Posts tagged ‘financial crisis’

Explaining the Financial Crisis: Government Creation of a Financial Investment Mono-culture

Arnold Kling on the recent financial crisis:

1. The facts are that one can just as easily blame the financial crash on an attempted tightening of regulation. That is, in the process of trying to rein in bank risk-taking by adopting risk-based capital regulations, regulators gave preference to highly-rated mortgage-backed securities, which in turn led to the manufacturing of such securities out of sub-prime loans.

2. The global imbalances that many of us thought were a bigger risk factor than the housing bubble did not in fact blow up the way that we thought that they would. The housing bubble blew up instead.

What he is referring to is a redefinition by governments in the Basel accords of how capital levels at banks should be calculated when determining capital sufficiency.  I will oversimplify here, but basically it categorized some assets as "safe" and some as "risky".  Those that were risky had their value cut in half for purposes of capital calculations, while those that were "safe" had their value counted at 100%.  So if a bank invested a million dollars in safe assets, that would count as a million dollar towards its capital requirements, but would count only $500,000 towards those requirements if it were invested in risky assets.  As a result, a bank that needed a billion dollars in capital would need a billion of safe assets or two billion of risky assets.

Well, this obviously created a strong incentive for banks to invest in assets deemed by the government as "safe".  Which of course was the whole point -- if we are going to have taxpayer-backed deposit insurance and bank bailouts, the prices of that is getting into banks' shorts about the risks they are taking with their investments.  This is the attempted tightening of regulation to which Kling refers.  Regulators were trying for tougher, not weaker standards.

But any libertarian could tell you the problem that is coming here -- the regulatory effort was substituting the risk judgement of thousands or millions of people (individual bank and financial investors) for the risk judgement of a few regulators.  There is no guarantee, in fact no reason to believe, the judgement of these regulators is any better than the judgement of the banks.  Their incentives might be different, but there is also not any guarantee the regulators' incentives are better (the notion they are driven by the "public good" is a cozy myth that never actually occurs in reality).

Anyway, what assets did the regulators choose as "safe"?  Again, we will simplify, but basically sovereign debt and mortgages (including the least risky tranches of mortgage-backed debt).  So you are a bank president in this new regime.  You only have enough capital to meet government requirements if you get 100% credit for your investments, so it must be invested in "safe" assets.  What do you tell your investment staff?  You tell them to go invest the money in the "safe" asset that has the highest return.

And for most banks, this was mortgage-backed securities.  So, using the word Brad DeLong applied to deregulation, there was an "orgy" of buying of mortgage-backed securities.  There was simply enormous demand.  You hear stories about fraud and people cooking up all kinds of crazy mortgage products and trying to shove as many people as possible into mortgages, and here is one reason -- banks needed these things.  For the average investor, most of us stayed out.   In the 1980's, mortgage-backed securities were a pretty good investment for individuals looking for a bit more yield, but these changing regulations meant that banks needed these things, so the prices got bid up (and thus yields bid down) until they only made sense for the financial institutions that had to have them.

It was like suddenly passing a law saying that the only food people on government assistance could buy with their food stamps was oranges and orange derivatives (e.g. orange juice).  Grocery stores would instantly be out of oranges and orange juice.  People around the world would be scrambling to find ways to get more oranges to market.  Fortunes would be made by clever people who could find more oranges.  Fraud would likely occur as people watered down their orange derivatives or slipped in some Tang.  Those of us not on government assistance would stay away from oranges and eat other things, since oranges were now incredibly expensive and would only be bought at their current prices by folks forced to do so.  Eventually, things would settle down as everyone who could do so started to grow oranges. And all would be fine again, that is until there was a bad freeze and the orange crop failed.

Government regulation -- completely well-intentioned -- had created a mono-culture.  The diversity of investment choices that might be present when every bank was making its own asset risk decisions was replaced by a regime where just a few regulators picked and chose the assets.  And like any biological mono-culture, the ecosystem might be stronger for a while if those choices were good ones, but it made the whole system vulnerable to anything that might undermine mortgages.  When the housing market got sick (and as Kling says government regulation had some blame there as well), the system was suddenly incredibly vulnerable because it was over-invested in this one type of asset.  The US banking industry was a mono-culture through which a new disease ravaged the population.

Postscript:  So with this experience in hand, banks moved out of mortage-backed securities and into the last "safe" asset, sovereign debt.  And again, bank presidents told their folks to get the best possible yield in "safe" assets.  So banks loaded up on sovereign debt, in particular increasing the demand for higher-yield debt from places like, say, Greece.  Which helps to explain why the market still keeps buying up PIIGS debt when any rational person would consider these countries close to default.  So these countries continue their deficit spending without any market check, because financial institutions keep buying this stuff because it is all they can buy.  Which is where we are today, with a new monoculture of government debt, which government officials swear is the last "safe" asset.  Stay tuned....

Postscript #2:  Every failure and crisis does not have to be due to fraud and/or gross negligence.  Certainly we had fraud and gross negligence, both by private and public parties.  But I am reminded of a quote which I use all the time but to this day I still do not know if it is real.  In the great mini-series "From the Earth to the Moon", the actor playing astronaut Frank Borman says to a Congressional investigation, vis a vis the fatal Apollo 1 fire, that it was "a failure of imagination."  Engineers hadn't even considered the possibility of this kind of failure on the ground.

In the same way, for all the regulatory and private foibles associated with the 2008/9 financial crisis, there was also a failure of imagination.  There were people who thought housing was a bubble.  There were people who thought financial institutions were taking too much risk.  There were people who thought mortgage lending standards were too lax.  But with few exceptions, nobody from progressive Marxists to libertarian anarcho-capitalists, from regulators to bank risk managers, really believed there was substantial risk in the AAA tranches of mortgage securities.  Hopefully we know better now but I doubt it.

Update#1:  The LA Times attributes "failure of imagination" as a real quote from Borman.  Good, I love that quote.  When I was an engineer investigating actual failures of various sorts (in an oil refinery), the vast majority were human errors in procedure or the result of doing things unsafely that we really knew in advance to be unsafe.  But the biggest fire we had when I was there was truly a failure of imagination.  I won't go into it, but it resulted from a metallurgical failure that in turn resulted form a set of conditions that we never dreamed could have existed.

By the way, this is really off topic, but the current state of tort law has really killed quality safety discussion in companies of just this sort of thing.  Every company should be asking itself all the time, "is this unsafe?"  or "under what conditions might this be unsafe" or "what might happen if..."   Unfortunately, honest discussions of possible safety issues often end up as plaintiff's evidence in trials.  The attorney will say "the company KNEW it was unsafe and didn't do anything about it", often distorting what are honest and healthy internal discussions on safety that we should want occurring into evidence of evil malfeasance.  So companies now show employees videos like one I remember called, I kid you not, "don't write it down."

