I was planning on ignoring the regulatory non-news that was the Obama financial regulation press conference, but it seems to have gotten so much coverage from thoughtful people (Krugman, Baseline, Rortybomb, Robert Reich) that I can’t resist. They’re wrong, and so is the President. Or perhaps not wrong; missing the point.
The regulatory changes come in three main flavors:
Administrative reorganization. Streamlining the number of regulators, eliminating regulatory arbitrage, creating special resolution authority for bank holding companies, etc.
Skin in the game. Requiring originators of securities to hold some portion of the resulting security.
Consumer protection. Some watchdog agency to try to standardize and idiot-proof financial products.
Deck chairs on the Titanic.
Let’s start with the administrative reorganization. It’s a Washington favorite, because fighting with other officials in DC over who gets introduced first at government functions is much more fun than trying to play bad cop to the cool kids in the private sector. Do you really think being a part of the Department of Homeland Security makes the Coast Guard magically better prepared to catch a terrorist taking a bomb into New York Harbor?
It is true that we have too many different regulators. It is true that the Office of Thrift Supervision was a bumbling agency ill-suited to understand AIG’s games. It is true that we have dozens of state regulators who are about as honest as building inspectors and as intelligent as, well, building inspectors. Maybe some consolidated super-regulator will be better. Or, far more likely, it will end up hiring exactly the same people as currently work at OCC/OTS/FDIC/NCUA/SEC, and they will be no smarter for the change of business card.
Moreover, the problem we are facing is not that the various regulatory agencies won’t work together. It is that they will. Look at recent history. When Lehman blew up, Reserve Fund broke the buck, AIG was on its way out, and it looked as though we were staring at the abyss of a full-fledged run on cash, Bernanke didn’t wait for the guys with legal responsibility to act; those guys reported to George W. Bush, and given how much brush needed to be cleared, an answer could have taken a while. He just jumped in with the Maiden Lane vehicles and let Paulson catch up. By the time it came to the big Merrill/BAC merger, Hank & Ben were the dynamic duo feasting on the weak-minded Ken Lewis (Hank to protect John Thain, Ben out of shell-shock from Lehman, but who cares about motivations). Skipping ahead in Administrations, when Treasury ran out of money from TARP and wanted the PPIP boondoggle, guess where they were going to get it: Congress the FDIC, which was all too happy to absorb the contingent liabilities of a bunch of securities it hadn’t valued in the name of goosing the equity of a bunch of banks it wasn’t responsible for.
There are also specific reasons to dislike making the Fed the super-regulator. The Fed has a side business as our central bank. Ideally, it is focused on the stability of the dollar, a full-time job that is constantly under threat from the government’s temptation to run deficits (yes, we are spending more than we have today – but tomorrow, when someone else is in charge, he can ignore his agenda and repay my debts). Being a regulator brings with it a natural closeness, an affinity that is hard to define and harder to shake. You will never see a Secretary of Agriculture question the entire premise of farm subsidies; whoever holds the seat takes it as a given that his job is to lobby for the folks he oversees. And when America’s farmers are behind the curve testing for BSE, when America’s slaughterhouses are comically overcrowded and prone to disease and pollution, can you really expect USDA to crack down on the entire industry? Of course not. It will cover for them, as the Fed will cover for the bankers when they next collectively get giddy. Does anyone seriously expect a regulator to raise rates if he knows that by doing so Citi and BofA are going to be inverted? A little central bank independence would be a nice thing at this point.
The argument that originators should have skin in the game seems like an odd love child of a conspiracy theory and the efficient market hypothesis. It is popular on the left because it plays on the lack of morality and principal-agent problems of the bankers – nasty brutes living off the sweat of the working man. But it doesn’t make much sense.
Let’s think about what you would need to believe. A loan originator sees someone walk into his office. He decides that the guy is going to default – he can’t pay the loan and housing prices will go down and prevent him from refinancing – but figures what the hell, he’ll originate the loan (perhaps with some fraud, or even a high-pressure boiler room tactic or two), it’s the problem of the bank that buys it anyway.
That’s great. How many real estate professionals do you know in high house-price appreciation areas who believed the market was going to crater in 2005? Or 2006? Or 2007? Hell, fall of 2008. Or today:
They believed. Deeply, truly, could pass a polygraph in the middle of the night after three fingers of Scotch and a sodium penethol drip. They bet their businesses on it, they leveraged their own houses, they thought they had found the perpetual motion machine. This wasn’t a Ponzi scheme with a few diabolical geniuses running for the exits; this was a panic. Unlike the typical metaphor, it wasn’t people stampeding to get out of a crowded theater, it was a crowd rushing to get in. The gatekeepers were first in line.
