Thursday, April 23, 2009

Moral Hazard: Bailouts and Regulation

Since the beginning of this economic crisis, there has been a steady demand for more control and regulation of banks and financial institutions in order to protect retirement accounts and the economy as a whole (jobs). That reaction is engrained in our nation's history as government regulation has only increased in response to banking and accounting scandals and asset bubbles. Not once has it decreased. Yet, after one year of dramatic government intervention, it is all too clear that our financial system remains as fragile as it was a century ago, despite the creation of countless government agencies whose mission is to protect and strengthen that system.

Some deregulation did take place in the 1980s and 1990s, but the only policies that could be tied to the current crisis have only exacerbated the fallout of the housing bubble, such as the 1998 bipartisan Gramm-Leach-Bliley Financial Services Modernization Act, which relaxed Glass Steagall provisions (leading to more securitization a la Freddie and Fannie) and exempted financial products such as CDSs. There are some like, Paul Krugman, who claim the act was instrumental in the crisis, but they cannot explain how the original laws would have saved Freddie and Fannie, who wasn't affected at all by the GLBA, and why European banks, which never had anything like Glass Steagall, did not suffer the same problems. The amount of financial regulation since 1907 dwarfs the recent deregulation, which at the very least helped financial institutions stay in business as they were acquired by healthier banks.

It is a widely held view that the asset bubble--fueled by cheap loans (artificially low interest rates) and easy credit, both for borrowers (think low/no doc loans) and investors (think bogus triple-A ratings)--had to pop sometime. There had never been a bubble like that in human history, and low interest rates only encouraged consumption, which meant that MBS investors lacked adequate capital in chasing these diminishing returns. But that didn't stop them.

Why didn't it? The investors purchased an insurance policy from Congress, unbeknownst to taxpayers. But the deal was too good to be true, for Congress, that is. For a nominal amount of campaign contributions, the bankers were able to get stinking rich, knowing all along the risks were being mitigated. The extent of the S&L Crisis of the 80s was a direct consequence of deposit insurance, and eventually cost taxpayers $200 billion, while many kept their profits of their risky practices. Only a handful went to jail. A decade later, the creditors of the Long Term Capital hedge fund, (the names might be familiar to you: Bear Stearns, Merrill Lynch and Lehman Brothers) were bailed out by the Federal Reserve. Over the years, as sort of a quid pro quo, those same companies donated heavily to candidates of both parties, just in case more of their investments should tank. It's no small wonder that two of the three were recently deemed "too big to fail".

These competing forces are actually anti-competitive and destructive. The regulators try to prevent bad behavior while the elected officials are financially compelled to make it all better should the behavior result in trouble. This is analogous to the life of a typical teenager who has a set of rules and responsibilities (regulations), but also enjoys a big safety net in the form of loving parents and free rent (the full faith and credit of the U.S. government). If the rules are broken, the lawn isn't mowed, no biggie, at least the teen won't be kicked out of the house. And most kids get to come home from juvenile hall. This codependent family dynamic apparently has weaved itself to every corner of industry and the bureaucrats who regulate it.

So with the same incentive structure, albeit more regulation and more bailouts, why would we expect different behavior, both on the part of careless investors and corrupt politicians? The pattern shows that problem isn't the undesirable actions that we regulate against, it's the current set of actors and incentives that lead to the undesirable actions that regulation can't keep up with. We need to change the incentives if we expect a different result. Our elected leaders are just as addicted to power as big corporations are addicted to money. This codependent relationship is a destructive monopoly that costs taxpayers and investors huge sums of hard earned money, and only by letting them both fail, will the destruction stop.

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