When Regulation Makes Things Worse -- Banking Edition

One of the factors in the financial crisis of 2007-2009 that is mentioned too infrequently is the role of banking capital sufficiency standards and exactly how they were written.   Folks have said that capital requirements were somehow deregulated or reduced.  But in fact the intention had been to tighten them with the Basil II standards and US equivalents.  The problem was not some notional deregulation, but in exactly how the regulation was written.

In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were "risk-free" in the sense that they were counted 100% of their book value in assessing capital sufficiency.  Most other sorts of financial instruments and assets had to be discounted in making these calculations.  This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.

Without the regulation, one might imagine  banks to have a risk-reward tradeoff in a portfolio of more and less risky assets.  But the capital standards created a new decision rule:  find the highest returning assets that could still count for 100%.  They also helped create what in biology we might call a mono-culture.  One might expect banks to have varied investment choices and favorites, such that a problem in one class of asset would affect some but not all banks.  Regulations helped create a mono-culture where all banks had essentially the same portfolio stuffed with the same one or two types of assets.  When just one class of asset sank, the whole industry went into the tank,

Well, we found out that mortgage-backed securities were not in fact risk-free, and many banks and other financial institutions found they had a huge hole blown in their capital.  So, not surprisingly, banks then rushed into government bonds as the last "risk-free" investment that counted 100% towards their capital sufficiency.  But again the standard was flawed, since every government bond, whether from Crete or the US, were considered risk-free.  So banks rushed into bonds of some of the more marginal countries, again since these paid a higher return than the bigger country bonds.  And yet again we got a disaster, as Greek bonds imploded and the value of many other countries' bonds (Spain, Portugal, Italy) were questioned.

So now banking regulators may finally be coming to the conclusion that a) there is no such thing as a risk free asset and b) it is impossible to give a blanket risk grade to an entire class of assets.  Regulators are pushing to discount at least some government securities in capital calculations.

This will be a most interesting discussion, and I doubt that these rules will ever pass.  Why?  Because the governments involved have a conflict of interest here.  No government is going to quietly accept a designation that its bonds are risky while its neighbor's are healthy.  In addition, many governments (Spain is a good example) absolutely rely on their country's banks as the main buyer of their bonds.  Without Spanish bank buying, the Spanish government would be in a world of hurt placing its debt.  There is no way it can countenance rules that might in any way shift bank asset purchases away from its government bonds.

A Partial Retraction on AIG

The story the other day that AIG was considering suing the taxpayers because the taxpayers did not give them a nice enough bailout was so vomit-inducing that I did not even look much further into it.

A couple of readers whom I trust both wrote me to say that the issues here are a bit more complex than I made them out to be.  The Wall Street Journal sounds a similar note today:

Every taxpayer and shareholder should be rooting for this case to go to trial. It addresses an important Constitutional question: When does the federal government have the authority to take over a private business? The question looms larger since the 2010 passage of the Dodd-Frank law, which gave the feds new powers to seize companies they believe pose risks to the financial system.

That vague concept of "systemic risk" was the justification for the AIG intervention in September 2008. In the midst of the financial crisis, the federal government seized the faltering insurance giant and poured taxpayer money into it. The government then used AIG as a vehicle to bail out other financial institutions.

But the government never received the approval of AIG's owners. The government first delayed a shareholder vote, then held one and lost it in 2009, and then ignored the results and allowed itself to vote as if the common shareholders had approved the deal.

In 2011 Mr. Greenberg's Starr International, a major AIG shareholder, filed a class-action suit in the U.S. Court of Federal Claims in Washington alleging a violation of its Constitutional rights. Specifically, Starr cites the Fifth Amendment, which holds that private property shall not "be taken for public use, without just compensation." The original rescue loans from the government required AIG to pay a 14.5% interest rate and were fully secured by AIG assets. So when the government also demanded control of 79.9% of AIG's equity, where was the compensation?

Greenberg is apparently arguing that he would have preferred chapter 11 and that the company and its original shareholders likely would have gotten a better deal.  Perhaps.   So I will tone down my outrage against Greenberg, I suppose.  But nothing about this makes me any happier about bailouts and corporate cronyism that are endemic in this administration.

Corporate Crony Entitlement

This story is simply  unbelievable.  Shareholders of AIG should have been wiped out in 2008 in a bankruptcy or liquidation after it lost tens of billions of dollars making bad bets on insuring mortgage securities.  Instead, AIG management and shareholders were bailed out by taxpayers.

It is bad enough I have to endure those awful commercials with AIG employees "thanking" me for their bailout.  It's like the thief who stole my TV sending me occasional emails telling me how much he is enjoying it.

Now, AIG managers and owners are considering suing the government because the the amazing special only-good-for-a-powerful-and-connected-company deal they got was not good enough.

Directors at American International Group Inc., AIG -1.28% the recipient of one of the biggest government bailout packages during the financial crisis, are considering whether to join a lawsuit that accuses the U.S. government of too-onerous terms in the 2008-2009 rescue package.

The directors will hear arguments on Wednesday both for and against joining the $25 billion suit, a person briefed on the matter said. The suit was filed in 2011 on behalf of Starr International Co., a once very large AIG shareholder that is led by former AIG Chief Executive Maurice "Hank" Greenberg. It is pending in a federal claims court in Washington, D.C....

Starr sued the government in 2011, saying its taking of a roughly 80% AIG stake and extending tens of billions of dollars in credit with an onerous initial interest rate of roughly 15% deprived shareholders of their due process and equal protection rights.

This is especially hilarious since it coincides with those miserable commercials celebrating how AIG has successfully paid off all these supposedly too-onerous obligations.  And certainly Starr and other AIG investors were perfectly free not to take cash from the government in 2008 and line up some other private source of financing.  Oh, you mean no one else wanted to voluntarily put money into AIG in 2008?  No kidding.

Postscript:  By the way, employees of AIG, you have not paid off all the costs of your bailout and you never will.  The single largest cost is the contribution to moral hazard, the precedent that insurance companies, if sufficiently large and well-connected in Washington, can reap profits on their bets when they go the right way, and turn to the taxpayer to cover the bets when they go wrong.

Capital Controls

I am not sure I understand Kevin Drum's argument for capital controls.  He seems to be arguing that these controls are a sort of financial speed limit and making an awkward analogy to highway speed limits to justify them.

