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E1FFIRS 06/16/2010 16:28:32 Page 2 E1FFIRS 06/16/2010 16:28:32Page 1 When Free Markets Fail E1FFIRS 06/16/2010 16:28:32 Page 2 E1FFIR06/16/2016:28:3Page 3 When Free Markets Fail Saving the Market When It Can’t Save Itself SCOTT McCLESKEY John Wiley & Sons, Inc. E1FFIRS 06/16/2010 16:28:33 Page 4 Copyright # 2010 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and speciﬁcally disclaim any implied warranties of merchantability or ﬁtness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of proﬁt or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: McCleskey, Scott. Financial regulation and the markets : a guide to understanding today’s environment / Scott McCleskey. p. cm. Includes index. Summary: ‘‘Authoritative guidance for navigating inevitable ﬁnancial market regulation. The reform of this country’s ﬁnancial regulation will be one of the most signiﬁcant legislative programs in a generation. When Free Markets Fail: Saving the Market When It Can’t Save Itself outlines everything you need to know to stay abreast of these changes. Written by Scott McCleskey, a Managing Editor at Complinet, the leading provider of risk and compliance solutions for the global ﬁnancial services industry. Looks at the intended result of these regulations so that institutions and individuals will have a greater understanding of the new regulatory environment. Offers a realistic look at how these regulations will affect anyone who has a bank account, a car loan, a mortgage or a credit card. Covers the reforms that have been enacted and looks forward to future reforms. Both theoretical and practical in approach, Financial Regulation and the Markets provides a strong overview of coming regulation laws with insightful analysis into various aspects not easily understood.’’ –Provided by publisher. ISBN 978-0-470-60336-9 (hardback); ISBN 978-0-470-64954-1 (ebk); ISBN 978-0-470-64955-8 (ebk); ISBN 978-0-470-64956-5 (ebk) 1. Financial institutions–State supervision–United States.2. Financial institutions–Government policy– United States. I. Title. HG181.U5M33 2010 332.10973–dc22 2010018648 Printed in the United States of America 10987654321 E1FFIRS 06/16/2010 16:28:33 Page 5 To my wife Ester and daughter Nicole, the two ladies who keep me going E1FFIRS 06/16/2010 16:28:33 Page 6 E1FTOC 06/16/2010 16:30:11 Page 7 Contents Acknowledgments xi About the Author xiii Preface: In Defense of Regulation (and of Free Markets) xv In the Beginning, There Was Adam xvi The Shift from Philosophy to Math xvii Can Markets Regulate Themselves? xix Regulation versus Justice xx Conclusion xx Introduction: Why Regulatory Reform Matters to You xxiii The Structure of the Book xxv Chapter 1: Meltdown in the Markets: Systemic Risk 1 How Systemic Risk Works 2 The Case for Government Intervention 9 Why Hasn’t the System Collapsed Before? 10 Conclusion 12 Chapter 2: Can an Institution Be Too Big to Fail? 15 Policy Options 17 Conclusion 22 Chapter 3: Moral Hazard 24 The Theory 25 The Reality 26 Punish the Leaders, Not the Organization 27 vii E1FTOC 06/16/2010 16:30:11 Page 8 viii n Contents The Other Moral Hazard 28 Conclusion 30 Chapter 4: Toxic Assets 31 What Are Toxic Assets, and Why Are They Toxic? 32 Building Low-Risk Assets Out of High-Risk Ones 33 Credit Rating Agencies and Structured Finance Products 35 Credit Default Swaps 37 Conclusion 40 Chapter 5: Should Regulation Stiﬂe Innovation? 41 Policy Implications 44 Conclusion 45 Chapter 6: Rewarding Success, Rewarding Failure: Incentives and Compensation 46 Big Brother is Paying You 47 Regulating the Level of Pay 47 Performance Goals and Risk 49 Methods of Aligning Reward with Risk 50 Who Matters? 53 The 2009 Federal Reserve Guidance 53 Was Adam Smith Right? 56 Chapter 7: Who Protects the Consumer? 57 Were Existing Regulations Effective? 59 Is a Separate Consumer Regulator the Right Answer? 61 What Powers Would the Agency Have? 65 A Word about Consumer Protection and Systemic Risk 67 Conclusion 68 Chapter 8: Transparency: Letting the Sun Shine In, or Sipping Water from a Firehose? 69 Transparency as Regulation 69 Degrees of Transparency 71 What to Consider When Transparency Is the Proposed Remedy 73 E1FTOC 06/16/2010 16:30:11 Page 9 Contents n ix Chapter 9: Rebuilding the Regulatory Structure 75 Why So Many Regulatory Agencies? 76 The SEC and the Investment Banks 77 The Federal Reserve 78 Other Proposed Changes 79 Consumer Protection 80 Do We Need a Systemic Regulator? 80 To Concentrate or Not to Concentrate 81 Chapter 10: Rating the Raters: The Role of Credit Rating Agencies 83 NRSRO Status 84 How Ratings Are Made 89 What Really Keeps the Rating Agencies Up at Night (And It Is Not Your Mortgage) 92 The End of the NRSRO? 