By Tom Berner
With the focus in Washington on bank bailouts and stimulus packages, we have yet to hear about any serious proposals for new regulations. Nevertheless, they will come, and anyone who thinks that a President McCain would have treated Wall Street any less harshly than President Obama must have been asleep during the Presidential campaign. Indeed, since Wall Street’s campaign contributions went to President Obama by a wide margin, it is clear that Wall Street, for one, didn’t expect mercy from the GOP. Stronger regulation was in the cards no matter who dealt the hand. The tricky part, however, is determining the kind of regulation that will have a beneficial effect on any part of the economy other than the pockets of the legal profession. There are several pitfalls to designing a satisfactory regulatory reform program.
First, regulations are inherently political. A Washington lawyer once told me that the difference between New York lawyers and Washington DC lawyers is that New York lawyers think that it is what you know that wins the day, whereas DC lawyers know that it is who you know that makes the difference.The SEC has been AWOL for the last two stock market bubbles, 1999 and 2008, and neither the party then occupying the White House nor the Loyal Opposition made much of an effort (or had much of an incentive) to stop the good times from rolling. You have to go back to the 1980s to find any spirited effort to control a bubble forming in the financial sector, and that had more to do with Rudolph Giuliani than any initiative from his superiors in the Reagan Administration.
Another problem is that regulatory agencies, like bad generals, tend to fight the current war with the strategy and weapons of the last one. As the world changes, they stay mired in the past. So we are approaching the current crisis as if it were 1932 and the best way to recreate those times is to behave as if we still lived there.
At a recent seminar on banking law sponsored by the American Bar Association, the faculty agreed on two things: The most efficient and effective financial regulatory regime in the world today is that of Australia and that we will never follow their example. Instead, we will add another layer of regulatory agencies to the grab bag of agencies that have been popping up since 1862. This will further bog down decisionmaking at banks and bank holding companies without making the system significantly safer.
A third problem is that regulations have a nasty way of supporting bad ideas. The subprime mortgage crisis was encouraged by regulations promulgated by the Office of the Comptroller of the Currency as well as a law passed by Congress called the Community Reinvestment Act, which encouraged banks to make mortgage loans to people who would not otherwise qualify for a loan. Not that the current crisis was entirely caused by unqualified borrowers: When a solution to allow banks to avoid the consequences of subprime lending – securitization – was created, the same sloppy underwriting pervaded the regular mortgage market, as happened in the “buy to rent” segment of the market.
Fourth, regulations are better at stifling good ideas than they are at preventing bad ones. The Shared Appreciation Mortgage (SAM), invented by American banks 40 years ago, would be a useful vehicle for dealing with families who can’t pay their mortgage. It allows banks to renegotiate a loan by reducing the principal to an amount that the family can afford and in exchange, the bank gets to share in any increase in the value of the real property. This keeps the loan alive, the family in their home and the property occupied and maintained. Unfortunately, the IRS can’t make up its mind whether such a transaction is an equity investment or a debt instrument, so it has created a vast body of rules before such a mortgage can be created, making the transaction costs so high that a SAM is feasible only for large commercial transactions.
So the current crisis was caused by a toxic combination of bad regulations, which encouraged banks to make questionable loans; no regulations, which allowed them to foist those bad mortgages on the rest of the economy; and complicated regulations, which have removed at least one remedy from the financial industry’s medicine kit. If a new regime of regulation is to put anyone back to work other than lawyers, you cannot just layer on additional regulations.
Therefore, let me suggest two principles which should guide President Obama’s regulatory proposals:
1. You cannot improve or regulate the way the market system works, but most of the world economy operates in a bastardized form of market system where psychology and politics, institutionalized by the existing structure of the economy, alter the way the market functions. It is on the interface of market forces and existing institutions that real reform can be achieved, and that’s where reform ought to be focused.
For instance, an ideal market requires the seller to take pesonal responsibility for his product. That is precisely what Wall Street stopped doing many years ago. Perhaps the most horrifying aspect to the current crisis are the emails that have surfaced in prominent investment banks and rating agencies where the writers acknowledge that the product they’re selling is rubbish and express the hope that they will have dumped it on some sucker and collected their bonuses before it blows up.
The solution is suggested by the problem itself. Make investment banks take most of their fee in the securities they have designed and marketed. Prevent them from selling these securities until the maturity of the instrument (or in the case of equities, a long enough period to cover any inherent flaws in the security itself). These should be put in an account on behalf of the then current employees of the bank. Let investment bankers earn a good income, but not the sort that allows them to retire as megamillionaires in their 30s. Instead, let their personal economic future depend on the health of the securities they have shoved down the throat of investors. It is a pretty good bet that the quality of average security coming out of Wall Street will be vastly improved.
2. The immortal Roman question, “Quis custodiet custodes?” (”Who will watch the watchdogs?”) should never leave President Obama’s consciousness. Too many laws are regulations of the people, by the lawyers and for the lawyers. Ideally, laws should be designed by mechanical engineers, or at least people who share that discipline’s goal of designing the simplest solution to the problem at hand. Lawyers, on the other hand, profit by promoting regulations so complex that you need to hire a lawyer to interpret them.
The place to start here is to reform Civil Service and allow elected officials to impose some degree of discipline on the Federal bureaucracy, sometimes called the “permanent government.” In his new book Presidential Command, Peter Rodman examines the efforts of every President since Richard Nixon to control his own foreign policy and finds that every Administration has been stymied by the State Department bureaucracy. Although Rodman’s book focuses on foreign policy, the same phenomena can be found throughout the government. Perhaps the most disturbing revelation of the Bernard Madoff affair is that although many complaints about him have been filed with the SEC for the last fifteen years, the staff never referred the matter up to the political decisionmakers, meaning that the staff is either incompetent or corrupt.
If the President can make the regulatory system more user-friendly and responsive, that would be change we can all believe in.