In a world where I as a taxpayer have to bail out banks, I don't have a huge problem with capital requirements for banks, though this seemingly simply topic is rife with unintended consequences -- I have seen it argued persuasively that the pre-2008 Basil capital requirements helped fuel the housing bubble by giving special preference to MBS in computing capital.  In fact, one might argue the same for the sovereign debt crisis, that by creating a huge demand for sovereign debt for bank balance sheets it fueled an unsustainable expansion in such debt.

Anyway, the point of this post was capital controls.  Drum quotes this from an IMF report:

19. Indeed, as the recent global financial crisis has shown, large and volatile capital flows can pose risks even for countries that have long been open and drawn benefits from capital flows and that have highly developed financial markets. For example, in several advanced economies, financial supervision and regulation failed to prevent unsustainable asset bubbles and booms in domestic demand from developing that were partly fueled by cheap external financing. Rather than favoring closed capital accounts, these experiences highlight the need for policymakers to remain vigilant to the risks. In particular, there is a constant need for sound prudential frameworks to manage the risks that capital inflows can give rise to, which may be exacerbated by financial innovation.

The logic, then, is that bubbles are exacerbated by inflows of foreign capital so capital controls can keep bubbles from getting worse.  I have very little knowledge of international finance, but let me test three thoughts I have on this:

  1. Doesn't this cut both ways?  If bubbles can be inflated by capital inflows, can't they also be deflated by capital outflows?  Presumably, if people domestically see the bubble, they would logically look for other places to invest their money.  International investments outside of the overheated domestic market are a logical alternative, and such capital flows would act a s a safety valve to reduce pressure on the bubble.  So wouldn't capital controls just as likely make bubbles worse, by confining capital within the bubble, as make them better by preventing new capital from outside the country flowing in?
  2. The implication here is that the controls would be dynamic.  In other words, some smart person in government would close the gates when a bubble starts to build and open them at other times.  But does that not presupposed the ability to see the bubble when one is in it?  Certainly there were a few who pointed out the housing bubble before 2008, but few in power did so.  And even if they had seen it, what is the likelihood that they would have pointed it out or taken action?  Who wants to be the politician who pops the bubble?  Remember the grief Greenspan got for pointing to an earlier bubble?
  3. Controls on capital inflows tend to be anti-consumer.  Yeah, I know, no one in government ever seems to care when they pass protectionist laws that protect 100 tire workers at the cost of higher tires for 100 million drivers.  But limiting capital inflows would reduce the value of the dollar, and make anything imported (or made from imported parts or materials) more expensive.

Lesson We Keep Missing in the Financial Crisis: Bite the Bullet Now

Investors have a saying - your first loss is your best loss.  In other words, if you think an investment sucks, swallow your pride, take your lumps, and get out entirely now.

This is NOT how we have dealt with the financial crisis.  Through a series of bailouts, we have tried to keep failing financial institutions and countries on life support.   We have dragged out the reckoning on mortgages, so we still have not had a real clearing in the real estate market.  Worse, we have postponed, even entirely interrupted, financial accountability for those who made bad investments or took on too much debt.

Here is an interesting counter-example - Iceland, which basically went entirely bankrupt along with pretty much all their banks, is on the road to recovery.

Will Reality Never Set In?

I had thought the situation in Greece would eventually hammer home for everyone the perils of reckless enlargement of the state and deficit spending.  But apparently, it is not to be.  This is how Kevin Drum describes the core problem in Greece:

the austerity madness prompted by the 2008 financial collapse

So the problem is not a bankrupt state, but the "austerity" which by the way has at best carved only a trivial amount out of spending.  And it was triggered not by a ballooning deficit as a percent of GDP and an inability to meet interest and principle payments, but by the US financial crisis.

This is willful blindness of absolutely astounding proportions.  Which means the same folks are likely just rehearsing to ride the US right into the same hole.

Also From the "This Time We Really, Really Mean It" Files

Apparently European leaders are close to an agreement that countries cannot run budget deficits higher than 3% of GDP.  If you are left to wonder, "hey, didn't they already have that rule before" the answer is yes.  Everyone had to promise a really, really stern oath not to run higher deficits before joining in the Euro group.

Of course, these promises meant nothing as there was no penalty for breaking the promise, and so the EU is proposing a new enforcement mechanism

Governments whose debts exceeded three percent of their GDP would be cited by the European Court of Justice, after which a super-majority of 85 percent of European governments would have to agree to impose some sort of sanction against the offending country.

I am not clear if the 85% is of the whole EU  (which would require a vote of 23 of the 27 members) or of just the Euro zone (which would require 15 of the 17 countries that use the Euro as currency).  Either way, I disagree with Drum and can't see how there is any hope at all here.  I am left with a number of questions

  • What is the likelihood that European countries will adopt this Constitutional provision and precedent for reduced sovereignty?  Don't treaty changes have to be unanimous?
  • Even if ratified, does anyone imagine the penalties will be high?  Imagine Greece today if such penalties exist.  How much are they going to worry about fines when they are already bankrupt?  And what will be the optics of the EU adding new costs to countries that are in financial crisis?  If a country in the future is doing things to endanger the euro from too much debt, the last thing the EU is going to be able to do is add to that country's burdens -- in fact, it is doing the opposite now, sending huge checks to all these countries
  • How are they every going to get the votes when this comes up?  Again, think about today.  Would Italy, Belgium, Spain, Ireland, etc. vote to sanction Greece, when they know they are next?

I just can't see this going anywhere.  And I would be surprised if the folks involved do either.  My guess is that they hope this will settle the bond markets so they can kick the can down the road.  Sure, we will have to deal with this all over again the first, inevitable time a country breaches the 3%, but that is later and right now they will accept a few years, even a few months, of survival.

Taxpayers to Fund Bank of America Derivatives Losses?

Or maybe it is more correct to say that the taxpayer is being set up to keep BofA counter-parties whole. From Bloomberg, via Zero Hedge:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

Obviously I am not a huge fan of bank regulation, but if the taxpayer is going to insure deposits, then the government has got to set and enforce capital restrictions on how those deposits are invested.  How many times do we have to learn this lesson?  The S&L crisis and the Texas bank collapse of the 1980's was caused by the exact same BS, investing taxpayer insured deposits in increasingly risky investments.

Normally, in a free economy, we expect lenders to enforce rules and discipline on those to whom they lend, just as fire insurers in the 19th century developed the first building codes and inspections to protect their themselves.  But if depositors are insured, they are not going to get worked up too much about BofA -- I am a depositor but I know the Feds will make me whole if the bank crashes.  Deposit insurance provides comfort to depositors and pays some dividends in heading off bank panics, but at the same time it relieves the bank of any accountability for how the deposits are invested unless the US government takes on that role.  Of all the BS regulations financial firms have to put up with, this is the one that should actually exist, and the implication in this article is that despite thousands of pages of new regulation, these basic protections still don't exist.  Sure, they exist in law, but there seems to be nothing to stop an agency from issuing exemptions, and this Administration has shown itself to love giving exemptions.