94 Conﬂicts in the Rating Agency Business Model 97 Are Rating Agencies Utilities? 97 Conclusion 98 Chapter 11: The Politics of Regulation 100 The Political Process 101 Chapter 12: Nice Law, Now Go Do It: Regulators and Compliance Ofﬁcers 106 The SEC 107 Examinations and Inspections 108 Conduct of Examinations 110 FINRA 112 Compliance Departments 113 Conclusion 119 Chapter 13: Cost-Beneﬁt Analysis 121 Basics of Cost-Beneﬁt Analysis 122 The Beneﬁts of Cost-Beneﬁt Analysis 128 Government Use of Cost-Beneﬁt Analysis 129 Cost-Beneﬁt Analysis as a Negotiating Tactic 130 Conclusion 132 E1FTOC 06/16/2010 16:30:11 Page 10 x n Contents Chapter 14: It’s a Small World, After All 133 Sunday Is the New Monday 133 Overseas Regulators 135 International Organizations 139 Conclusion 141 Chapter 15: Where Do We Go from Here? Conclusions, Observations, and Recommendations 142 Modern Markets Are Too Complex to Regulate Themselves 143 Planning for the Next Crisis 144 The Need for a Professionalized Regulatory Service 146 Creating a Federal Regulatory Service 148 Elevating the Compliance Profession 151 Decisions Are Made by Individuals, Not Organizations 152 Keep the Rating Agencies—But on a Short Leash 153 Put Down the Pitchforks 154 Conclusion 154 Chapter 16: Judging for Yourself 156 Conclusion 161 Appendix 1: Summaries of Regulatory Concepts and Issues 163 Moral Hazard, Too Big to Fail, Systemic Risk 163 Unlevel Playing Fields 165 Unintended Consequences 166 Self-Regulation 168 Regulatory Capture 169 Information Asymmetries 172 Conﬂicts of Interest 173 One Size Fits All 174 Appendix 2: Excerpt from Obama Administration’s Reform Proposal, ‘‘Financial Regulatory Reform: A New Foundation’’ 177 Index 187 E1FACK 06/16/201011:30:0Page 11 Acknowledgments LTHOUGH THERE IS ONLY one name on the cover of this book, in one sense it is the product of the combined experience of a number of A people with whom I have had the pleasure of discussing regulatory reform since, and even before, the onset of the ﬁnancial crisis. In some cases, their contributions came in the form of the normal debates and interactions around which my work revolves, and in other cases through more focused discussion and guidance. The colleagues with whom I have discussed and debated the issues include market professionals, regulators, journalists, and academics in the United States and overseas. A few individuals and organizations in particular stand out for their support and guidance. First among these are my colleagues at Complinet, where I serve as Managing Editor for the New York ofﬁce. In many ways, this is my dream job because it lets me talk all day long with people smarter than I am about issues I believe are important and interesting. Whether in London or New York, and whether journalists, compliance ofﬁcers, or salespeople by trade, I have learned a great deal from them and I am grateful for that. Additionally, I have sought the guidance of a handful of individuals whom I regard as experts in particular areas in order to inform, amplify, or verify the views reﬂected in these pages. Lisa Roth has an incredible breadth and depth of knowledge regarding the role and responsibilities of compliance ofﬁcers, and she was very helpful in helping me make sure that my depiction of the world of Compliance was not limited to my own, possibly unrepresentative, experience. Likewise, you can stop Nick Paraskeva in the hallway and ask him what is the current status of any regulatory issue in the market, and he’ll be able to tell you, along with the practical implications for the ﬁrms involved. Sufﬁce it to say I spent a lot of time stopping Nick in the hallway. Eric Kolchinsky was a respected colleague at Moody’s, and was kind enough to review my description of the rating process in Chapter 10. Similarly, Jerome Fons, another former Moody’s colleague (and also well respected), gave xi E1FACK 06/16/2010 11:30:0 Page 12 xii n Acknowledgments me valuable insight into the challenges of regulating the rating agencies in the course of several discussions and professional interactions. Genevievette Walker-Lightfoot, a former SEC attorney and one of the very few who raised concerns about Bernie Madoff, walked me through the SEC examination and investigation process to provide the kind of insight that comes only from experience. Additionally, each of these three, in their own capacities, raised alarms about practices and abuses that lie at the center of the ﬁnancial crisis and its aftermath. We all owe them a debt of gratitude for that service as well. They are not alone, and I hope the historians who will write the story of the crisis recognize that the ranks of ﬁnancial professionals, regulators, journalists, and academics who