Roger’s Rules

Email This to a Friend

April 3rd, 2009 2:26 pm

Scylla and Charybdis, or regulation, risk, and the passion for “fairness”

Today’s two essential articles: 1) Paul Singer’s “Free-Marketeers Should Welcome Some Regulation,” which appeared in The Wall Street Journal and 2) Charles Krauthammer’s “Obama’s Ultimate Agenda,” available in many outlets.

Let’s start with Mr. Singer’s column. I suspect that its title has caused many conservatives to break out in a cold sweat: “Free-Marketeers Should Welcome Some Regulation.” What’s going on here? “Oh no!,” I can hear my conservative friends say say, “What is happening? How could Paul Singer, who not only runs a successful hedge fund but is also chairman of the libertarian-leaning Manhattan Institute, how could he be calling for Regulation? Is this not a betrayal of free market principles? Et tu, as Shakespeare’s Caesar memorably put it, Brute?”

Calm down. I know that “regulation” is a suspect, even a dirty, word in the conservative’s lexicon. I myself, when ever encountering it, follow the practice George Orwell recommended regarding saints, i.e., I consider it guilty until proven innocent. But Mr. Singer is on to something important and it behooves us, especially those of us who are supporters of the free market, to heed what he has to say. First, the problem:

In the past decade, most global financial institutions built highly leveraged balance sheets — sometimes as high as 30 to 1 — that were stuffed with risky assets. These institutions also bought on a large scale for their own accounts the same securities they sold to their customers. Our anachronistic regulatory framework didn’t catch the problems, and warped incentives and compensation schemes fueled the risk-control failures that eventually brought on the crisis we face today.

The economic implosion we have just witnessed was not caused by the operation of the free market, but rather by a failure to follow certain strictures that allow for the orderly working of the free market, i.e., an adequate recognition and pricing of risk. As. Mr Singer observes,

[W]e must create a new regulatory infrastructure that will meet three fundamental tests. First, it must assess and measure risks accurately, including the compounded risks of herding (traders being similarly situated and forced to unwind simultaneously). Second, it must impose significant margin requirements on all exposures. And finally, it must bring all investors and traders — regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency — under the regulatory umbrella.

Calling for regulation of any sort can seem like heresy to conservatives, especially at a moment when governments in the United States and Europe seem poised to increase the role of the state, and of regulation, in every aspect of our social and economic life. But as I have observed in this space before, the real issue is not regulation per se “but unintelligent and overbearing regulation.” The problem — well, one problem — with the Community Reinvestment Act was that it stymied the operation of the market by refusing to acknowledge and price risk accurately. It did this in pursuit of a utopian political dream. The result was a $1.5 trillion avalanche of bad debt guaranteed by the taxpayer and gobbled up by creative speculators who compounded the problem by once again refusing to recognize the risks inherent in their ingenious financial instruments.

The bottom line is that in calling for intelligent regulation Mr. Singer is not impeding the free market: he is helping to assure its successful operation. The market depends on the candid and publicly available adjudication of risk. That, indeed, is what makes it free. The explosion of highly leveraged financial instruments that depended heavily on inscrutable agglomerations of debt represented a gigantic risk that was never publicly acknowledged nor adequately insured against. We are now living with the results.

Paul Singer expatiates on one side of the social-economic-cultural crisis we face (and make no mistake, the crisis, although it began on Wall Street will have unsettling reverberations throughout society). Charles Krauthammer touches on a complementary aspect of the crisis. The financial crisis, Mr. Krauthammer points out, are for the Obama administration merely “sideshows”–”enormous sideshows,” he acknowledges, but in the end subsidiary to Obama’s main ambition, which is to alter in the most fundmental way the traditional relationship between the individual and the state, to the aggrandizement of the latter and the hampering and circumscription of the former. “His goal,” Mr. Krauthammer observes,

is to rewrite the American social compact, to recast the relationship between government and citizen. He wants government to narrow the nation’s income and anxiety gaps. Soak the rich for reasons of revenue and justice. Nationalize health care and federalize education to grant all citizens of all classes the freedom from anxiety about health care and college that the rich enjoy. And fund this vast new social safety net through the cash cow of a disguised carbon tax.