This reminds me a ton of the AIG bailout.  For some reason, there are a group of Wall Street companies (cough Goldman cough) that seem to have immense political power to protect investments in which they are a counter-party.  To this point, people have been expecting that the BofA holding company might soon fail, but the underlying banks would be fine and just sold off in pretty good shape.  Most of the trash is apparently at the holding company level.

The losers in all this are the counter-parties to these various derivatives, who would rather have a better set of assets to grab if the ship starts sinking.  Of course, they don't have any right to this -- they didn't make these original deals with the depository banks, they made them with Merrill Lynch and other trash BofA has bought.  But never-the-less, the Fed seems fired up to give these guys a special deal.  It reminds me of the Solyndra deal where the Administration allowed certain private parties to move ahead of the US Government on the creditor list, though at least in Solyndra's case these parties actually put some money into the pot for the privilege.  This seems to be a straight giveaway, and it is no surprise that the FDIC is apoplectic.

Hoist on Its Own Petard

Does anyone else find it funny that after being the butt of Congressional and Administration demagoguery, trying to lay blame for the financial crisis on them for applying AAA ratings to risky debt, that S&P's first visible step to correct such overly-optimistic ratings is to downgrade US debt -- based mainly on the fiscal management failures of Congress and the Administration.

By the way, many observers seem to be declaring this a punishment for not raising taxes.  The lack of accountability inherent in the government's spending like a drunken sailor, and then using such reckless and profligate spending as an excuse to raise taxes, just makes me want to scream.

Chicken or the Egg

Brad DeLong and Arnold Kling have been going back and forth on Fannie Mae and its culpability, or lack thereof, for worsening the recent bubble and financial crisis.   DeLong originally argued, if I remember right, that the default rate for Fannie Mae conforming loans were not worse than those being bought by other groups.  Kling argued that even their based default rate of 7% was awful (How do you make money on a pool of debt paying 5% if there is a 7% default rate).  DeLong countered

Arnold Kling's response is simply not good. It is silly enough to make me think he has not thought the issues through. a 7% delinquency rate on a mortgage portfolio is horrible in normal times, but is actually very good if you are in a depression--ever our Lesser Depression. For an investment with a 15-year duration that's a cost of less than 50 basis points in a "black swan" near worst case scenario. A portfolio that does that well under such conditions is a solid gold one.

I may not be thinking about this right, but I think DeLong is making a mistake in this analysis.  In the comments I wrote

First, I have no clue what a "reasonable" default rate is in a black swan event, and my guess is that, almost by definition, no one else does either.

However, it strikes me that DeLong's argument is a bit off. If mortgage default rates went up in an economic crisis that was wholly unrelated to mortgages, ie due to an oil shock or something, that would be one thing. But in this case, the black swan is in large part due to the mortgages issued. I guess it is sort of a chicken and egg problem, but the mortgages started defaulting before the depression, not the other way around, and helped precipitate the depression.

Remember, we are not talking about how well a portfolio survived the economic downturn.  We are talking about if a portfolio contributed to the economic downturn.


Bank Regulation

This article by Mark Perry seems right to me -- the lightest touch (and probably the most effective) approach to bank regulation is to return to a regime that puts its major emphasis on capital requirements.

We can talk all day about causes of the recent financial crisis, but in my mind the root cause was taking real property with a volatile underlying value (e.g. homes) and leveraging the absolute crap out of it.   In the initial transaction, home buyers were allowed to come to the table with less and less equity, until deals were being cut with more than 100% debt.  This stupidity was a true public-private partnership, as the government kicked off the party and encouraged its growth via various community development policies as well as policies atFannie and Freddie, but private originators as well as home buyers eagerly jumped into the fray.

This debt backed by property that was already too highly leveraged was thrown into portfolios that were themselves highly leveraged, and then further leveraged again through CDS's and other derivatives.  And then the CDS's were put into leveraged portfolios.  I would love to figure out the effective leverage in the AIG portfolio.  For ever $1 million in real property that secured the mortgages they insured, how much equity did they have?  A thousand bucks?  Less?

These investors felt protected by diversification that didn't really exist.  The felt safe with AAA ratings from agencies who really didn't understand the risks any better than anyone else did.  They relaxed assuming everything was watched by government regulators who were in way over their heads.  But more than anything, they felt protected by history.  The system of putting mortgage risks into tranches, such that the top tranches could only be affected by default rates consider then to be wildly improbable, had never to that point failed to deliver its promise.   Default rates had always stayed withing expected norms.

And this is the most dangerous risk -- the risk that something will happen that has never happened before.  Default rates that seemed impossible suddenly became reality.  Tranches that were untouchable suddenly were losing large chunks of their value.  Sure, there were warning signs, but at the end of the day what happened was that events occurred that were worse than people had thought was the worst case scenario  (there is a whole body of interesting behavioral study on how humans tend to overestimate their understanding and underestimate the width of a probability distribution).

As new financial products are created and the economy evolves and the government pursues new forms of interventions in commerce, new failures can occur that have never happened before.  And never has there been invented a micro-regulatory approach that guards against new-type failures (they don't even do a very good job against old-style failures).  Capital requirements are the one approach that guard against catastrophic failures even for unanticipated risks.

It can be argued that this will raise the cost of capital, at it is true interest rates at any one point of time would have to go up.  But one can argue that the low interest rates of the 2000's greatly understated the true cost of capital, and that those additional costs were paid in a sort of balloon payment at the end of the decade.

I am still thinking this through -- I don't think any regular reader would be mistake me for someone who favors regulation in general, but I am coming around to some extent on the notion that banks are different.  I would ideally like to see a self-policing market where companies that choose to cut equity too fine just go bankrupt.  But the reality of the political-financial complex today is that this never happens -- costs of large failures are socialized, and executives who made bad choices get fat gold parachutes and Treasury jobs.

Postscript:  I have arguments all the time about whether the financial melt down was mainly caused by government or private action.  Was it a public or private failure.?  My answer is yes.

One thing that those of us who promote private action over public can never repeat enough is this:  Our support for private action does not mean that private actors don't screw up, that there are not bad outcomes, that people don't make bad decisions, etc.  They do.  Lots of them.  When these constitute outright fraud, there should be prosecution.  For the rest of the cases, though, libertarians believe that in a free society there are automatic corrections and sources of accountability.

