Only Tighter Regulation Will Stem This Crisis Of Confidence

I have a funny feeling that we’re not in Kansas, anymore.” Like Dorothy’s sublime observation of the surreal in “The Wizard of Oz,” our taking stock of where we are in the vortex of this economic tornado leads us to the same scary observation.

It also forces us to ask some tough questions - questions for which there may be no simple answers. Key among them:

• Where are we?
• How did we get here?
• How do we get home?

There are innumerable opinions as to how we got where we are - not to mention about who and what caused the housing bubble, the credit crisis, the insolvency of banks, the implosion of markets and the slippery slope to potential reprise of the Great Depression. All the opinions and bad directions aside, we would not have crashed if we had not thrown away the regulatory map that had been designed to guide us.

In 1980, stirring winds of change began buffeting the regulatory edifice that for decades had protected us from unsound banking practices. Ultimately, the safe harbors of pragmatic and prudent regulation, born of the Great Depression, were swept away. And deregulation unleashed unmitigated greed.

In the ensuing rush for profits - under the bigger-is-better banner - the unfettered and unchecked growth of illusive financial instruments and excessive leverage spawned an unprecedented concentration of systemic risk. The result has been a global financial catastrophe of truly biblical proportions.

Death by Derivatives

It used to be that new financial products were only allowed to come to market after a thorough examination by several different regulators who each weighed in on how the product might affect the portion of the market that they supervised. While that was a cumbersome process, it served to keep dangerous products off the shelves of institutional and retail investors.

In the brave, new deregulated world of today, however, the story is very different. Indeed, it’s frightening to conclude that toxic products with nuclear potential were manufactured and stockpiled in every neighborhood in America.

The specific products - structured collateralized mortgage obligations (CMOs) and credit default swaps (CDS) - are “derivative” products that stand out as being particularly egregious. There were no regulations against creating newfangled, incendiary residential and commercial mortgage products that, only on their surface, looked like other tried-and-true securitized mortgage products. Imagine your kids being given real guns and told they were just like the toys they were used to, only better.

As for credit default swaps, only in a deregulated world could a “product” of such massive destructive power be allowed to proliferate into a $60 trillion market, impact virtually any company it targets for destruction and not be subject to even a single rule or regulation. In the absence of any regulation, credit default swaps have become a financial plague. If you need proof, just look at what happened with insurer American International Group Inc. (AIG).

Even in an appropriately regulated marketplace, sound products are subject to changing market conditions. In a properly regulated product market, regulated ratings agencies would provide transparent, researched and documented analyses of the products they rate, and would also adjust their ratings in a timely manner to reflect changing conditions. One of the reasons we are here in this mess is that the debt-rating agencies were not regulated.

That’s right: No one was watching the watchers.

You Can’t Rate What You Can’t See

Incongruously and deceptively, ratings agencies are paid handsomely by the issuers of the products they rate, who would like high ratings on their products so they can sell more of them, more easily, and for greater profits.

Ratings are vital to ascertaining the risk and reward relative to the market price of products. Ratings agencies and the existing business model they work under must be changed and strenuously regulated.

“Buyer beware” might be acceptable advice when shopping in a regulated financial supermarket. But, in the current deregulated market, it is a prescription for suicide. And without proper regulation, dangerous products stamped “rating agency approved” proliferated.

That was bad enough.

But these toxic products were then distributed by co-conspirators in the age-old game of “heads I win, tails you lose.” The existing, self-serving, self-policing regulatory regime that oversees financial professionals is a very unfunny joke.

Regulations with repercussions must replace the thin veil that covers and covers-up the criminal and stupid individuals and firms that prey on retail customers and unsuspecting institutional clients alike. The financial-services industry is about products and professionals. Without better oversight of the individuals and the companies involved, there will be no confidence in the integrity of the financial system.

As far as regulating other intermediaries at such non-bank institutions as mortgage originators, they need to come under a united umbrella and be regulated, not separately, but under a comprehensive apparatus.

Of the multiple failures of inadequate regulation, one in particular is responsible for the coalescing of destructive forces that imploded the world as we knew it: There is no mechanism to monitor and dilute the inordinate concentration of risk that leverage and greed conspired to allay in a gross gambit for profitability.

The build up of systemic risk was largely a byproduct of deregulation, or non-existent regulation. Banks merged with investment banks and stand-alone investment banks borrowed more and more to compete with commercial bank subsidiaries that had access to massive depositor capital. Meanwhile, giant hedge funds were borrowing from banks and investment banks to leverage returns, all in a machismo-fueled competitive frenzy to out-earn each other.

They all ended up in the same small sandbox holding the same lottery tickets for a dance with the school prom queen. When everyone realized that the queen had already been spoken for, their mass exodus to cash in their lottery tickets created the great de-leveraging and the sell-off that swept through all the world’s markets. Where were the regulators?

The Crisis of Confidence

There are, no doubt, free-market disciples who will argue that regulation actually created the problems we are facing. While the theory makes for good debate, the reality is that greed is a part of human nature, which can’t be regulated away.

The truth is that our system of regulatory protections has been hollowed out while we watched. And what’s left is inadequate. In order to fix a banking crisis - which is what we’re faced with now - the very first task, and the most important step of all, is to restore confidence. Or create it anew.

Without appropriate, transparent and dynamic regulation, there will be no recovery. The world has changed and the financial system must change with it. Only a new, comprehensive, transparent and protective regulatory apparatus can save future investors from again experiencing the financial horrors of the past.

The time for change is now.

Subscribe by RSS Subscribe by Email