WHY CONSERVATIVES SHOULD EMBRACE FINANCIAL REGULATION
The earthquake that shook the world’s financial system in September of 2008 opened many eyes to the fact that the largest companies on Wall Street had become heavily engaged in the extremely profitable but wholly unregulated derivatives market without a clue as to understanding the extraordinary damage their gambling could do to the economies of the industrialized countries if a financial shock came along.
There were some - in government and out - who sensed the trouble we were in but whose voices were drowned out in the speculative frenzy, the drive for ever larger profits, and the mania for secrecy upon which these firms traded. And the enablers in the Clinton Administration - including Larry Summers, Tim Geithner, and Robert Rubin - along with the anti-regulatory Fed Chief Alan Greenspan, worked hard during the 1990’s (as did their successors in the Bush administration) to keep the regulators at bay, discrediting them with Congress, and trying to bully them to toe the party line on keeping the derivatives market free of scrutiny by the government.
We paid for this shortsightedness with a meltdown of the financial industry that we are still feeling today and are likely to feel for years to come.
Those who continue to believe that the collapse of Lehman Brothers and subsequent tsunami that led to our current economic problems was the result of a few hundred thousand poor people who got loans they shouldn’t have received through the Community Reinvestment Act need to wake up and smell the coffee. The still unregulated derivatives market is worth $600 trillion today. That is not a misspelling. An unknown tens of trillions of that market - nobody can possibly know exactly - are in “toxic assets” still being carried on the books of big banks just waiting for the next shock to hit Wall Street to bring these great houses of finance to their knees again.
Yes, mismanagement of risk by Fannie and Freddie had something to do with the crisis, and the CRA had its own small role to play. But this crisis virtually begins and ends with the mind boggling way in which the largest financial service companies in the world fought tooth and nail to keep the government from finding out just what they were up to with these credit swaps.
I suppose I should mention that my understanding of all this is a mile wide and an inch deep. But the political explanations offered by both sides never satisfied my curiosity. The crisis was more than 2 decades in the making, and the idea that one side is more or less to blame for it is nonsense. Both Clinton and Bush, Democrats and Republicans in Congress have a lot to answer for and trying to place relative blame on a scale and weigh out who should be designated as the winner of the blame game is an exercise in futility.
No transparency, no record keeping, and little understanding by either the companies or the government of the systemic risk of these derivatives and credit swaps led directly to the collapse. But we can’t get rid of derivatives even if we wanted to, as business writer for the NY Times Timothy O’Brien points out:
But it’s really important to remember that there are a lot of good, practical uses for derivatives. In fact, the average person who’s a homeowner owns a derivative. It’s the insurance policy on their house, and it’s essentially a contract that you enter into with an insurer that pays you a certain amount of money if some kind of damage or calamity happens to your home. And you pay a little bit of money, or a lot of money depending on the size of your home, each year for that policy.
Wall Street has all sorts of contracts like this. Derivatives, in essence, are insurance policies that various players on Wall Street and in the business world enter into to protect themselves from unforeseen calamities, whether it’s wild interest-rate swings, changes in the values of currencies, someone’s debt going bad. …
And that’s a good thing. When people have protection from things they can’t control, it enables them to take sensible risks, which allows them to grow their business and allows more money to get created and creates jobs. These are all good things, as long as that’s what these things are being used for.
As you might have guessed, it was the other things derivatives were used for that sealed our fate:
The problem is, no one really knows exactly what derivatives are being used for because it all exists in a black box. They’re unregulated; the contracts aren’t traded on exchanges; they’re entered into between private parties. No one knows whether or not one company, let’s, for example, call them AIG, a big insurance company, has entered into so many of these contracts that if an unforeseen financial hurricane comes and hits the house known as Wall Street and suddenly AIG is required to make good on … so many of these policies that they don’t have enough money to do this, and they run into danger of going belly up. Which is exactly what happened at AIG.