They would have happily held 5% if that was the price of doing business. Sure, it was nice to be able to recycle their capital more quickly by taking fees and not tying up a balance sheet, but anyone with ambition in these businesses was running acquisition pools at night. Loan officers in Orange County leaned on developers to let them buy in pre-construction. A world away, CDS salesmen in New York were fighting with their risk management groups for the right to buy structured products personally.
Sometimes I wonder if academics – even truly brilliant academics such as Krugman and Johnson and Reich – miss out somewhat on the mob mentality by dint of both their roles and their acclaim. Perhaps you don’t approach a Nobel Prize winner with just any idea, but I know that I was approached with all sorts of dumb shit. And for years I watched what seemed to be dumb shit make money, and lacking the validation of the awards these guys have won, for each of those years I wondered if I wasn’t the dumb shit for sitting on the sidelines. I don’t blame the folks who jumped in.
There is a further funny variant of this argument that comes from Lloyd Blankfein and has gotten some traction of late: employees do not have enough skin in their firms’ game (the principal-agent problem) so compensation should be in deferred equity. The junior folks get some sort of vesting schedule, the senior folks get to hold their equity until retirement. And with that, a Wall Street CEO with a straight face managed to propose something awfully similar to baseball’s old Reserve Clause. Workers are not paid in the current period, but rather are expected to roll their compensation for years at a time to support the equity of their employer. How decent of them.
As I have previously addressed, compensation, like other contracts, is a matter of allocating risk. Lloyd wants all employment risk to fall on the employee. The corporation that hires him sits on his earnings for some period of time between three years and the rest of the guy’s career (God knows what penalty clause Lloyd imagines for folks who leave to go to rivals – it’s nice to dress up a non-compete as a public policy concession). If something should happen to the company – say, the sort of thing that happened to every independent investment bank over the last year – tough luck. If something should happen to the individual – say, he wants to sail the world, or join a start-up across the street – well, he’s out some part of the earnings he accrued in a previous period. I can understand why Goldman thinks it wants this – when it sees how much better it would be to work for a monoline partnership under this structure than a diversified corporation where your net worth can be blown AIG-style by a group you have never met, it might change its mind – but folks should see this as merely an employer looking for leverage over its employees.
And that brings me to consumer protection. I like the general idea; in fact, I like just about anything Elizabeth Warren proposes. Buried fees, double-cycle billing, fine print, servicers repeatedly changing payment addresses – these are all simply forms of fraud, dressed up in legal boilerplate. If it can be cleared out and a more transparent world put in its place, so much the better.
But let’s be clear about the big items – the no-doc subprime option ARMs and HELOCs and their cousins throughout the financial universe. These products did not displace the thirty year fixed-rate mortgage (itself hardly received wisdom, and merely an American convention, like a 65mph speed limit) by being sneaky; they replaced the 30 because with them a house buyer could get more purchasing power, plain and simple. No one had to fool the purchasers into taking the debt; they went looking for it. Even if Joseph Stiglitz and Robert Shiller had personally sat down with the borrower and run through every possible risk, he would have signed at the X.
Furthermore, the stuff that blew up the system – the web of credit default swaps and other derivative obligations – wasn’t even a retail product. Is some financial products commission going to review a bespoke deal between two experts, each of whom knows more about what he is trying to accomplish than the guy called in to referee the deal (this won’t prevent one or both from making a terrible mistake, but they’re going to get their deal done)?
No, the one thing the regulatory system needs, and the thing that has been most absent from both the Dubya and Obama reactions to the crisis, is this: will.
None of the questions of who should bear what risk would have been of the slightest consequence if the Administration had been willing to live with the consequences. When AIG was at death’s door, and Goldman stood to blow up if it couldn’t get its hands on cash immediately, the government had a choice. It could fund AIG and let the money go out the back door to Goldman and the rest of the counterparties. Or it could say “your creditors and investors are not my problem.” On any of the several occasions that Citi has been in the balance, FDIC had the choice of saying “that’s it, give me your banking license, show’s over,” and every time it flinched. And of course, when AIG itself could not pay its bills, the government could easily have nationalized the insurance operation and the custodial business and let AIGFP roll into bankruptcy court.
Sure, it would have been convenient if there were a law stating “when confronted with a bank run by a buffoon that is in the process of acquiring at a premium a bank run by a liar, the Secretary of the Treasury shall not direct the buffoon to consummate the merger.” Responsibility is a cross to bear. But the government already has more than enough power to intervene where it sees fit. What it lacks is the will.
With that, I propose the real test for financial regulation: can the regulator honestly say to himself “if the CEO of the company calls me in an hour and tells me that he needs X to stay out of bankruptcy, I will tell him to pound sand”? If the answer is no – in fact, if the regulator cannot be certain of his answer – the company needs to be broken up immediately.