October 21, 2008
Turning a Blind Eye?
Posted by Lisa Fairfax

Last week, the Senate Banking Committee held a hearing on the genesis of the current economic crisis.  In his testimony to the Committee, Former SEC Chairman Arthur Levitt noted that, when examining what went wrong, there is plenty of blame to go around from banks, to mortgage brokers, to financial engineers, to regulators.  And hence his and other testimony focused on these groups and their part in the crisis.  The hearing also touched on whether or not the crisis is something we could have anticipated, and hence taken steps to prevent.  During Maryland’s conference on the Sub-prime Meltdown, there was some discussion about this issue.  Indeed, one person from the New York Times editorial board noted that all too often, the refrain from executives at ailing companies has been that this crisis is something that no one could have seen coming.  To be sure, it may be that no one could have predicted the extent or magnitude of the crisis, but is it true that no one could have predicted that things would take a turn for the worse?  And if it is not true, what does that tell us?

In fact, the New York Times featured at least two editorials warning about risky mortgage transactions and their potential consequences.  The first, written in July of 2005, entitled Risky Mortgage Business, focused on the implications of the housing boom.  It noted that the boom was “particularly unnerving” because it “owes much of its longevity to the explosion of risky mortgages.”  It then not only pointed out that lenders rarely took on the risk of such mortgages, but also emphasized the many problems associated with the securities market based on such mortgages. 

“So far, the mortgage-backed market has generated cash and profits galore.  Someday, however, someone will lose money.  No one knows who, when or how much because housing has never been so frothy, risky mortgages so ubiquitous or the market in which they trade so vast.”  And the editorial ended with this: “It is high time for Congress to focus on the implications for the entire economy of boom-time mortgage lending—and for regulators to pay more attention.”

The second editorial, written in September of 2006, entitled Who Bears the Risk?, also focused on the downside of the mortgage lending industry and its relationship to our financial system.   It notes “In a market so vast and dynamic, everyone knows that if mortgage defaults should rise, damage could reverberate throughout the financial system.”

And then the editorial had this warning:

“No one can predict the depth of the housing slowdown or its effect on the global economy.  Even the Federal Reserve has taken, for now, a wait-and-see approach.  Meanwhile, markets seem to take comfort in the belief that if housing hit the skids, the Fed would exert damage control by aggressively lowering interest rates.  There is no guarantee, however, that interest-rate easing would have the same powerful effect is had in the past. 

What if it didn’t?  Market makers and central bankers don’t talk about that, for fear of unleashing a self-fulfilling prophecy.  But we sure hope someone in charge has a fallback plan.”

To be sure, it is not the housing crisis in and of itself that prompted this crisis, but rather the connection between the housing market and the financial instruments based on that market.  As the New York Times noted in September of 2008, “Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts. . . . They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.”

Yet the two editorials suggest that some were aware of the potential for impending problems, and even sought to sound the alarm.   In this regard, the editorials undercut the notion that such problems could not have been anticipated.  Hence, when we consider the crisis, its genesis, and our response, we need to consider not simply whether we could have anticipated the current financial turmoil, but also whether people will pay sufficient attention to warning signs or at the very least have more effective and timely fall back plans when those warning signs are not dealt with.  Because, as Arthur Levitt suggested, this crisis speaks volumes not just about decisions and actions made and taken, but also about those not made or taken.  Or at the very least, the crisis speaks volumes about people's failure to pay heed to the writing on the wall.  And how do we make sure that phenomenon does not happen again?

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Comments (3)

1. Posted by Elizabeth Brown on October 21, 2008 @ 10:21 | Permalink

Unless the current crisis results in a change in the regulatory structure in the US, then we will not avoid a crisis similar to the current one in the future. When I first started talking about consolidating US regulators towards a FSA-style structure back in the fall of 2001, I was told that Congress would not untake such a change absent a major financial crisis because it was captured by financial services firms who were making too much money by engaging in regulatory arbitrage or by operating in the regulatory gaps in the existing system.

Moving towards a multi-peaks system like the one proposed by Paulson and used in Australia or a single regulator like the ones used in Sweden, the UK and 21 other nations would necessarily avoid every future financial crisis. It would, however, make it easier to figure out where the breakdown in regulation occurred, how to fix it, and who to hold responsible for allowing the problem to develop in the first place.

It is too easy in our current system with 115 regulators for them to avoid blame by claiming that it was the responsibility of another regulator to prevent the problem. For example, many derivative instruments, like credit default swaps, have attributes that make them a bit like insurance, securities, and futures. Since they didn't clearly fall within the regulatory authority of one of the existing regulators (the 50 state insurance commissions, the SEC, or the CFTC), they were allowed to go largely unregulated. Afterall each of the existing regulators could claim that it wasn't their responsibility to regulate them. Now that they have played a major role in the current financial crisis, there is a lot of fingerpointing going on but no one is really be held accountable. In addition, there is going to be a lot of debate over which regulator should be assigned the responsibility for regulating them. Is the SEC the best place given its overreliance on disclosure as the solution to every regulatory problem? Or should the state insurance regulators be given the task even though this would like result in a dozen or more different regulatory schemes with the providers seeking to move to the weakest regulator (classic race to the bottom problem)? Rather than fighting over who should regulate wouldn't it better to have a prudential regulator figuring out what capital requirements firms offering this instruments need and a market conduct regulator figuring out the appropriate types of regulations for the risks (credit, operational, market, liquidity, market, and systemic risks) posed by these instruments?

2. Posted by Jake on October 22, 2008 @ 20:30 | Permalink

"Moving towards a multi-peaks system like the one proposed by Paulson and used in Australia or a single regulator like the ones used in Sweden, the UK and 21 other nations would necessarily avoid every future financial crisis. It would, however, make it easier to figure out where the breakdown in regulation occurred, how to fix it, and who to hold responsible for allowing the problem to develop in the first place."

The final point in that statement -- figuring out who to hold responsible for perceived failures in governmental regulation of the economy -- is a noble policy goal. But several somewhat contrary thoughts come to mind.

First, lots of bad stuff happens no matter what government regulators may wish.

Second, any supposed comprehensive regulatory scheme aimed at avoiding the next crisis in the financial markets would, human nature being what it is, be fraught with loopholes for the opportunistic to exploit, unless such a scheme were Stalinist in its severity.

Third, why should talented folks line up for federal civil service jobs in the expectation they will get dubbed scapegoats?

3. Posted by Elizabeth Brown on October 23, 2008 @ 4:36 | Permalink

Just because a multi-peaks model or a single regulator model would not be perfect does not mean that it would not produce considerably better results than the current system. I discussed why a single regulator would be better than the current system in considerable detail in an article that was published back in 2005. See Brown, Elizabeth F. ,E Pluribus Unum - Out of Many, One: Why the United States Needs a Single Financial Services Agency. U of St. Thomas Legal Studies Research Paper No. 05-04
Available at SSRN: http://ssrn.com/abstract=757010

As for why would talented folks sign up for such an agency, they may find the work interesting, it may give them a sense of serving the common good, and the pay would be better than what state-level government agencies pay. Certainly the UK FSA and the agencies in the other 49 countries that use a single regulator or a multi-peaks model seem to have no problems finding employees.

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