Ride of the Regulators

National Review, November 3, 2008

Georgetown, November 2008 © Andrew Stuttaford

First fire, then brimstone, then collateralized debt obligations: Both Nicaragua’s Daniel Ortega and Iran’s Ayatollah Ahmad Jannati (a hardliner’s hardliner) are arguing that the 2008 crash is down to the Big Fellow upstairs. Ortega reportedly maintains that the Almighty is using the chaos on Wall Street as a scourge to punish America for imposing flawed economic policies on developing countries. The ayatollah, meanwhile, insists that it is Uncle Sam’s unspecified “ugly doings” that have brought down the wrath of Allah, and with it the housing market. I’m not entirely convinced either way.

I am, however, sure that the crash is a godsend for regulators, meddlers, and big-government types of every description, nationality, and hypocrisy. Speaking on behalf of his famously clean administration, Russia’s president, Dmitri Medvedev, has called for stricter regulation of financial markets, as has the EU’s top bureaucrat (the mean-spirited might interject that the EU is about to have its accounts rejected by its auditors for the 14th consecutive year). They are joined by the green-eyeshade types at the United Nations Conference on Trade and Development and the always-understated Nicolas Sarkozy, who pronounced: “Laissez-faire is finished.” Sacre bleu! 

Closer to depreciated home, Democratic congressman Barney Frank has blamed the crisis on a “lack of regulation,” a gap that he obviously plans to fill and more with the eager assistance of Nancy Pelosi. In the now-infamous speech she made ahead of the first, calamitous House vote on the bailout package, Pelosi claimed, ludicrously, that the source of our problems lay in the fact that there had been “no” regulation and “no” supervision. Even if we make necessary allowance for hyperbole, dishonesty, and ignorance, Speaker Pelosi’s revealing choice of adjective indicates that an extremely heavy-handed, destructive, and counter-productive regulatory regime lies ahead.

The ideological winds have shifted. With free markets generally, and Wall Street specifically, being blamed for an economic predicament that is grim and getting grimmer, it’s going to be a struggle for those of us on the right to convince the rest of the country that the solution is not a financial system micromanaged by the feds. Nevertheless, we must try.

It was too much to expect John McCain to contribute anything to this effort, and, with his diatribes against “greed and corruption” on Wall Street, he hasn’t. But if, to use a vintage insult, demonizing “banksters” is unhelpful (full disclosure: I work in the international equity markets, but I am writing here in a purely personal capacity), trying to pin the blame on the Democrats’ uncomfortably cozy relationship with Freddie Mac and Fannie Mae won’t do the trick either. It is true that this unlovely couple was running amok and that the Democrats helped them do so. But the conceit that the failure to regulate them appropriately is in itself an argument against wider financial regulation is absurd. Equally, to proclaim that free markets are always their own best regulator is not only to fly in the face of history and common sense but also to ensure that the debate will be lost.

As we survey an economic landscape littered with shattered 401(k)s, broken banks, and anxious businesses, the idea of leaving the free market to clean up after itself comes perilously close to the old notion that it was sometimes necessary to destroy a Vietnamese village in order to save it. The free market is a very powerful engine for economic growth, the best we have, but it is that power that makes it too dangerous to be left solely to its own devices. Adam Smith certainly understood as much. To face this reality is to recognize that the sensible debate is not whether financial markets should be regulated, but how much and in what manner.

As a starting point, we must accept (as if there could now be any reasonable doubt about it) that the interconnectedness and scale of today’s markets mean that far more institutions than had been previously thought are, as the cliche goes, “too big to fail.” (I’d add that this country’s fragmented regulatory structure has now clearly shown itself too small to succeed.) Market fundamentalists will hate it, but it’s time to be honest about this. Bear Stearns was too big to fail, but so, quite possibly, was Lehman Brothers. And if an institution is indeed too big to fail, that means it is effectively underwritten by the poor conscripted taxpayer. Under the circumstances, it’s neither unreasonable nor inconsistent with free-market principle to insist that the price of that privilege (which can bring with it a competitive advantage) be a more cautious approach to risk. Not to do so would, in fact, provide a perverse incentive to do the opposite, creating the notorious “moral hazard” about which we read so much these days.

Now that they have become conventional banking companies, this more closely supervised world is where Morgan Stanley and Goldman Sachs will, justifiably, find themselves. The question, then, is which other institutions should be brought within a tighter regulatory net. The answer is, I suspect, to be deduced from facts of size, function, and client base, but it is difficult to avoid the conclusion that the category of “too big to fail” will include at least some money-market funds and — remembering the Long-Term Capital Management fiasco — perhaps others on the buy side.

Getting this right is crucial because the corollary is that we will then know which firms are not too big to fail, and can ensure they are allowed to carry on business with minimal government interference. Traditionally, establishing a sleep-at-night risk profile has been a matter of closer regulatory scrutiny and ever-tougher capital requirements, but in the wake of this trauma we must ask whether certain instruments are simply too complex, too leveraged, and too thinly traded to be permitted anywhere near a “too big to fail” balance sheet. I may not share Warren Buffett’s politics, but it’s impossible to deny that his 2003 warning about the dangers of derivatives (“financial weapons of mass destruction”) was, to say the least, prescient.

Yes, the Chicago Mercantile Exchange is establishing a facility for the centralized trading and, critically, clearing of credit-default swaps (on some estimates a $58 trillion market, although that number may be swollen by double counting), something that, if successful, should enhance both liquidity and pricing transparency. Additionally, attempts are being made to come up with a mark-to-market rule that accurately reflects risk without triggering unnecessary disaster (although it is essential that any such change be accompanied by greater disclosure of “off balance sheet” exposure). The role of the ratings agencies is also being subjected to long-overdue reappraisal. These are all steps in the right direction, but they are no panacea. For a different approach, go to Spain. The Spanish central bank discouraged the banks it supervised from participating in the structured-credit markets. This had the virtue of simplicity and, it seems, some degree of success. It’s not a perfect precedent (some of these banks were playing around with structured-credit products), but it is a start.

Even though Spanish banks largely kept clear of America’s subprime swamp, they could not escape their own. Spain too had a real-estate bubble. Manias, like panics, are global. But we do learn from them. The Bank of Spain’s relatively tough line has its origin in a major Spanish banking crisis some three decades ago. America’s real-estate lenders are unlikely to repeat the mistakes they have made (at least on the same scale) for many years: burned fingers and all that. Lending standards have tightened and will probably stay tight for a long time. This is not to suggest that the regulation of housing finance should be left untouched. Writing in the Wall Street Journal, George Soros (I know, I know) has argued that we should look at the Danish mortgage-bond market for inspiration, and there’s something to that. There’s no space here to go into the details, but suffice it to say that the Danish system aligns, prices, and manages risk far more effectively than anything we have in the United States. It would be nice to report that, as a result, the descendants of Polonius (“Neither a borrower nor a lender be”) had avoided gambling on Danish real estate. Unfortunately, they didn’t. To speculate is human.

But the housing crisis is also a cautionary tale of political mismanagement (or it would be if anyone were paying attention). While promoting a home-ownership society is a legitimate function of government (thus the tax deductibility of mortgage interest should be retained), it must be exercised openly and honestly — and it must be properly costed. The misuse of the Community Reinvestment Act and, even more, the odd, anomalous, and unhealthy existence of Fannie Mae and Freddie Mac (they should be broken up and privatized as soon as possible, which in current conditions may be a while) played malign parts in this whole miserable saga. They are a reminder that excess, overreach, and worse can be as much a feature of the public sector as of the private. Preventing such abuses in the coming age of regulatory fervor will be the next challenge.