worked to prevent or address the crisis far outnumbered the greedy and incompetent few who caused it. Manuscripts don’t become books by themselves, it turns out. I am grateful to the professionals at Wiley who believed in this book and worked hard to get it out where it could, hopefully, do some good. I am particularly grateful to David Pugh, Brandon Dust, and Dexter Gasque, but there are many others all along the way from manuscript to book who helped make this happen. Finally, I am deeply grateful to Ester. Being married to me is probably never all that easy, but when I committed myself to writing this book I committed her, too. Thanks for the patience and toleration. E1FABOUT 06/16/201011:28:4Page 13 About the Author COTT McCLESKEY IS New York-based ﬁnancial journalist and is the US Managing Editor for Complinet. Specializing in ﬁnancial regulation S and reform, he has two decades of industry experience including roles in New York, Washington, Brussels and London. His background includes a range of roles, including retail stockbroker, stock market surveillance analyst, stock market policy director participating in the drafting of new European Union legislation, and working in and managing global compliance departments. His publications include books and articles examining the ﬁnancial mar- kets with an eye to making regulatory issues understandable for everyone, in outlets ranging from professional journals to The New York Times. He has testiﬁed to Congress and worked with a number of agencies involved in reviewing the events that led to the ﬁnancial crisis. Scott holds a Master’s degree in International Relations from Cambridge and a Bachelor’s degree in Government from William and Mary. He lives near Philadelphia with his wife and daughter. xiii E1FABOUT 06/16/2010 11:28:49 Page 14 E1FPREF 06/16/201011:31:2Page 15 Preface: In Defense of Regulation (and of Free Markets) EGULATION IS NOT SEPARATfrom ‘‘the market,’’ a concept foreign and antithetical to capitalism. It is in fact an integral part of a free R market, as necessary as such widely accepted notions as competition or transparency. This is because free markets in the real world operate differently than in Economics textbooks, where models are distilled in an attempt to illustrate the principles of how real-life markets work. It is too often forgotten that markets came ﬁrst, and market theory later arose to explain them. Much of the recent debate seems to take the view that the models came ﬁrst and markets should be constructed to reﬂect the (largely regulation-free) models to which the commentator subscribes. In other words, it is all too easy to fall into the ideological trap of trying to make reality ﬁt the model rather than the other way around. This may not seem an especially provocative argument, but in some circles it is regarded as heresy to acknowledge the ideological legitimacy of regulation. During a time of turbocharged markets in everything from stocks to real estate to esoteric new ﬁnancial instruments, there was an almost reﬂex reaction to regard regulation as a socialist corruption of the pure model of free markets. Though this mindset was not universal, it was widespread enough to cast any new regulatory proposal under a pall of suspicion. It didn’t help that the booming markets coincided with an enthusiasm for deregulation that began in the early days of the Reagan Administration and endured for over two decades, regardless of which party held power. The most glaring and tragic example was the resistance to efforts by the Commodities Futures Trading Commission to bring transparency to the credit xv E1FPREF 06/16/2010 11:31:29 Page 16 xvi n Preface derivatives market nearly a decade before that market collapsed. The very thought of imposing mere transparency—to say nothing of actual restrictions— on this market was greeted ferociously not only from the industry but by other government agencies as well. 1 The lineage of the notion that regulation reduces the freedom of the market can be traced back through the history of economic thought at least to the Scottish Enlightenment and the birth of modern capitalism, though the connection is actually a bit tenuous. IN THE BEGINNING, THERE WAS ADAM Capitalism existed long before Adam Smith, just as gravity existed long before Isaac Newton. There were even attempts to describe what we now regard as markets and market behavior before The Wealth of Nations was published in 1776. But The Wealth of Nations gave the world an aha! moment when it described, in a mere thousand pages or so, the way that markets worked at that time. And so, we rightly attribute the birth of the theory of free markets to Adam Smith and The Wealth of Nations. Don’t try to read the