Obama is a leveler. He has come to narrow the divide between rich and poor. For him the ultimate social value is fairness. Imposing it upon the American social order is his mission.

In short, “Fairness through leveling” — which is to say ” ‘fairness’ through leveling — “is the essence of Obamaism.”

So we have our work cut out for us. On the one hand, Paul Singer is right that we need formulate new regulations to curb irrational and dangerous risk taking. On the other, Charles Krauthammer is right that the Obama administration is poised to employ the enormous power of the state to renegotiate the social contract upon which American society was built. We must, in other words, weave our way gingerly between the Scylla of incontinent, unchaperoned risk-taking and the Charybdis of a rampant new statism predicated on a soul- and enterprise-blighting egalitarianism. Never a dull moment.

Pajamas Media appreciates your comments that abide by the following guidelines:

1. Avoid profanities or foul language unless it is contained in a necessary quote or is relevant to the comment.

2. Stay on topic.

3. Disagree, but avoid ad hominem attacks.

4. Threats are treated seriously and reported to law enforcement.

5. Spam and advertising are not permitted in the comments area.

The clause regarding "hate speech" has been deleted because readers criticized it as being too loosely defined. We agreed.

These guidelines are very general and cannot cover every possible situation. Please don't assume that Pajamas Media management agrees with or otherwise endorses any particular comment. We reserve the right to filter or delete comments or to deny posting privileges entirely at our discretion. If you feel your comment was filtered inappropriately, please email us at story@pajamasmedia.com.

8 Comments

1. mk.:

I agree, but I would feel better if discussions from liberty-oriented people emphasized transparency and the “free” in “free market”.

The outcome might be the same, but I think they better describe some of the issues. With more information, markets handle risk better (that is, they can better anticipate risks).

More importantly, it seems that statists will be able to abuse calls for “more”, “different”, or “better” regulation. I always hate to see news reports that give the impression that conservatives agree that markets have failed or that existing regulation is not strong (read: intrusive) enough.

Apr 3, 2009 - 2:56 pm 2. Fred Z:

I generally agree with you but in this matter my agreement is very general.

The only regulations worth having are variants of “tell the truth to your customers, the whole truth and nothing but the truth.”

You say “we need formulate new regulations to curb irrational and dangerous risk taking.” and I say buzz off, I’ll take risks just as dangerous as I choose, you gotta lot of nerve telling me what I can or cannot do. Just make the industry tell me the truth.

Singer says the regulations “must assess and measure risks accurately, including the compounded risks of herding”. Once again, buzz off, I’ll assess and measure my own damn risks.

Just stop those guys from lying all the bloody time. Madoff lied. Moody’s lied. The Dems are lying about the CRA. Chris Dodd lies all the time. Barney Frank has never told the truth about anything. Geithner? An honest man? Sure, no doubt about it.

Apr 3, 2009 - 5:15 pm 3. JMH:

Well, the first problem is to get the current crop of Democrats out of power. Nothing can be fixed as long as they are running things. As Krauthammer points out, their goal isn’t to fix problems, it’s to acquire more power. Barney Frank was perfectly happy to rail against regulatory oversight of Fannie Mae when his cronies (and lovers) were running it and funneling money to him and his party. Now that it blew up and caused a bunch of collateral damage, he’s happy to rant about increasing regulation of sectors that didn’t contribute to the problem.

I could, we all could, go on with examples. But the basic problem is that both Singer and Krauthammer are right. We need regulation, but not by the clowns currently in office.

Apr 4, 2009 - 1:05 am 4. Andrew_M_Garland:

AIG didn’t blow up because psychopathic speculators in their financial products group were running a totally unregulated betting shop in high-flying hedge fund style.