Make a bad product - people stop buying it.  Sign a union contract with wages that are too high - you go bankrupt.  Treat your workers shabbily - and the best of them go work for someone else.  Take on too much risk - you will fail and lose all your capital.

The problem with our financial sector is not that it is not regulated -- it is the most regulated sector of the economy.   The problem is that, as always happens, there has been substantial regulatory capture.  There has been an implicit deal cut by large financial institutions - regulate me, but in return protect me.  In a sense, as is typical in a corporate state, large corporations and government have become partners.

As a result, many of the typical checks and balances on private action in a free economy have been disrupted.  In effect, certain institutions became too big to fail, and costs of failure and risk taking were socialized.

That is why the answer is not one or the other.  Certainly the massive failures were driven by the actions of private actors.  But they were driven in part by incentives put in place by the government, and their stupid behavior was not checked because traditional private avenues of accountability had been neutered by the government.    This is why the recent financial crisis will always remain a sort of political Rorschach test, where folks of wildly different political philosophies can all find justification for their position.

More Great Moments in Regulation

Today's episode -- the shut down of the new debt market

Ford Motor Co.'s financing arm pulled plans to issue new debt, the first casualty of a bond market thrown into turmoil by the financial overhaul signed into law Wednesday.

Market participants said the auto maker pulled a recent deal, backed by packages of auto loans, because it was unable to use credit ratings in its offering documents, a legal requirement for such sales. The company declined to comment.

The nation's dominant ratings firms have in recent days refused to allow their ratings to be used in bond registration statements. The firms, including Moody's Investors Service, Standard & Poor's and Fitch Ratings, fear they will be exposed to new liability created by the Dodd-Frank law.

The law says that the ratings firms can be held legally liable for the quality of their ratings. In response, the firms yanked their consent to use the ratings, hoping for a reprieve from the Securities and Exchange Commission or Congress. The trouble is that asset-backed bonds are required by law to include ratings in official documents.

The result has been a shutdown of the market for asset-backed securities, a $1.4 trillion market that only recently clawed its way back to health after being nearly shuttered by the financial crisis.

Conservatives are Screwing Up

Conservatives, nominally supporters of smaller government and free markets, are yet again torpedoing these principles in the name of short term political expediency.  In order to score a few fleeting points against Obama, they are calling him out over the BP oil spill, saying that this is his Katrina, a massive failure both in regulation and response.

That's stupid.  One can certainly raise some questions about the government -- why have they been collecting an oil spill cleanup tax but not any oil spill cleanup capability or equipment, why are we driving oil companies out of easy oil in shallow waters to crazy-hard oil in deep waters.  But this is not Obama's fault nor the government's fault.  This is BP's fault.  They screwed up and started the spill, and it was they that had no contingency plan for such a disaster.  And its going to cost them a staggering amount of money, as it should.

After all, what are the feds going to do?  They certainly can't be expected to maintain the expertise to deal with this kind of thing, particularly in cutting-edge deep water.  Which is why Obama has had to resort mostly to joggling BP's elbow demanding that hey hurry.

We have the incredible sight of Conservatives, rightly, saying that more regulation could not have prevented the financial crisis because regulators are any better than industry participants in spotting problems when entering uncharted territory.  But here we have exactly the same situation and Conservatives are hammering on Obama for not being authoritarian enough or regulating enough.

Postscript: One of the few things the Obama administration has done is demand BP stop using a certain oil dispersant chemical because it is toxic.  Duh.  So is all the oil.  Which is probably why BP ignored him.  Government is terrible with this type of decision.  We have something really bad happening that we can't control.  But we can make it less bad by doing X, but X has some downsides as well.   In the heat of battle, when discretion is required, government will choose the sin of omission (letting more oil reach the shore) over the sin of commission (using a toxic dispersant), even if this decision is irrational.  In their incentive system, the sin of commission is impossible to sluff off on someone else.  The sin of omission can always be blamed on BP, or Bush, or whoever.  This is one reason why government bureaucratic rules are often so detailed and prescriptive -- given these incentives, certain decisions will never be made in the heat of battle by bureaucrats unless their actions are guided by detailed rules, which then give them cover.

Postscript #2: I think the media has tended to underestimate the difficulty here.  5000 feet of water is really deep and complicated to work in, orders of magnitude harder than shallow water, which in turn is orders of magnitude harder than on land.  In a way, its actually kind of amazing that BP has sealed this thing, given that the Soviets, in much less difficult leaks, reportedly had to resort to nukes to seal the well.

Fox, Meet Henhouse

Via Maggies Farm and a commenter on TigerHawk:

During consideration of H.R. 3126, legislation to establish a Consumer Financial Protection Agency (CFPA), Democrats on the House Financial Services Committee voted to pass an amendment offered by Rep. Maxine Waters (D-CA) that will make ACORN eligible to play a role in setting regulations for financial institutions.The Waters amendment adds to the CFPA Oversight Board 5 representatives from the fields of "consumer protection, fair lending and civil rights, representatives of depository institutions that primarily serve underserved communities, or representatives of communities that have been significantly impacted by higher-priced mortgages" to join Federal banking regulators in advising the Director on the consistency of proposed regulations, and strategies and policies that the Director should undertake to enforce its rules.

By making representatives of ACORN and other consumer activist organizations eligible to serve on the Oversight Board, the amendment creates a potentially enormous government sanctioned conflict of interest. ACORN-type organizations will have an advisory role on regulating the very financial institutions from which they receive millions of dollars annually in direct corporate contributions and benefit from other financial partnerships and arrangements. These are the same organizations that pressured banks to make subprime mortgage loans and thus bear a major responsibility for the collapse of the housing market.

In light of recent evidence linking ACORN to possible criminal activity, Democrats took an unprecedented step today to give ACORN a potential role alongside bank regulators in overseeing financial institutions. This is contrary to recent actions taken by the Senate and House to block federal funds to ACORN.

ACORN was an important actor in the housing bubble, responsible for numerous lawsuits and other political pressure to force banks to lend to borrowers who by objective standards did not have the income or credit history to sustain mortgage payments.  It would be interesting to see how many mortgages ACORN was involved with have gone belly up.  But now, as part of the "solution" to the financial crisis, we will put ACORN in charge.

Because there is no disaster that immediate, decisive, wrong action cannot make worse

The post title is a quote from this video on the bailout, which is not a deep analysis of the financial crisis, but spot-on none-the-less. Via the Liberty Papers.