book, unless you enjoy spending ﬁve hours with Smith’s unhealthy fascination with how nails are made. The good news is that people have read the book over the last two centuries and distilled from it the essence of Smith’s economic theory. The bad news is that they overdid it and boiled it down to two words: invisible hand. For the ensuing 200-odd years, economic practitioners then reversed the process and expanded those two words into an economic dogma faithful to the original, they think. A lot of nuance was lost in the process. The Wealth of Nations was written at a time when government intervention in the markets didn’t mean pesky regulations here and paperwork there. This was the time of the British East India Company, an absolute government- imposed monopoly with no legal competitors (unless you count the Dutch East India Company). Smith’s book was written as a repudiation of the prevailing mercantilist system, in which decisions were made by governments rather than by a dispassionate market. Given the state of governments in 1776, it is no wonder that Smith held little faith in the competence of government ofﬁcials. His acceptance of government regulation was grudging and limited, but three points remain: He wrote at a theoretical level; his theories were grounded in 1 For an excellent summary of this battle, see the PBS Frontline documentary, ‘‘The Warning’’. E1FPREF 06/16/2010 11:31:34 Page 17 Preface n xvii reference to a far simpler economic and market environment than exists today; and, in spite of it all, his rejection of regulation was not absolute. So when Smith talked about freeing markets from government interven- tion, he was writing about simpler markets operating in a completely different context from that in which we live. Of course, his basic premise still holds true in a general sense, but not in an absolute one. Finally, Smith was an academic writing a treatise on the theoretical principles under which markets operate. Like other theories, it assumed away practical matters that complicate the actual operation of the theory (just as Newton’s laws of motion assume no friction) in order to illustrate the guiding principles of free markets. Inefﬁciencies and imbalances distorted markets then, and they do now. Some participants seeking their own self-interest will have more market power (Smith loathed monopolies), or more information than others. People sometimes act dishonestly to distort prices. Do markets automati- cally correct these frictions? Not always, and not in the short run. Rules and regulations are meant to address these ‘‘market failures’’ and ensure a more fair and efﬁcientmarket. Whenused this way, regulationsactually make themarket more efﬁcient, not less. Of course, there are bad regulations as well, such as the one that said you had to buy all your tea from the government monopoly. The point,however,isthatregulationsarenotinherentlyantitheticaltofreemarkets, and that good ones areas necessary to the operation of markets in the real world as trafﬁc signs are necessary to free travel. Smith’s arguments in The Wealth of Nations center on three issues, only one of which is really related directly to markets: the division of labor, the pursuit of self-interest, and free trade. The markets he discusses, it should be remembered, were not speciﬁcally capital markets and certainly not capital markets as we understand them today. The market mechanism he described was as much a reference to 18th-century markets in corn as it was to anything else. Moreover, Smith and other political economists of his day were attempting to do for economics what Newton had done for nature—create a model system that could describe universal and therefore general phenomena. His models were meant to be descriptive of how markets work in principle, not prescriptive as an absolute blueprint of how they should be constructed. THE SHIFT FROM PHILOSOPHY TO MATH If you do crack open Smith, or for that matter Ricardo, Malthus, Mill, or most other economists of the 18th and 19th centuries, you won’t see many graphs, E1FPREF 06/16/2010 11:31:35 Page 18 xviii n Preface symbols, or arrows. Throughout its ﬁrst century, Economics—political economy, as it tellingly was called back in the day—was philosophy. Indeed, many economists like Smith and John Stuart Mill had already established reputations through philosophical works before they tackled Economics (Smith with his Theory of Moral Sentiments, for example). Even the concepts of supply and demand, equilibrium price, and marginal cost were largely creations of the very late 19th century and the 20th century. The disadvantage to treating Economics as philosophy was that it wasn’t very precise and therefore not of much practical