The League

Regulating the Crash

by Erik Kain · April 30, 2011

Erik Kain

Erik writes about video games at Forbes and politics at Mother Jones. He's the contributor of The League though he hasn't written much here lately. He can be found occasionally composing 140 character cultural analysis on Twitter.

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mark boggs says:

April 30, 2011 at 8:19 pm

I’m not an economist, don’t pretend to know squat about economies, and am not sure I want to. Having said that, after reading the book “The Big Short”, and hearing it described how things like credit default swaps and CDO’s and how they were packaged and then rated (quite inaccurately) by Moody’s and Standard and Poor’s, I find it hard to believe that the biggest financial players in the world can, simply by creating things almost out of thin air, manage to rattle the national economy so profoundly with their poor judgement and behavior. But if it makes them money in the short term, especially if they don’t understand the long term consequences of what they’re doing, aren’t they simply going to do it again? I guess it seems, especially in the case of the ratings agencies, that someone either was incompetent or intentionally misleading about the quality of the bundled sub-prime loans.Report
RTod says:

May 1, 2011 at 8:20 am

“is it still possible that finance was under-regulated and that certain regulations, should they have been implemented, would have helped prevent or predict the collapse ahead of time? ”

I’m going to say Yes and No.

I know that the delusion/outright malfeasance related to the bond & housing market gets all the press – probably because it affects most of us so very directly. But I am not sure how much deregulation itself contributed. It seems to me that a big part of that problem was simple hubris and greed, which occurs whether or not regulation is employed. What’s more, it seems there actually were regulatory oversights in place that should have not let the crisis happen at all; but even regulation is a poor tonic when everyone in the chain decides that they’re loving the results and are going to keep pushing ahead with their heads in the sand. Or, to put it another way, if regulation had caught the bond housing issues, history shows that people would have just found another way to make really poor choices. (Think 1990s tech bubble.)

On the other hand, the credit default swap issue – which I believe from a macro point of view was a far bigger wound in the system – was absolutely a disaster that would have been a literal crime had the criminal activities not been made legal by deregulation; without the purposeful changes in the oversight structure this part of the collapse simply never would have happened.

In insurance there is a central philosophy that guides everything, and remains the only reason the entire industry survives: insurable interest. If you’re not an insurance person, the theory of insurable interest states that in order for an insurance system to work, you can only insure against potential bad outcomes that would result in your having a financial loss; and you cannot insure against an amount greater than that loss might be. This is why, say, if your next door neighbor is in the last stages of pancreatic cancer treatment you can’t go out and purchase a $5 million dollar life insurance policy on them; in fact, you can’t even do that if they are not sick at all – you have no insurable interest in their life. Insurable interest is one of the cornerstones of all financial laws and regulations; it may in fact be the oldest.

Credit default swaps were simply deals that allowed large companies to buy what were essentially huge life insurance policies on other large companies. They existed for literally no other reason than to make those that sold them rich, and those companies that purchased them to positively but fraudulently overstate their asset to debt ratios on their financial statements. To make it worse, those potential assets that were to pay for the potential liability of a company going out of business didn’t exist; deregulation meant that AIG didn’t actually have to have any funds to pay for a loss for which they were pocketing insurance premiums.

And unlike the housing bond market disaster, no one was putting their head in the sand. EVERYBODY knew what they were doing was wrong, and EVERYBODY knew that the system would eventually collapse, and the hope was that each person in the system could just make enough before one large company folded. So a large part of the meltdown occurred because lobbyists for AIG and others got the government(s) to say that while most people and companies had to adhere to the principles on insurable interest, if you had a big enough company you could simply ignore it.

The last point I might make is that one of the reasons that financial regulation succeeds in working in the small scale but fails so often on the large is that that in our regulatory system accountability is oddly reduced by scale: If you are a mom and pop insurance agent and you sell a policy but pocket the money, you go to jail or at least have the state forbid you selling insurance in the future. But do it on a multi-billion to trillion dollar level, and not only don’t you have to serve time, you get to keep just about everything you pocketed. I don’t think this is a failing of financial regulation; it just happens to be a failing of our implementation of it.Report
- mark boggs in reply to RTod says:
  
  May 1, 2011 at 9:24 am
  
  But what do you do when the folks who are supposed to be the law enforcers don’t enforce the law after the fact? Are those law-enforcers simply another piece in the chain of what I think gets referred to as regulatory capture? Bought and paid for?
  
  And thanks for your deeper explanation of what the housing mess was about. I read the book “The Big Short” and it made it clearer but still sorta murky.Report
  - RTod in reply to mark boggs says:
    
    May 1, 2011 at 10:03 am
    
    Good questions; an I think to answer them I stick with my last paragraph, that regulation is needed, but they need to be better (not bigger) than what we have always had. Some sort of regulation that protects the entire system has to be in place; I am a free market guy, but if the “free” part of the market exorbitantly rewards people for crashing the entire market than ignoring this issue seems inherently nihilistic. But that doesn’t mean that our current regulatory system is the best regulatory system.
    
    I’m not a conspiracy theorist, but the fact that the only ones in the system that are not penalized for profiting from actions that meet any lay person’s definition of fraud are the ones with a seat at the table deciding what the rules should be is not a coincidence.Report
    - DensityDuck in reply to RTod says:
      
      May 3, 2011 at 9:42 am
      
      “The people responsible for enforcing the laws were unable or unwilling to enforce the laws!”
      
      “Well, the solution to that is more and better laws!”
      
      :confused:
      
      Like he said: If the regulators don’t regulate, then what does it matter how many regulations there are?Report
      - RTod in reply to DensityDuck says:
        
        May 3, 2011 at 4:50 pm
        
        Did you read the first comment at all?Report
WardSmith says:

May 2, 2011 at 4:50 pm

RTod, you make some excellent points above, and I hope folks will link to your explanation since it is better than most I’ve read elsewhere. There are only a few holes to be filled in my opinion. One element of “regulation” which actually contributed to the disaster was the attack on AIG by Spitzer. Read this book for an excellent treatise on a critical missing puzzle piece that allowed the CDS market to spiral out of control (and yet retain a AAA rating, courtesy of AIG’s own AAA rating). Don’t have time for the book? Read Paul Bradshaw’s excellent review there.

As for regulation itself, we didn’t see regulation do any good with Madoff et al. Furthermore, where was the mighty Sarbanes Oxley in all of this? Mountains of new regulation, $Billions in compliance costs and it didn’t accomplish a tinker’s damn to quell this debacle. The Dodd/Frank bill likewise is nothing but eye candy for the next disaster, which I predict will occur within 5 years or less.Report