And the lingering question is, if these transactions - if the derivatives market - had been regulated adequately, could we have avoided the worst of the meltdown? Joe Nocera, also of the Times:
The technical term for the kind of derivatives that really got us into trouble is bespoke derivatives. Bespoke means one of a kind. And these were complicated contracts that covered a particular, you know, one deal only. It couldn’t be replicated. It wasn’t like buying a share of IBM that is exactly the same as every other share of IBM. You bought a credit default swap; it would be built around a particular series of deals. It would have a particular set of terms. It would be one of a kind.
This is, by the way, why this stuff became so untradable. How do you trade a one-of-a-kind? There is no real market for them. It has a utility as a contract on a one-on-one basis. But there is no trading function. And that has been part of the whole problem. They don’t mark to market, i.e., because there is nothing to compare it to. What’s out there that you can compare this one thing to? So they mark to model. They come up with fancy, financial models every quarter. And they mark this thing to the model.
And for many years the model said they were worth more, worth more, worth more, so you mark them up. And then finally the model said: “Uh, you know what? Foreclosures are up. Subprime is down. We have got to start marking them down.” You start to blow up. But even though they are blowing up, you are still stuck with them. There is nothing you can do with them. You can’t trade them.
Bottom line:
So one of the big problems with the rise of credit derivatives is that Wall Street was terribly resistant to the idea of standardizing contracts and allowing them to be traded on an exchange, because it would hurt their profits.
The question now before us is what should be done about it? And for me and for many conservatives, the question becomes is there any regulatory regime that would be consistent with conservative principles?
It is a false assumption that regulation of markets is inherently un-conservative. Libertarians might take that position but since conservatives should value order above almost all else, sensible regulation of markets is a requirement for promoting a just and orderly society.
The size of companies like JP Morgan and Citigroup gives them an enormous advantage in the market already. And as I demonstrated above, these credit swaps take place in a totally unregulated, secret environment. Add the potential for harm to the community - harm that could be avoided or mitigated with a regulatory regime - and I think a solid, general case can be made for conservatives to support some kind of minimal regulation.
The problem as I see it, is that as with everything else President Obama wishes to do, he takes a good idea and ruins it by overkill. The president wants to transform the financial services industry. Conservatives want to rein it in. Obama wants to drastically reduce risk. Conservatives recognize the value of risk (as explained above) and want to minimize it without destroying its many advantages. The president wants to create a federal agency - the Consumer Financial Protection Agency - that some analysts believe would make credit extremely difficult to get for ordinary Americans. Conservatives believe that laws already on the books to protect consumers in this regard could be strengthened, but that a whole new agency is dangerous and unnecessary.
The differences then, are a matter of degree. Clearly, where there is no regulation or transparency, government must be there to create it so that not only is the economy protected, but that the derivatives market itself becomes less prone to the kind of exploitation that secrecy encourages.
Being supportive of a free market most decidedly does not mean that conservatives should oppose all regulation, or support less than adequate regulation, due to an ideological belief that such “interference” is an anathema to the functioning of the market. If the derivatives crisis showed anything, it is that our modern financial system is so complex that ordinary market forces that are supposed to correct imbalances are actually a danger to the economy as a whole. There may have been steps short of trillions in bail outs for firms “too big to fail.” We will never know because they weren’t tried. But even solutions like forced mergers of teetering banks, managed liquidations, guided bankruptcies, and the like would have required massive government intervention in the markets to achieve. And since the problem was worldwide, such measures may still have not been enough to keep the crisis from imperiling the world’s banking system.
A free market is only free if all benefit from its workings. When big companies can skew the market to gain advantages not available to others, or when they can game the system - backed by taxpayers - to take wild risks and place our economy in peril, it behooves conservatives to support reasonable steps by the government to rectify the situation.
Some of what the president proposes makes sense. Preventing big banks from both taking deposits and trading securities that benefit their own house - a small move back toward Glass-Steagell - is a good idea. Other ideas, like making the Fed the overseer of “systemic risk” and the creation of the CFPA smack of overreach. What eventually emerges from negotiations with Congress, with Wall Street, and the White House we can only hope will be adequate to address the problems without being so burdensome that they stifle economic activity.