use to those buying and selling in the market. The good thing was that everyone knew that was the case, and economists didn’t try to measure things that deﬁed accurate measurement. It was enough that free market theory told you in which direction prices or your proﬁts would move as you produced more or less of your product. The shift of Economics from applied philosophy to applied mathematics both reﬂected and propelled a desire to predict outcomes in the market. Later in the 20th century, a parallel development occurred in the ﬁeld of risk manage- ment. In both cases, the ability to make outcomes more predictable and easily measured had great beneﬁts. Policymakers could determine with greater certainty whether their measures were having the desired effect and when those measures could be stopped or reversed (think of the Federal Reserve and interest rates). But the race for ever-more-precise measures runs the risk of forgetting that there are limits to the precision of measurements and that not all things are measureable and predictable—in other words, treating an art like a science. But when something is regarded as progress, it is difﬁcult to argue that further progress is not achievable or desirable. No one ever got a patent, promotion, or Nobel prize for saying, ‘‘We’ve taken this as far as we can.’’ Conventionalnotionsofprogress assumethatthereis always onemore degree of exactitude that can be reached. But in a world of chaos and uncertainty driven as much by human whim and error as by the forces of mathematics, there is not always an nth degree. You may be able to measure only up to a certain point and then the rest is unpredictable. When it comes to risk, in particular, we should understand that our models are useful ways to group information and put it in context, but the equations can’t tell us what to do and not to do. A second danger arises with respect to the creation of mathematical models. Too often, their validity is tested by reviewing how accurate they have been in the past. That’s all well and good as long as the future looks roughly the same as the past. Rating agencies were conﬁdent of their models E1FPREF 06/16/2010 11:31:38 Page 19 Preface n xix used to assess the credit risk of subprime-loan pools because their methodolo- gies had worked well in the (stable and benevolent) past. And here’s where regulation comes in. If you think that regulation in the form of ‘‘transparency’’ is sufﬁcient on the grounds that the market can regulate itself as long as it has sufﬁcient information, you place more faith in our ability to measure and predict market behavior than can reasonably be done. In a complex ﬁnancial system, it’s difﬁcult enough just to know who has sold credit default swaps to whom, let alone the consequences of their deterioration under speciﬁc market circumstances. Reforming the credit default swap market by making their trading and ownership transparent may help to solve the ﬁrst problem (though even this premise is somewhat doubtful, as one chapter in this book discusses), but it won’t do anything to solve the second. CAN MARKETS REGULATE THEMSELVES? One of the powerful things in favor of free markets is their ability to ‘‘regulate’’ themselves. While it is true that they do tend to self-correct with respect to prices, supply, and demand, that falls far short of saying that regulation is unnecessary. Regulation operates on other goals and characteristics of mar- kets, for instance, to protect investors, to avert systemic risk, or to prevent unfair competition. In other words, they are meant to correct the parts of the market that it can’t inherently correct itself. Regulation aims to make real- world markets look more like the ideal free market model, and that is why it is illogical to argue that regulation has no place in a free market. So the argument in favor of free markets is that market mechanisms work automatically to set prices and allocate resources, not that they will automati- cally identify and neutralize their own failures. Some would grudgingly concede the need for the odd regulation here and there, but say that they should be as few and as limited as possible. I would agree. But as the markets have grown more complex, and hence more uncertain, the need for regulation grows. We need more regulatory oversight than we did 20 years ago, and less than we will need 20 years from now. This book will also touch on the Efﬁcient Market Theory, which holds that markets perfectly absorb information and translate it into changes in the price of a good (this is an oversimpliﬁcation of a concept that could ﬁll volumes). Implicit in the Efﬁcient Market Theory is the assumption that regulation is superﬂuous. But, as I argue in the