Talking Us Into A Depression

At what point do politicians bear some public accountability for their public statements and the effect those statements have on the economy?  I almost want to ask Obama and Pelosi -- what is the minimum size of pork-spending bill you will accept so we can just go ahead and pay the money and get you and your cohorts to shut the hell up on trying to convince everyone we are in the Great Depression.  Because, to some extent, such statements can be a self-fulfilling prophesy.  Seriously, the biggest stimulative effect of passing this stimulus bill will be, almost without doubt, that it will end the felt need for Washington weenies to create an atmosphere of panic.

Now, I suspect that I would have a different observation if I lived in Detroit, but I ask every business owner or manager I meet for the personal evidence they have of economic cataclysm.  Is their business down?  And in a surprising number of cases, I get the answer that their business is doing OK, but they are cutting back because surely the worst is soon to come, based on everything they see in the media.  And do you know what?  I have done exactly the same thing.  I had one bad month, but since then things have been pretty steady, but I am cutting like crazy anyway, because I can't ignore the only other information source I have on the economy, which are pronouncements in the media.

I strongly believe that public pronouncements of doom, starting last October with Henry Paulson and continuing now to almost daily excess by Obama (today's statement:  the economy is in a "virtual free fall") have measurably contributed to job losses in this country.  Many people who are on the street without a job today can probably trace their unemployment to "just in case" cuts made more in response to government assurances of doom as on actual declines in output.

I can't prove this, of course, but I will present one pretty good pointer that I might not be totally full of it.  With the January jobs report, the recent recession has become one of the five worst since WWII in terms of jobs losses as a percentage of the work force (I know you may, from reading the paper and listening to Obama, think it is the worst, but it is still only the fourth or fifth worst).  Let me compare the job losses and the output declines at this point in the recession for these 5 recessions:


As you can see, we have had far more job losses relative to output losses than any major post-war recession.  This does not mean that more output losses are not coming, but it means that, perhaps unique to this recession, job losses are preceding rather than following output losses -- in other words, job losses are occurring more than in any other recession based on the expectation of output losses, rather than in reaction to them.  I wonder who it is that is setting these expectations?

Wow, using panic to achieve political aims and in the process accelerating job losses.  And they say we libertarians are heartless!

Data updated by the Minn. Fed here.  They actually have job losses through 13 months, but I jused 12 months because there are only quarters for the output numbers.

Update: Via the Washington Times:

Just Friday, Mr. Obama said a report that 600,000 jobs were lost in January meant "it's getting worse, not getting better. ... Although we had a terrible year with respect to jobs last year, the problem is accelerating, not decelerating." Last week he said, "A failure to act, and act now, will turn crisis into a catastrophe."

But he isn't the only Democrat ramping up the rhetoric while talking down the economy. House Speaker Nancy Pelosi of California said last month that our economy "is dark, darker, darkest." Rep. David R. Obey of Wisconsin said, "This economy is in mortal danger of absolute collapse." And Sen. Claire McCaskill of Missouri said of the economic-stimulus bill, "If we don't pass this thing, it's Armageddon."

Can You Say, "Moral Hazard?"

Moral hazard is the term for what occurs when one shelters an entity from the full cost or downside of taking risks.   The result is that the entity will tend to take on more risk than it would have had it had to bear the full costs.  For example, if a company knows that the government will make up the shortfall if its pension investments suffer, it will tend to invest in high-risk, high-return investments that reduce the company's need to contribute funds in the good years.   This is sometimes called privitizing profits and socializing losses.

One of the problems with demonstrating moral hazard is that the hazard often occurs years after the action (usually a government action) that creates the hazard.   But this week we have an amazing opportunity to see moral hazard operating within days of a government bailout:

Immediately after GMAC became eligible for TARP money, GM reduced to zero the interest rate"¦ on certain models. This, of course, penalizes GM competitors, including Toyota, Honda and other "transplants" whose cars are made in America by Americans for Americans, and Ford, which does not have the freedom of maneuver conferred by TARP money because Ford is not taking any"¦

GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America's median credit score is 723"¦

If you pay people trillions of dollars in response to a bad behavior (in this case, credit lenience) then you will just encourage more of that behavior, even if everyone achnowleges it to be a bad behavior.

Comparing College to Home Ownership

Sorry, an unfinished version of this post may have shown up earlier today in your feed readers.  This one is the completed version.

For years, America has pushed home ownership.   Mortgage interest is one of the few personal expenses that is tax deductible, giving people a strong financial incentive to shift from renting to owning.  The Federal Reserve has pursued a policy of keeping interest rates low, further decreasing the cost of owning.   Congress passed a myriad of laws and created numerous organizations to help insure that anyone who wanted to buy a home could probably get credit.  And every politician, talking head, "expert", etc. who ever got in front of a camera tended to advise everyone regardless of circumstance to try to buy a home.  It was not just home ownership, it was The American Dream Of Home Ownership.

Hayek could have told us years ago that there was a fundamental problem with this.  In short, 300 million people do not have the same situation and needs and preferences.  Take just one example.  Does it really make sense to encourage a worker who has a risky income stream (e.g. is vulnerable to layoffs or reduced hours) to buy a house?  Leasing provides much greater flexibility to adjust fixed housing costs to changing circumstances.  Rent, get your hours reduced, move to a smaller apartment.  Buy, get your hours reduced, default, ruin your credit.

The result of our full-court press for home ownership has been rising home ownership rates ... and rising foreclosure and bankruptcy rates.

OK, none of the above is new information.  But I was having a conversation with my dad about education, and it struck me that we may be doing the exact same thing with four-year college liberal arts degrees.  Every talking head, from talk show hosts to politicians, push kids to go to college.  Along with home ownership, the BA is described as a keystone to the American Dream.  As with home ownership, we subsidize college education with state-run schools and government loan programs.  Just as the government tries to make sure everyone can own a home, they try to make sure every kid can go to college.

Returning to Hayek for a moment, is it really likely that spending four years getting a college liberal arts degree is really the best possible course for every single person?  Sure, one can argue that the state offers community colleges and other alternatives to the standard 4-year degree, as do private companies like the University of Phoenix, but I get no sense that politicians and the intelligentsia are really promoting this kind of nuance and choice.  I think the message clearly is "four year liberal arts degrees are the goal, everything else is second best."

State university systems that were originally founded to help teach scientific agriculture to farmers wouldn't be caught dead having anything so pedestrian show up in their marketing brochure today.  They want to have Nobel prize-winning faculty and be influencing public policy and be doing (and getting grants for) state-of-the-art research.   Teaching students a useful trade?  That's so ... uncool.  Let 'em go to DeVry if they want that.