I am an unabashed liberal that reads this site because, while I don’t agree with you often, you rarely scream. Having said that I think this article is very good except for two points. One is that I believe that many of the banker knew they were getting in deep but did now care about anything but the size of the wallet. Number two is that “conservatives should value order above all else” is frightening to me.
Comment by dexter45 — 2/17/2010 @ 11:34 am
dexter45 said:
It might comfort you to understand that conservatives valuing order is fundamental to the DNA of people in that political spectrum. Conservative brains crave order and structure, while tending away from novelty and change.
So, saying that conservatives should value order above all else shouldn’t be frightening. That’s just the way the system works. It’s about equivalent of, “If you’re a conservative, this is how you think” and NOT “If you’re a conservative, this is how you *should* think.
Comment by Chuck Tucson — 2/17/2010 @ 12:08 pm
You are correct that both sides have to own up to this one. However, this article focuses on the financial collapse created by mortgage defaults and the payout of the swaps/insurance issued on those mortgages. It seems to me that if historical mortgage qualification standards had remained the SOP, the volume of defaults would’ve remained relatively unchanged from times past. Unfortunately, they were not and mortgages were being handed out like candy.
Furthermore, I am of the opinion that businesses are in fact greedy but greed also translates into an unwillingness to loose money, hence the swaps. Following that thinking, the issuing banks would not have approved risky mortgages if they had to keep them on their books. This brings me to securitization. Since the banks could sell their mortgage products to Fannie and Freddie, who would in turn securitize them and issue them into the global financial markets, the issuing banks experienced no risk but had to remain competitive. However, excessive mortgage default risk had neen introduced into the financial markets and the traders had to deal with it - Credit Default Swaps These CDS’s simply amplified an impending disaster.
I think the solution lies in why were mortgages so readily available. What allowed banks to become so risk adverse in approving mortgage applications? After all, if people had stayed current on their mortgages none of this would’ve happened. On a side note, it is interesting to chronologically follow the price of gas and the foreclosure rate.
Comment by Scooter — 2/17/2010 @ 1:23 pm
Dear Rick
Once again a very meatty post on a topic that is near and dear to my heart as a CPA and a believer in Austrian economics whose principles I am sure you are familiar.
I would only say your diagonosis of the problem is overly simplistic which is true because you are writing an opinion piece not a treatise on the causes and consequences of the collapse of Lehman Brothers and AIG.
I understand that politics is at work as part of the blame game but the ignorant Congress and clueless President in financial matters and structures that were put into place over 3 decades to construct and created financial products and services that no one understood or understands.
If you want to get a good flavor of what the financial geniuses were upto and how greed and avarice trumped common sense and reason, I would pick up a copy of When Genius Failed by Roger Lowenstein. It is an excellent summary of whatis happening today. It conncerns the rise and fall of the hedge fund Long term capital management in 1998 which collapsed because of uncontrolled speculative trades on derivatives.
Bottom line to say financial services is not regulated or evil Phil Gramm or the repeal of Glass Steagall is the cause of all our problems misses the mark entirely. I think you are understating the contribution of Fannie Mae and Freddie Mac to the current situation. They have a huge roll in this disaster as well as the large investment banks and banks like Citigroup and Goldman Sachs.
The point is the big institutions like governemnt and banks and investement banks srewed the pooch and pushed the world into a Great Depression just will not seem as bad as the 1930s, but as they say history does not repeat itself but it rhymes.
Comment by Kevin Brown — 2/17/2010 @ 2:32 pm
In a world in which it is known that anything that gets through Congress is going to be a compromise, does it not make sense for each side to ask for more then what they want, so they have some things to cut as part of the compromise?
When I take a pig to the slaughter house, I hope to take the best parts home with me and leave the stuff I wasn’t interested in behind.