following chapters, we have reached the E1FPREF 06/16/2010 11:31:42 Page 20 xx n Preface point where markets are too complex to absorb and process all of the relevant information. The market collapsed in 2008 in spite of all of its efﬁciency. The problem with invisible hands, then, is that they are invisible. If we simply assume that the markets are invisibly regulating themselves, we abdicate our responsibility to conﬁrm that they are in fact doing so. That is the story of the last decade, and how the Great Recession began. REGULATION VERSUS JUSTICE A recurrent theme in this book, and indeed in the regulatory reform debate, is that the ﬁnancial crisis has left us with a sense of failed justice as well as failed markets. It doesn’t help matters that so few individuals have been held accountable for their roles. There are logical and historical reasons for this. Building a criminal case takes a long time given the higher burden of proof required compared to a civil case, and historically regulators have found it more 2 cost effective to settle a case than to go to court with it. But the problem facing policymakers now is how to prevent a future crisis, not how high to hang the executives responsible for the last one. Although there are regulations against fraudulent activity, punishment is more properly the domain of the civil and criminal justice systems. Regulation should focus on preventing systemic failure and on protecting customers. The distinction between regulation and retribution is an important one, and one which policymakers and voters alike should bear in mind. CONCLUSION Perfect markets regulate themselves perfectly; all others require some level of regulation. And perfect markets don’t really exist. Given the very real calamities for the many caused by the excesses of the few, regulation should be viewed no longer as a necessary evil, but as necessary, period. All this supposes, of course, that the regulations in question are appropriately crafted, intelligently implemented, and effectively enforced by knowledgeable regulators. 2 Kevin G. Hall, ‘‘Why Haven’t Any Wall Street Tycoons Been Sent to the Slammer?,’’ McClatchy Newspapers, September 20, 2009. E1FPREF 06/16/2010 11:31:43 Page 21 n Preface xxi While the pursuit of self-interest may be the driving force that makes markets work, it did nothing to prevent homebuyers from applying for mortgages they patently could not afford, investment bankers from churning out billions of dollars’ worth of instruments based on shaky sub-prime mort- gages, rating agencies from diluting the meaning of AAA, or Bernie Madoff from stealing money on the order of a small country’s gross domestic product. Self-interest can drive markets, but selﬁsh interest can drive irresponsibility, inordinate risk-taking, short-termism, and outright fraud. If you believe in free markets, you believe that they should be efﬁcient and fair. You believe that they should be regulated. January 2010 New York E1FPREF 06/16/2010 11:31:43 Page 22 E1FINTRO 06/16/20111:30:4Page 23 Introduction: Why Regulatory Reform Matters to You DISHONEST MORTGAGE BROKER persuades an unwitting home- owner to sign paperwork transferring ownership in her house to him. A A high school senior learns that he has no money for college because the trust fund established by his grandparents invested with Bernie Madoff. The Secretary of the Treasury calls the heads of the largest ﬁnancial institutions into an emergency meeting to tell them that the government is going to take an ownership stake in their ﬁrms in order to save the world’s largest economy, whether they like it or not. These (true) stories have become typical and almost mundane, high- lighting both the human cost of the recent ﬁnancial crisis and the frightening scale of a crisis that sent the world to the edge of an economic abyss. Yet the stories are all about what happens when regulation fails. When regulation works, it is no more newsworthy than a trafﬁc accident that doesn’t happen. As the dust begins to settle on the ﬁnancial crisis, people want to understand what happened and how we can avoid a future crisis. To do that, they need to become familiar with how ﬁnancial regulation is made and how it works. It seems strange that we don’t take more interest in a process that has such a direct effect on our lives. We grow up learning that every good citizen should know the basics of how government works. We vote for the people who will best represent our interests in Congress—it seems we should know what those interests are. We follow, and sometimes participate in, active debate on somewhat esoteric subjects such as separation of Church and State or the meaning of the right to bear arms, but we have no idea how our