Saturday, October 25, 2008

Bush and Regulatory Incompetence

I've been intrigued by attempts by the RNC to exonerate Bush for failing to regulate the financial markets. According to the RNC, the problem was that those Evil Democrats (TM) in Congress prevented the passage of legislation that would have allowed him to regulate the markets.

Bush had no problem imposing his own policies on torture or domestic surveillance under the guise of "signing statements." If he had been so hot to introduce regulation, he could have done so on his own hook, as the head of the executive.

In fact, additional regulatory powers were part of the compromise that led to the bipartisan repeal of Glass-Steagall.

Contrary to RNC talking points, Fannie and Freddie did not start the rush to securitizing subprime mortgages. They joined in, and they made the problem worse, but they didn't start it. Claiming that they did betrays a lack of understanding about the nature of the current financial crisis.

Beyond that, you have to look at CDSs to see the mechanism by which problems in one part of the financial system are dominoing through other parts of the financial system. (People who watch such things were very relieved that the final settlement of the outstanding Lehman-related CDSs was on the low side of the estimates. The high side of the estimates could have made things really interesting. The fact that the estimates varied so widely shows exactly the transparency sorts of problems I've been talking about.)

Regulation of these CDSs was well within the powers of the regulators who were appointed by Bush. It is silly to try to give his administration a pass and blame the entire mess on the minority party in Congress. Fortunately, there are a lot of people for hire who specialize in oversimplification and silly mudslinging.

Blaming Fannie and Freddie exclusively is like blaming Mrs O'Leary's cow for the Chicago fire. The underlying problem was lax building and fire codes. If it hadn't been for the cow, there would have been little Timmy playing with matches or a lightning strike on Mrs O'Leary's barn.

The mortgage crisis was a precipitating event. Fannie and Freddie alone do not explain how the consequences of rising default rates were able to propagate through the international financial system so quickly and thoroughly.

Both parties participated in setting up a financial system that was under-regulated and that relied far too much on private ratings agencies and fraudulent (or at least opaque) financial statements. I don't find the finger-pointing exercise to be helpful or even particularly enlightening. Both parties gleefully accepted money in exchange for their connivance in setting up underregulated financial markets.

The real solution is to provide more transparency in financial instruments, especially derivatives. As long as derivatives (such as CDOs and CDSs) are opaque, there will be smart people who will be able to hide sludge in an apparently AAA asset. The only hope is to allow buyers and analysts to uncover the sludge. Obviously, this will probably require re-definition of some of these derivatives, and may require that a regulated exchange be set up for things like CDSs.

We're seeing so much butt-covering going on that nobody is looking at how to implement fire codes in our financial system.

In my view, sunlight is the best way to deal with a political infection. If we can force greater transparency on the financial markets, investors will be able to make more informed decisions. Premiums will be placed on experts who can perform insightful analysis rather than on tricksters who can hide toxic waste in a AAA rated bond.

One of the most frightening interviews I heard over the last couple of weeks was with someone who had been explaining CDSs to an official at the SEC. Evidently, that official thought that CDSs were being used exclusively as "insurance" and not as the world's biggest unregulated gambling salon. And the official had no idea that nobody was checking to see if the underwriters of CDSs actually had the capital reserves to make good in the event of a default. "Asleep at the switch" doesn't even start to cover it.