To some extent this is the result of the takeover of most campuses by the faculty, who wield most of the power nowadays (just ask Neil Rudenstein and Larry Summers at Harvard).   Academics are a special class of folks who work as much for, or more for, prestige among their peers as for money.  Those incentives are great when you want someone to focus in 120 hours a week on inventing a new type of superconducting material.  But in a university, it tilts the entire institution towards a focus on teaching interesting things vs. teaching useful things.

So what has been the result?  Well, college has an equivalent to foreclosure and bankruptcy, and it is called drop-out rates.  And drop-out rates seem to be rising, at least reading articles anecdotally.  The only actual figure I can find was this one:

Just 54 percent of students entering four-year colleges in 1997 had a degree six years later "” and even fewer Hispanics and blacks did, according to some of the latest government figures. After borrowing for school but failing to graduate, many of those students may be worse off than if they had never attended college at all.

I can't prove there is a trend, because I just can't find a good online source, but 46% non-graduation rate strikes me as pretty high.  And I would argue that there is, in addition to drop-out rate, a second figure one must consider.  How many of those that did graduate could actually do with their degree what they thought they could?  How many have a 4-year journalism degree from Michigan and now are working at Starbucks, either by choice or necessity?  I call this the soft drop-out rate, the rate of, for lack of a better word, underemployment of one's education investment.

I know that education leaders can all give a nice speech about how important a liberal arts degree is to the health and functioning of the polis, but the fact of the matter is that it is a luxury.  It is an incredibly rich world that can have its youth in their strongest and most productive years studying Italian Renaissance poetry or Portuguese literature for four years.  And I am not talking about this as a luxury for garbage collectors or auto mechanics, but a luxury even for future white collar workers, who need basic skills like these but are, based on my hiring observations, graduating from college without them:

  1. A strong sense of personal responsibility and a commitment to excellence in one's work
  2. The ability to break down a task and organize work towards its completion
  3. The ability to write a well-organized five paragraph persuasive essay or letter
  4. The ability to do basic computational math
  5. The ability to manage personal finances and make smart financial decisions
  6. The ability to understand basic accounting terms and concepts
  7. The ability to interact with other people honorably and on the basis of a reasonable level of self-awareness
  8. A reasonably well-developed sense of ethics and responsibility

To illustrate this further, I want to end with something I have observed over the past year.  During the last election, I sensed something in the average 20-something Obama supporter that went beyond just frustration with the incumbent President and the normal level of youthful flirtation with progressivism.   I sensed a real anger that somehow some promise had not been kept to these folks.  One interpretation of this is that these folks were all promised that a 4-year liberal arts degree would be the guaranteed ticket to success, and that their college degree would make them future leaders and the world would soon tremble at their pronouncements (seriously, just go read the marketing literature from any college).  Having gotten this "promise," they suddenly find the world doesn't really hang on the every word of a 22-year-old who has never really been out of the womb, and the employers of the world are not beating the doors down to hire a gender studies major who wrote a really well-received thesis on the role of women in the Paraguayan post-modernist movement.

The Washington Post had a great profile on such folks (though written with far more sympathy than I would have mustered).  Here is an example from that article:

Armed with a Georgetown University diploma, Beth Hanley embarked in her 20s on a path hoping to become a professional world-saver. First she worked at nonprofit Bread for the World. Then she taught middle school English in central Africa with the Peace Corps. Finally, to certify her idealism, she graduated last spring with a master's degree in international relations from Johns Hopkins University.

But now the 29-year-old faces a predicament shared by many young strivers in Washington's public interest field. After years of amassing so many achievements, they struggle to find full-time employment with decent pay and realize they might not get exactly what they set out for. Hanley, a think tank temp who dreams of aiding the impoverished and reducing gender discrimination in developing countries, is stuck.

TJIC had some classic comments on this article, and I added some more.

Which brings me finally, of all places, to Michelle Obama.  She said something that I thought was relevant to this post:

Despite their Ivy League pedigrees and good salaries, Michelle Obama often says the fact that she and her husband are out of debt is due to sheer luck, because they could not have predicted that his two books would become bestsellers. "It was like, 'Let's put all our money on red!' " she told a crowd at Ohio State University on Friday. "It wasn't a financial plan! We were lucky! And it shouldn't have been based on luck, because we worked hard."

You can see the whole piece here, but she is a pretty clear example of what I am talking about.  She got a Princeton liberal arts degree and is just amazed that it did not automatically pay off for her.  Somehow, some promise to her has been broken.

Just as she is an example of this phenomenon, she is now endeavoring to be part of the problem, working hard to further confuse the expectations of young people.  Her message to them is -- go get an expensive education, but whatever you do don't do anything money-making with it:

"We left corporate America, which is a lot of what we're asking young people to do," she tells the women. "Don't go into corporate America. You know, become teachers. Work for the community. Be social workers. Be a nurse. Those are the careers that we need, and we're encouraging our young people to do that. But if you make that choice, as we did, to move out of the money-making industry into the helping industry, then your salaries respond." Faced with that reality, she adds, "many of our bright stars are going into corporate law or hedge-fund management."

I have no particular problem with people taking on these occupations, as long as I don't have to pay for it.  And I am proud that my university, Princeton, is one of the few that has changed its financial aid rules to allow students to graduate debt-free and have the financial flexibility to pursue careers that are not high-paying (making Ms. Obama's comments doubly ironic since this is her alma mater as well).

But the general expectation here is just unrealistic.  Here is how I responded previously to Ms. Obama's comments on her education:

This analogy comes to mind:  Let's say Fred needs to buy a piece of earth-moving equipment.  He has the choice of the $20,000 front-end loader that is more than sufficient to most every day tasks, or the $200,000 behemoth, which might be useful if one were opening a strip mine or building a new Panama Canal but is an overkill for many applications.  Fred may lust after the huge monster earth mover, but if he is going to buy it, he better damn well have a big, profitable application for it or he is going to go bankrupt trying to buy it.

So Michelle Obama has a choice of the $20,000 state school undergrad and law degree, which is perfectly serviceable for most applications, or the Princeton/Harvard $200,000 combo, which I can attest will, in the right applications, move a hell of a lot of dirt.  She chooses the $200,000 tool, and then later asks for sympathy because all she ever did with it was some backyard gardening and she wonders why she has trouble paying all her debt.  Duh.  I think the problem here is perfectly obvious to most of us, but instead Obama seeks to blame her problem on some structural flaw in the economy, rather than a poor choice on her part in matching the tool to the job.

And this is what it is all about when you cut through all the misty-eyed Utopian notions about education:  For most people, it is a tool.  And the tool needs to fit the circumstance, the goals, the capabilities, and the budget.  Its time to stop advocating (and subsidizing) and one-size fits all college education program.

