis is the result of some regulatory gaps or bad communication between the agencies. Rather, investment banks, hedge funds, and other unregulated organizations now control huge amounts of the lending going on today.

These high yield relatively unregulated instrumemnts should continue. Investors should simply take their lumps when they stray from the regulated arenas of commercial banks and publicly traded companies.

I don't gainsay the argument that Paulson's proposal is DOA, at least insofar as its lack of utility is concerned. However, it seems obvious to me that Stelzer's suggestion - that capitalization requirements be extended to cover investment banks & etc. - is a prudent one. Markets price risk tolerably well, in most circumstances, until they don't; and, when they fail to price risk accurately, and are highly leveraged, the entire financial apparatus unwritten by a loose monetary policy, the the calamity is spread more broadly throughout the economy as a whole. Whatever one might claim for the 'rights' of individual speculators to pursue the highest conceivable returns, it is at least equally arguable that the rest of us are entitled to shelter from speculative fallout.

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