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Is regulation to blame for the financial meltdown?

Mike Flynn in the latest issue of Reason argues that government regulation was the primary culprit in the financial meltdown of the last half of the year. This is an old argument on conservative radio and libertarian newspapers, particularly the role of activists and the Fed in supporting “affordable housing.”

Much of the argument has been thoroughly debunked already, including his analysis of Fannie Mae/Freddie Mac and the Fed. In fact, his argument for Fannie Mae/Freddie Mac hinges on the point that Congress prevented the Bush administration from properly regulating the two companies based on laws and regulations already on the books.

In terms of the Fed, Flynn both overplays the role of the Federal Funds Rate and, at the same time, grossly simplifies the decision-making process that led to cuts in the rate. That Greenspan and the Fed governors were slashing away at the rate in order to drive down mortgage interest to drive up home ownership is madness and ignores everything the Fed and its representatives were saying.

Furthermore, even the dimmest of affordable housing advocates understood that the free market was making a hash of their goals by ballooning up housing prices in proportion to or greater than the discount buyers were enjoying through low mortgage interest rates. A $200,000 mortgage at a fixed 9% interest rate is more affordable than a $500,000 mortgage at a 4% adjustable rate interest rate, as we’re finding out.

Finally, the numbers have spoken. The bulk of junk mortgages were originated by mortgage brokers and others who were outside federal regulatory jurisdiction and enabled by CDO purchases by investors, traders, and investment banks that were only barely regulated.

Still, Flynn makes some valuable points, particularly in how the government could have suspended or eased regulations at the beginning of the crisis rather than committing untold billions of future taxpayer obligations. More after the break.

Flynn’s deeply flawed article is worth reading for its denouement. It is unquestionable that at least one federal regulation had everything to do with the cascading failures in banks holding CDO’s derived from subprime mortgages. While, yes, those banks were trading in instruments they didn’t understand, their value fell precipitiously because of federal “mark-to-market” valuation regulations.

After the revelation of vast accounting frauds at Enron and WorldComm, the government addressed, among others, one particularly thorny issue as to how entities like Enron and WorldComm would “value” assets in order to meet capital requirements of lenders. For instance, when Enron’s books were finally fully parsed, they were found to be over 90% leveraged, a capital structure no lender would tolerate. But the books showed otherwise, largely because of imaginative valuations of assets some of which followed generally accepted accounting principles.

To prevent any other company from leveraging itself to hell and back through imaginative valuations, the government sought to ground asset values in the price those assets would fetch on the market. In many ways, it’s the same way house valuations are made. An assessor catalogs the physical property and compares it to the selling prices of houses in the proximity. The assessed value of your house, when done well, is the price it should fetch on the open market.

Two major problems spilled their bad mojo all over mortgage-backed CDO’s. The first was that they were traded in an unregulated market, meaning there was little grounding for their valuation. The second was that otherwise vastly intelligent people were trading in instruments they did not understand and were assuming risk they did not understand.

When the defaults on the junk mortgages started, the buyers of CDOs suddenly realized they weren’t valuing them correctly. Because everyone lost confidence, the market seized up. Even though these securities were still fully performing, their value on the market declined precipitously because no-one was buying them. The same thing is happening right now with GM’s bonds. Even though all these bonds are still performing — GM is still making payments — their value has slipped to 60% of their face value because people aren’t sure that GM will continue to make payments. So, if you have a GM bond with a face value of $10,000, you have an asset that marked-to-market is only worth $6,000, even though GM is still paying the coupons and may just pay the full value of the bond and interest.

Faced with mark-to-market rules, investment banks holding big piles of these CDO’s had to decrease their value, thus decreasing their capital, thus triggering capital requirements on loans, other derivative contracts, and required by federal regulations.

Flynn:

Two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (using a five-year rolling average valuation instead, for example) would have helped shore up the balance sheets of some banks. And a temporary easing of capital requirements would have given banks the breathing room to sort out the mortgage-backed security mess. Although it is hard to fix an exact price for these securities in this market, given that 98 percent of underlying mortgages are sound, they clearly aren’t worth zero.

We’ll never know how much taxpayer money tweaking the mark-to-market rules would have saved, but it would have substantially reduced the amount of “troubled assets” that TARP was designed to get off the books of troubled investment and depository banks.

Which raises an interesting question for the Obama administration. Regulations are clearly intended to prevent nefarious corporate machinations that disappear investors’ and other’s money and erode public confidence in investments and corporate behavior. In a severe economic downturn, however, should government be looking at regulations such as mark-to-market to prevent insolvency? If an underlying asset is good, but has declined in value on the market based on forces independent from its performance, should regulatory authorities “correct” the market by easing regulatory rules?

We have voted with our feet against the free market in the panic of the last few months. But if we’re going to fiddle with the free market through massive injections of taxpayer-backed capital, should we not include fiddling with regulations that are primarily designed for an expanding, not a contracting, market? Are there other regulations that need, so to speak, a “holiday” to correct the panic in the market?

Because the standard line is that deregulation created the current crisis, the move is on to regulate more heavily. Most of these regulations are long overdue. However, the standard line obscures the role that current regulations might have in furthering the crisis, such as the mark-to-market rule.

Put another way, how much of our “market regulation” is, in reality, “bull market regulation”?

James Surowiecki, in this week’s issue of The New Yorker, makes this salient observation:

Fraud is a boom-time crime because it feeds on the faith of investors, and during bubbles that faith is overflowing. So while robbing a bank seems to be a demand-driven crime, robbing bank shareholders is all about supply.

So much of our regulatory apparatus is designed for boom-time fraud, not the problems faced in a contracting economy. Are we smart enough to figure out which regulations help to prevent boom-time fraud but create unnecessary drags on the economy when everything is tanking?

That’s the article that needs to be written.

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One Response to “Is regulation to blame for the financial meltdown?”

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  1. [...] In a previous post, I ask the question if easing regulatory restrictions, such as the mark-to-market asset valuation rules, can achieve the same results without costing taxpayers money. This is especially important now that we know that Treasury is proceeding with the attitude that money can be burned. [...]


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