Comment by KenGirard — 2/17/2010 @ 3:15 pm
“Those who continue to believe that the collapse of Lehman Brothers and subsequent tsunam….Lehman, Merrill were junk. They knew, hedges knew they were done two years earlier. At least. Ditto many other greedhead companies. Sorry, you are factually in error.Since Continental Illinois, the first Chrysler bailout ( and not paid back, propaganda aside ), Long-Term Capital Management all established moral hazard, that too big to fail companies could keep the upside and distribute the downside costs to the public at large.
Comment by Paul — 2/17/2010 @ 6:23 pm
Kevin Brown:
I would only say your diagonosis of the problem is overly simplistic
…
The point is the big institutions like governemnt and banks and investement banks srewed the pooch
Kevin, you’re accusing Rick of oversimplifying the situation but being overly simplistic in your own comment. Yes, the banks were a large part of the problem, but what can you expect? The bankers are greedy, but that’s their job. They want to be free to make money with no government intervention, and who can blame them? Government regulations are a pain no matter what industry you’re in.
You’re completely ignoring the two important questions:
1. Would more/smarter financial regulation have prevented the crash?
2. Will more/smarter financial regulation prevent these situations in the future?
As Rick has made it clear, the answer to both of these is “yes.” Right now Republican leadership is completely ignoring this issue. Politically, they can’t admit that the predominantly Democratic point — that more regulation is necessary — is correct. And also politically, they can’t admit that government intervention in the private sector is good under any circumstance.
The more Republicans refuse to participate in this dialog, the more they’ll be left out of the conversation. Whatever happens with regulation, it’s going to be a deal between Democrats and bankers. It’s going to stupid and dirty, but hopefully there will be something constructive hidden in the muck.
Comment by Aaron — 2/17/2010 @ 8:59 pm
Aaron
No government or other institution with as much regulatory power as possible can repeal human greed and fear.
You want me to provide you a blow by blow account of what happended from 1980 until 2008 of what decisions were made that did improve the operations of financial markets but human greed factored in and the good that was done collapsed because of greed.
I am not even going to comment on government regulators who are a joke SEC the Fed Treasury Department. Why do you think the largest donor to both political parties in the last two election cycles was financial institutions
If you are counting BIG Government and BIG Money Banks to cut a reasonable well though out deal you are insane. When these institutions get together the US taxpayer better reach for his wallet.
Also you do realize that the US government owns AIG and Citicorp. The deal that was cut by a certain Treasury Secty when he was president of the NY Fed to rescue AIG stinks to high heaven it is rotten and I would be pushing the House of Reps to prepare artcles of impeachment against him and the newly confirmed Fed Chairman
Finally I will give you a simple solution to these problems:
1. Abolish the FED
2. Return to the gold standard of 1913 ie if no gold in vault we have no money to create with fractional reserve banking which makes Big Banks unable to become to Big to FAIL or BAIL
Comment by Kevin Brown — 2/17/2010 @ 9:30 pm
There was the mistaken belief with some folks that unregulated greed is somewhat a conservative principle. When we say we’d like less government that statement was misused by financial institutions to mean ‘we’d like to do whatever we want’. Teddy Roosevelt showed the monopolies the limits of their power and we should do the same regarding financial institution.
Comment by funny man — 2/17/2010 @ 10:38 pm
The biggest problem I see with CDS’s is that they are a fancy name for what are effectively insurance policies issued on a third party’s assets. This has nothing to do with their liquidity. This should be illegal. If everyone on a street can take out a million dollar insurance policy against the liquor store on the corner burning down, what are the odds that there will be a mysterious fire? Can you even construct a more dangerous moral hazard?
Comment by jms — 2/17/2010 @ 11:22 pm
Being supportive of a free market most decidedly does not mean that conservatives should oppose all regulation, or support less than adequate regulation …
Brilliant. A thousand times yes. Establishing rules of the game, assuring competition and market stability, protecting the government’s purse from the ravages of systemic meltodown- all strike me as reasons conservative should endorse reasonable regulation. Certainly most have benefited from the reasonable regulation of depository banks. Alas, most House conservatives see “reasonable regulation” as oxymoronic. It isn’t, though I see little hope the GOP will view things in this light.
Comment by kreiz — 2/20/2010 @ 4:23 am