AIG went broke guaranteeing MBS (Mortgage Backed Securities) and CDOs (Collateralized Debt Obligations). The MBS were rated AAA by government regulated and approved ratings agencies. The CDOs were rated AAA because they were built on the AAA MBS bonds. AIG was furthering a market in CDO bonds that the government wanted to expand. The government was happy with the operations of AIG.

Much of the MBS may have been privately issued, but they were entirely similar to the MBS issued by Fannie Mae and Freddie Mac, called GSEs (Government Sponsored Enterprises).

Fannie, Freddie, and all other issuers were directly regulated by the House Financial Services Committee (Barney Frank and Maxine Waters among others) and a special regulator OFHEO. Fannie Mae and Freddie Mac were specifically put outside the regulation of the SEC, outside the influence of the Bush administration, and under the captive OFHEO.

Congress maintained close oversight of what Fannie, Freddie, and others were doing, and approved of it. Congress created OFHEO (The Office of Federal Housing Enterprise Oversight) especially to regulate FanFred. The much larger and more visible SEC (Securities and Exchange Commission) was available, but Congress wanted its own regulator.

OFHEO was captive to House congressional committees, and outside the influence and control of the Bush administration. All of the private issuers of MBS and CDOs were under the same regulatory regime. This was the regulatory regime that Barnie Frank and Chris Dodd were running.

The House committee regulating banking and financial services (the Financial Services Committee) did not object, and actually encouraged more lending to subprime borrowers.

Barney Frank (D. MA) has served as ranking (most senior) Democratic member on this committee at least since 1992, and has chaired the committee since 2007 in the Democratic majority.

There is a long history of Barney Frank proclaiming that all was well with Fannie and Freddie, and no further oversight or inquiry was needed.

It is laughable that more government “regulation” will have a good effect. Our difficulties arise from trust in government regulation, and that regulation was designed to specifically do things that were MORE risky and MORE systemic than any group of independent agents would do in a free market.

We Guarantee It

The government found a way to spend as much as it wanted, by guaranteeing the debts of off-budget government agencies, called GSE’s. The current bailouts and huge budgets continue to serve the self-interest of politicians and government aligned groups.

Apr 4, 2009 - 1:26 pm 5. Chlorian Theoreticus:

“In no system that could be rationally defended would the state just do nothing. An effective competitive system needs an intelligently designed and continuously adjusted legal framework as much as any other. Even the most essential prerequisite of its proper functioning, the prevention of fraud and deception (including exploitation of ignorance), provides a great and by no means yet fully accomplished object of legislative activity.”

- F. A. Hayek, from “The Road to Serfdom” 1944.

Apr 5, 2009 - 9:15 am 6. Martian #256t:

Life is moral and markets and investing are as well.

I am in disagreement. Everyone, investors, capital allocators etc need to be responsible.
“I lost because the regulators didn’t prevent 30-1 leverage”, read a freaking annual report and take the risks you want and wish to bear.
Citibank specialized in firing 1sr tier talents and hiring 4th tier, everyone knew that, is that what you want to own? It was doomed. Weill paid himself $1BILLIOn in 2000, free market? Theft. Buffett sold on that news. Buffet pays himself $100,000 annual.

Equity investing has risks, people who don’t want to takie and bear the +s and -s of outcomes, shouldn’t own equities, get out don’t come back.

In 1980 I started as a stock broker and dealt with many in a small college town. Consistently I had 25-32 yr old young academics who would sell stocks gifted to them by parents and grandparents. Military-industrial-complex polluters!! Others bought those stocks.

We are all different and have different desires.

25k of Exxon in 1981 is worth 645k today- the buyer wanted Exxon risk and seller wanted out, each got what they wanted and deserved.

Grow up, be responsible and don’t complain.

COF

Apr 5, 2009 - 4:14 pm 7. Forbes:

There are two problems with Paul Singer’s prescription for financial regulatory reform, “Free-Marketeers Should Welcome Some Regulation” (April 3). First, as a global mandate: this puts us all in the same boat–we sink or swim together, so to speak. And second, this prescription is based upon a faulty assumption: this time “we” get it right. Under Mr. Singer’s construct, the problem is simple (”Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear.”), therefore, the solution is simple.

