Friday, September 25, 2009

Where's Elliot Ness When You Need Him?

Over at Rortybomb, Mike Konzal and Jeffrey Friedman have engaged in a lively discussion on the role of regulation in the failure of the financial sector.

Jeffrey Friedman is the editor of Critical Review, and a contributor to the Causes of the Crisis blog (a great resource for people like me who are seeking out various perspectives in an attempt to understand why the economy tanked so terribly.)

Jeffrey believes the crisis is the result of regulation - specifically, no-recourse laws that many states had on the books that enabled consumers to walk away from mortgages they had no interest in paying back, and the Recourse Rule, which rated MBSs favorably, thus were more attractive to bankers. Since I'm not a banker or economist, I'll let Jeffrey explain the Recourse Rule:

"Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages—regardless of how sound the borrowers were—sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability."

(I personally do not understand how the Recourse Rule absolves bankers from issuing mortgages responsibly, but I'm not an economist.)

Mike, both on Rortybomb and over at the Atlantic Business Channel, takes a look at the rule in question:

"So let’s look at this new amendment more critically. It takes an older, blunter government rule (all mortgages at 50% risk), and makes it more market friendly (mortgages at the level where the market prices risk). It outsources risk-management to private companies, the ratings-agencies, assuming that companies willing to pay to get ratings on their mortgage bonds would lead to more efficient information than government regulators. It takes as granted that financial innovation has “worked” and that government regulation should act to help move the latest financial innovations more coherently into the regulatory regime."

Mike thinks that this rule is in line with deregulation, something all capitalists claim to desire. And he notes that the regulation trusts the financial markets to manage the risk. Here, Mike quotes from the regulation itself:

"The [regulatory] agencies expect that banking organizations will identify, measure, monitor and control the risks of their securitization activities (including synthetic securitizations using credit derivatives)...Banking organizations should be able to measure and manage their risk exposure from risk positions in the securitizations, either retained or acquired, and should be able to assess the credit quality of any retained residual portfolio…Banking organizations with significant securitization activities, no matter what the size of their on-balance sheet assets, are expected to have more advanced and formal approaches to manage the risks."

In several comments responding to Mike's post, Jeffrey provides intriguing arguments to counter Mike's reasoning - including this provacative image:

"If the prohibition of liquor was enforced with only 90% success and as a result of this “loophole,” the cost of a drink went so high that gangsters started killing each other for the right to control the supply of liquor, would you defend prohibition on the grounds that it’s the loophole that’s causing the problem? Or would you acknowledge that there would be no problem without the artificial profitability of liquor caused by prohibition?"

And I think to myself - is a conservative writer really bringing up Prohibition in a discussion of the economic crisis? Because yes - we all agree that Prohibition was a huge regulatory failure - and I'm sure we all agree that enormous regulatory failures were at play in the collapse of the economy.

But last I checked, when Elliot Ness went after the masters of the mayhem resulting from Prohibition, he wasn't going after the guys who legislated Prohibition into law. He went after the men who picked up the guns and pulled the triggers and profited greatly on a crappy piece of legislation.

So if Jeffrey wants to absolve bankers from their abysmal failure to manage risk - which is a big part of the job they're paid awesome sums of money to do - then he really should avoid any reference to Prohibition. People who push through loopholes to create mayhem should be held accountable for their actions. And that's true for banksters, as well as gangsters.

(See below if you're a Sean Connery fan...)

"I'm making you a deal. Do you want the deal?"

(Useless trivia - I worked on this film for a week. Filming at night in a dark and smelly alley. Kevin Costner's parents came into town to watch him work (it was before he was famous.) Total run time in the film for the week of work was about five seconds (Charles Martin Smith gets gunned down in an elevator created out of smoke and mirrors by the crew - the mob, like Enron, knew that if you wanted to screw up the free market, it was essential kill the accountants....)

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