credit card rates can be determined, whether a broker is required to give us the best xxiii E1FINTRO 06/16/2010 11:30:45 Page 24 xxiv n Introduction available price when we buy or sell a stock, and whether our ﬁnancial system will be steered off a cliff. We tend to close our eyes and assume that the development of ﬁnancial rules is too complicated to be grasped by the lay- person. We assume regulation is the domain of faceless lawyers, bankers, and civil servants with specialized knowledge and a high tolerance for tedium. It does seem strange that we ignore the rules that govern our ﬁnancial health. But there’s something about the collapse of an entire global ﬁnancial system that focuses the mind. The reform of ﬁnancial regulation has become a popular, not to mention populist, issue. More and more people are concerned about how we got to the brink in the ﬁrst place, and whether the laws being written to change the market will work. To do so, though, they need to be brought up to speed in the discussion. Terms like credit default swap and concepts like moral hazard aren’t self-explanatory but they are swung around in the debate with abandon. But you don’t need to be ﬂuent in the lingo to understand what’s being discussed—you just need to be conversant. That’s what this book is for. It is writte n for the outsider. It presumes little or no knowledge of regulation and is meant to be clearly written so that it is accessible to nonspecialists. It doesn’t aim to provide an exhaustive exami- nation of each issue, but rather to provide sufﬁcient background for the reader to understand the debate and the policy alternatives and their potential impact. If you wish to explore a particular issue in greater depth, there is a long and expanding list of sources from which to draw and you are encour- agedtodoso. When Free Markets Fail is meant to be objective in its analysis and descriptions, but like any book of this nature it rests on certain practical assumptions. Among these are that free markets are best for society and that that the goal of policymakers should be that the markets operate as efﬁciently as possible. Importantly, it also assumes that markets left to themselves will be inefﬁcient and even fail, which good regulation can prevent or moderate. The book also recognizes that regulation is a political process, subject to ideological ﬁltering and to the give-and-take of Beltway negotiation. Lastly, the book assumes that bad regulation (whether poorly written or poorly imple- mented) can also damage the market and cause harm to individuals, and so regulation for regulation’s sake is not always the answer. It would be disingenuous to represent that the author of any book does not have his or her own views, experiences, and theoretical framework that form the foundation of its content. So here are mine: I support free markets, and have worked in a number of them for some 20 years, both on the business side and the compliance/regulation side. This experience has led me to see the markets E1FINTRO 06/16/2010 11:30:47 Page 25 Introduction n xxv as they really are, warts and all. And that is why you will see reﬂected in these pages an acknowledgment of the need for regulation as part of a free market. The reader may not agree. If this book is like good regulation, there will be something in it for everyone to disagree with. And so the book also aims to assist readers in making their own judgments about regulatory proposals. In addition to the explanations in the body of the text, it offers at the end a series of questions to ask about any piece of regulation, to serve as the framework for deciding whether the proposal is or is not ‘‘good’’ regulation. Armed with this reasoned opinion, readers can then have a say on the subject through the same channels as they exercise civic responsibility—by writing members of Congress, through the media, or by the ballot box. THE STRUCTURE OF THE BOOK The book is divided into three sections. Chapters 1 through 10 discuss a wide range of issues that underlie the debate on how to reform the markets. The topics of some of these primers may ring a bell: systemic risk, ‘‘too big to fail,’’ and the question of compensation. Others may be less familiar but are none- theless important to the reform of the markets. The debate over the very structure of ﬁnancial regulation and the roles of the various agencies is also discussed, with the caveat that the outcome of the debate is still up in the air as this book goes to press. The section also includes a chapter on the role of credit rating agencies, because they play a central role in the markets in good times and bad, but their function and processes are not particularly well understood. By way of full