Fight Price Gouging

LOL, via Phil Miller:

Please join me in support for poor, beleaguered gas station owners, the victims of unconscionable price gouging by ruthless consumers who are taking advantage of market conditions to reduce their demand for gasoline,  riving down the price by nearly $2 per gallon over the last four months. Fortunately, governments are swinging into action. Georgia governor Sonny Perdue issued this statement:

"The financial crisis has disrupted the consumption of gasoline, which will have an effect on prices. However, we expect the prices that Georgian gasoline station owners receive at the pump to be in line with changes in consumers' incomes and the prices of substitutes and complements. We will not tolerate consumers taking advantage of Georgian business owners during a time of emergency."

The Panic Imperative

Eric Posner writes:

Many legal academics claimed that courts should serve as fire walls
against the conflagration of fear. When the government locks someone
up, the courts should realize that in many cases either government
officials have panicked or are violating someone's civil liberties
merely to assure frightened citizens that something is being done. For
that reason, courts should treat the government's justifications with
skepticism, and never ever trust the executive branch.

These arguments have not yet surfaced in the current crisis. The
specter of fear is everywhere, not just on Wall Street. And the scale
of the government's reaction is no less than what it was after
9/11"”that is what probably scares ordinary people the most. Yet no one
who believes that the government exploited fears after 9/11 to
strengthen its security powers is now saying that the government is
exploiting financial crisis fears in order to justify taking control of
credit markets. No one who thinks that government would use fear to
curtail civil liberties seems to think that government would use fear
to curtail economic liberties. Why not?

No one, except me of course.  From my October 1 discourse with a Democratic friend:

I find it surprising that you take this administration
on faith in its declaration of emergency in the financial sector.
You've lamented for years about the "rush to war" and GWB's scare
tactics that pushed, you felt, the nation into a war it should not be
fighting, all over threats of WMD's that we could never find.  You
lamented Democrats like Hillary Clinton "falling for this" in Congress

But now the mantra is the same - rush, rush, hurry, hurry, fear,
fear, emergency, emergency. Another GWB declared crisis in which the
country needs to give the administration unlimited power without
accountability and, of course, stacks of taxpayer dollars to spend.  A
decision that has to be made fast, without time for deliberation.
Another $700 billion commitment.     And here the Democrats go again.
Jeez, these guys may have the majority in Congress but it is sure easy
for GWB to push their buttons when he wants to.  Heck, Pelosi is acting
practically as the Republican Whip to get GWB's party in line.

This is Iraq without the body bags, and without the personal honor
of brave soldiers in the trenches to give the crisis some kind of

Government and Regulation

One argument about regulation that seems to be gaining traction through the recent financial crisis is "See, private action and enterprise is not infallible.  They can make mistakes that have costs for everyone.  Therefore they need to be regulated." 

I don't have time for the full refutation of this, but a few thoughts:

  • No one ever said that private actors in the economy are infallible or even universally honest.  However, no one has ever been able to make the case that government employees are any more infallible or honest. 
  • There are a couple of reasons government regulators are going to be demonstrably worse than the marketplace in making decisions.  The first is information -- a few actors in Washington can never have the same access to information as thousands of actors across the country or around the world.  The second is incentives -- while regulatory hawks cite private greed as a bad incentive in the marketplace, bureaucratic incentives can be at least as problematic.
  • Governments are subject to all sorts of rent-seeking initiatives, not to mention regulatory capture, that undermine regulatory effectiveness.  Just look at the bailout bill. Wooden arrows?

For some reason, the argument "private actors screwed up" seems sufficient justification for regulation.  The burden of proof should instead be "the government could have done better."

Here is a nice example of how regulation really works, from an interview with Warren Buffett:

QUICK: If you imagine where things will go with Fannie and Freddie, and
you think about the regulators, where were the regulators for what was
happening, and can something like this be prevented from happening

Mr. BUFFETT: Well, it's really an incredible case study in regulationbecause
something called OFHEO was set up in 1992 by Congress, and the sole job
of OFHEO was to watch over Fannie and Freddie, someone to watch over
them. And they were there to evaluate the soundness and the accounting
and all of that. Two companies were all they had to regulate. OFHEO has
over 200 employees now. They have a budget now that's $65 million a
year, and all they have to do is look at two companies. I mean, you
know, I look at more than two companies.

QUICK: Mm-hmm.

BUFFETT: And they sat there, made reports to the Congress, you can get
them on the Internet, every year. And, in fact, they reported to
Sarbanes and Oxley every year. And they went--wrote 100 page reports,
and they said, 'We've looked at these people and their standards are
fine and their directors are fine and everything was fine.' And then
all of a sudden you had two of the greatest accounting misstatements in
history. You had all kinds of management malfeasance, and it all came
out. And, of course, the classic thing was that after it all came out,
OFHEO wrote a 350--340 page report examining what went wrong, and they
blamed the management, they blamed the directors, they blamed the audit
committee. They didn't have a word in there about themselves, and
they're the ones that 200 people were going to work every day with just
two companies to think about. It just shows the problems of regulation.

The problem, of course, is that Fannie and Freddie were doing exactly what Congress wanted them to do -- systematically lowering mortgage underwriting standards.  They won't put it that way now, but that is  what spreading home ownership to lower income families really amounted to.

Fed To Start Buying Commercial Paper

Paul Kedrosky reports:

The Federal Reserve Board on Tuesday announced the creation of the
Commercial Paper Funding Facility (CPFF), a facility that will
complement the Federal Reserve's existing credit facilities to help
provide liquidity to term funding markets. The CPFF will provide a
liquidity backstop to U.S. issuers of commercial paper through a
special purpose vehicle (SPV) that will purchase three-month unsecured
and asset-backed commercial paper directly from eligible issuers.

Kedrosky has a lot of interesting coverage of the current financial crisis.  He observes:

As Buffett has said, everyone in the world is trying to deleverage at
once -- which is unworkable -- leaving the U.S. as the only institution
in the world that can lever up at all -- and levering up it is. I just
wish it was more obvious to me how you exit the other side of programs
like this. Would we not be better off to quickly recapitalize and
backstop some banks?

I share his concerns, but I actually kind of like the idea of bringing liquidity to main street business directly, rather than indirectly by bailing out failing financial institutions.  The problem of unwinding the program is a big one.  Right now, I get the sense that the financial markets are operating almost entirely on expectations of government action -  will the Feds buy back mortgages, will the Feds keep the overnight borrowing window wide open, will the feds gaurantee commercial paper, how much commercial paper will they buy.  This latter actually seem the least bad of a lot of other options.  At least the Feds are buying good assets from good companies.