Regulatory Rabbit

June 3, 2009

by Chidem Kurdas

The official, semi-official and anonymous voices collectively known as Washington have spread the word for months that new financial regulation is coming. Now, we’re told the first draft will arrive shortly, but there are questions such as who will receive new powers and which bureaucracies will be merged.

One question that gets minimal attention is why the existing agencies with wide-ranging powers did not prevent banks from taking excessive risk, the behavior widely blamed for causing the credit bubble and subsequent collapse. That’s the crux of the regulatory issue, but Washington has already waved it aside.

A common excuse is that the financial system became too complicated for regulators, which lacked the expertise and manpower to deal with Wall Street’s newfangled notions. If that was the case, then the particular bureaucracies that did not supervise Wall Street should have performed well.

Consider what used to be called the Office of Federal Housing Enterprise Oversight. The sole responsibility of OFHEO was to oversee Fannie Mae and Freddie Mac, the mortgage financers that were created by – and since September have become the wards of – the Federal government.

Fannie and Freddie have already been bailed out to the tune of $60 billion and reported another combined loss of about $33 billion in May. OFHEO, having failed to keep its charges minimally solvent or even honest in their accounting practices, has become part of the Federal Housing Finance Agency. That agency recently reported that Fannie and Freddie have “critical” problems.

Why didn’t OFHEO perform its job? Because Fannie and Freddie became too complicated for their regulator? They were set up by the government to buy mortgages and turn them into securities. That’s what they did, year after year, decade after decade. OFHEO was set up to regulate this one activity. Yet it failed.

The Federal Reserve is responsible for banks and the Securities and Exchange Commission for broker-dealers. Investment banks like Bear Stearns and Lehman Brothers, the collapse of which brought on the crisis, were broker-dealers regulated by the SEC. However, the Fed could have worked with the SEC to impose capital requirements. All these agencies failed.

Washington is not really interested in why. The one clear-cut item on the regulatory agenda is to increase regulation on hedge funds—which did not cause the crisis and are too small to threaten the system. Hedge funds were affected by the collapse of Lehman Brothers and made losses in markets, but required no bail-out. Why focus on small fry?

Well, if you have no notion how to make Fannie, Freddie and the banks work better, you may as well divert the public’s attention elsewhere. Pull a rabbit out of the hat so that it looks you’re doing something. Plus, to protect their interests hedge funds will have to lobby alongside everyone else, so more money will flow to K street. And that’s where the real Washington is, behind all the PR about preventing crises.

5 Responses to “Regulatory Rabbit”

  1. Phil Maymin Says:

    Well put, and convincing, but what alternative do you propose?

    By this logic, we should abolish the Fed, the SEC, and prohibit any governmental regulation of any financial transactions, leaving only the standard justice system to prosecute fraud and enforce contracts.

    If that’s *not* what you believe, i.e., if you believe we need some particular regulations, then we will inevitably end up exactly where we are today — too much regulation leading to too many failures leading to even more regulation.

  2. Public Choice Theory predicts that over time regulators’ interests will align with those of the industry they regulate. Anyone advocating regulation must grapple with how the system can be incentive compatible. What incentives would align the interests of regulators with those of the general public? If there are simple rules (“Simple Rules for a Complex World”), and there is transparency, perhaps the public could monitor the performance of regulators. The more complex the regulations, the more likely the industry will game them, and the less likely the public will understand what is going on.

  3. Bob D Says:

    It’s the safety in numbers theory. If you can get enough people employed or supported by the government surely you will get reelected. If the Government were to have an honest evaluation of what went wrong the blame would largely point to easy money by the Fed and Government encouraged loans to credit unworthy borrowers.

  4. Phil Maymin Says:

    So it seems that the only possible solution that doesn’t lead to a repeat of the current situation is to abolish all financial and economic regulations, permanently.

  5. […] the rules and investigate violations. These range from the Securities and Exchange Commission to the specialized overseer of Fannie Mae and Freddie Mac, the government-backed mortgage finance […]

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