Monday, March 22, 2010

The real story on financial regulation you need to see

Did you see Michael Lewis on 60 Minutes Sunday night? He was there to promote his new book, The Big Short: Inside the Doomsday Machine. Lewis is a great writer, one of the best around. His books Moneyball and The Blind Side are two of the most enjoyable things I've read in the last several years. Aside from great storytelling, his books also show he knows a good idea when he sees one... But nobody's perfect.

On 60 Minutes, Lewis made the same mistake as everyone else, glossing over the fact that the financial crisis couldn't have happened if the U.S. financial services industry weren't the most heavily regulated industry on Earth. And like everyone else, Lewis complained about the "unregulated" credit default swap (CDS) market. CDSs are essentially insurance policies on bonds. They're cheap for safe bonds and expensive for riskier ones. Like everyone else, Lewis ignored the fact that the CDS market is private only because the Commodity Futures Modernization Act made it that way. It was regulated underground. Without the CFMA, a transparent public futures market in CDSs could have formed and was, in fact, being discussed before the law put the kibosh on it. Everybody and his brother would have seen prices on CDSs for Lehman Brothers and AIG rising during the summer of 2008, harbingers of impending doom, way ahead of the ratings agencies. What's more, banks sold prime mortgage loans and bought "triple-A-rated" collateralized debt obligations (CDOs) only because the Basel II Capital Accords established lower capital requirements for triple-A-rated securities than for prime mortgage loans. When capital requirements drop, you suddenly have more money you can spend on other things. Basel II made the ratings agencies instantly more powerful and important to a bank's competitive position than the behavior of its own underwriters. Throw in the Community Reinvestment Act, two ill-managed massive entities making markets in mortgages (Fannie and Freddie), and the Federal Reserve – a government-created private banking cartel – and you have a government-led financial disaster. There's plenty of blame to go around, I know. But how anyone could miss the massive role of the misguided, heavy-handed regulation is beyond me. Everyone who ought to know better – from hedge-fund managers to our elected representatives – says we need more regulation, not less. Isn't that curious? The solution is never less regulation, and the fault is never too much regulation. If I were more paranoid, I'd cry conspiracy. It might not be a conspiracy, but there is a media blackout on this subject. Nobody says CDSs were regulated underground, delivering an oligopoly to JPMorganChase, Bank of America, and Citigroup. They were the only firms with enough scale to handle the expensive task of contacting counterparties, producing contracts, and a thousand other expensive things necessary to create a large private market in CDSs. Pushing CDSs underground concentrated risk in big financial institutions (you know, the ones that blew up all at once a year and a half ago?), instead of diversifying risk via a broad, open, liquid trading market. The ultimate irony of our overregulated financial system came across the newswires yesterday. One story said a new law was being unveiled that would "force the [financial] industry to pay for its failures." The only reason the industry isn't paying for its failures is the government interfered and staged the biggest bailout in history! The government creates a problem, and the solution is somehow always... more government.

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