This is hubris.

Hindsight is always 20/20. After the fact, the problem is never “as difficult as it may appear.” We’re geniuses now, though apparently we were imbeciles before the collapse.

The factors cited as contributors (or as answers) to the financial collapse: leverage, margin, risk, and concentration, were already regulated and under the purview of the SEC, the Fed, other bank, state, market, or other regulators.

Capital controls, margin requirements, internal risk control systems, disclosure (transparency) requirements, audit standards, compliance regulations, performance (market) expectations, access to capital (public and private) markets, are mere details that make up the foundation of the financial system. Simple, this is not. And this foundational/regulatory complexity spawns so-called loopholes, much like our legal and tax system–if it is not explicitly forbidden, then it is allowed (and perhaps, required).

Humans make mistakes, and last I checked, regulators are human too. This characteristic will not be overturned, by legislation or regulation.

Our rules-based system attempts to remove human judgment, and therefore ill-judged (usually, after-the-fact) mistakes, from of the workings of the financial system. Moral and ethical judgment regarding right and wrong are proscribed–supplanted by this rules-based system of do’s and don’ts.

And still, it was a fundamental judgment–an assumption–that led to this calamity. And that assumption was home prices would inexorably continue to rise–and in this rise was a cushion of safety upon which our foundation would rest.

While pointing fingers can be politically satisfying, I think the record is pretty clear–mistakes were made regarding the constancy of rise in home prices, and all our institutions–legislative, executive, regulatory, and financial markets–contributed.

While no one factor triggered the meltdown, the totality of the commitments (and reinforcing feedback loops) to this assumption are pretty impressive: the CRA; “affordability” mortgages; low (negative real) interest rates from the Fed; Fannie Mae and Freddie Mac morphing into trillion dollar, hedge fund-like institutions with, essentially, one-way bets on interest rates and home prices; rating agencies rating securities lacking transparency (CDOs, CDO-squared, et al.); over-the-counter derivatives, e.g. CDSs, with its inherent counter-party risk, rather than exchange-traded that reduces such risk; bank capital requirements advantaging AAA mortgage securities; risk models based on Gaussian “normal” distribution when financial market disruption is anything but normal; tax treatment of mortgage interest and home re-sale capital gains; and on and on and on. While lengthy, the list is not exhaustive of the contributors.

Markets are messy. They require rules and procedures. There is no way around this fact-of-life. Tackle each of the issues and factors individually in the requisite venue so that “we” might systematically and institutionally learn the appropriate lessons from these mistakes—experience being the only teacher available. It will require hard work and effort from many quarters. There is no omniscient (or centralized) body that can “know” how to get each of these issues right.

I am not suggesting we throw our hands up in frustration and futility because it will be difficult, but unlike Mr. Singer, I do not see a silver-bullet answer–passing the responsibility off onto another layer of regulation and regulators, be it a global framework, foundation, umbrella, or mandate, and hope they get it right.

Besides, hope is not a plan, it is a prayer.

Apr 11, 2009 - 11:34 am 8. Steven Earl Salmony:

Dear Friends,

Perhaps you can assist me. There must be something wrong with the “picture” I am about to draw, but no one with wealth, power, status, and privileges to conspicuously consume and endlessly hoard has said anything. Their bought-and-paid-for politicians and absurdly enriched minions in the mass media are also silent.

Picture this:

A remarkably tiny group of conniving, deceitful, ostentatiously greedy, patently fraudulent financial schemers on what is left of Wall Street in the remaining investment houses and the major {stress-tested} banks that are described as “too big to fail” are at one and the same time being given hundreds of billions of dollars in taxpayer money, racking up billions of dollars in profits, and paying themselves millions of dollars in bonuses. All the while, millions of people are losing their livelihoods, homes, pensions, etc.

What is wrong with this picture?

Sincerely,

Steve

Apr 15, 2009 - 5:59 am