disclosure, I was responsible for compliance at one of the major rating agencies for two years (which might make me biased in their favor), but I have also provided testimony in Congress critical of some of that agency’s practices (which might make me biased against them). Chapters 11 through 14 shed light on the way regulation is made. It addresses the political drivers at the beginning of the process as well as how the regulators and compliance ofﬁcers at the pointy end of the sword make sure that ﬁrms and individuals comply with the rules. There is also a discussion of how regulators and others weigh the costs associated with proposed regulation against the beneﬁts to be gained. These ﬁrst two sections are meant to be reasonably objective in outlook, except where they identify arguments in the debate that are not well founded. The ﬁnal two chapters are about opinions. This section starts by considering various regulatory alternatives and offers recommendations based on my own E1FINTRO 06/16/2010 11:30:48 Page 26 xxvi n Introduction conclusions and experience. Lastly, I offer the questions that might form the basis for the reader to form his or her own opinions about what they read or hear regarding ﬁnancial reform. Together, the three sections are meant to build a coherent picture that will help lift the veil of jargon and complexity from the ongoing debate, and perhaps provide a persuasive argument in favor of particular policy proposals. At the same time, the chapters can be read as more-or-less standalone essays for those who have an interest in a particular subject. They do not presume that previous chapters have been read although they do on occasion point to other parts of the book for deeper discussion of particular topics. The inevitable consequence of such an approach is a certain degree of repetition, which is hopefully restricted to reinforcing concepts previously discussed or putting them in a different context. For better or worse, the entire concept of ﬁnancial regulation is up for grabs in a way it has not been since the Depression and in a way that is not likely to recur in our generation. This book is about why that matters, and why it matters to you, whatever your connection to the world of ﬁnance. C0106/16/11:1Page 1 CHAPTER ONE 1 Meltdown in the Markets: Systemic Risk stand Economics is that the economy is about connections; this is all the T more the case with respect to the ﬁnancial system at the core of the economy. This seems both simplistic and obvious, but it is often overlooked as trees—rather than how these ﬁrms are connected to and dependent on each other—the forest. An economy is not the sum total of its parts, but rather the sum total of the interactions among the parts. before our eyes. We were all busy watching the individual ﬁrms and not looking at how the interactions could turn the system upside down. The notion that one or two failures could endanger the whole system is known as systemic risk. 1 C01 06/16/2010 11:13:50 Page 2 2 & Meltdown in the Markets: Systemic Risk HOWSYSTEMICRISKWORKS The whole idea behind an institution being too big to fail is that its collapse would lead to the collapse of other ﬁrms (what has been called micro systemic risk), or of virtually the entire ﬁnancial system (macro systemic risk). In connection with the ﬁnancial crisis, the term systemic risk has been bandied about rather widely, and in policy debates the concept is often swallowed whole without substantial critical thought. This is troubling, given that the most important and wide-ranging regulatory reform proposals have been premised on the notion of systemic risk. So, exactly how does the collapse of one ﬁrm risk the collapse of others? To understand this, it is important to understand how big ﬁrms operate and fund themselves, and how the markets they engage in lead them to be more, or less, deeply entangled with other ﬁrms large and small. It is also important to understand the importance of the most elusive and difﬁcult-to-price commodity in the market: conﬁdence. Day-to-Day Funding The collapse of Bear Stearns provides an instructive example of how ﬁrms fund their operations. The important point to understand is that, although they are competitors, they fund each other. This is one of the main reasons why they are so exposed to each other and why it is as important to see the connections in the ﬁnancial system as it is to see the individual ﬁrms. The fact that ﬁnancial institutions fund each other is logical and perhaps inevitable. They are not in the business of keeping money hanging around in vaultsdoingnothing,sotheyliketokeepitinvested.Buttheydon’tnecessarily want to tie up their spare cash for long periods of time, and so they lend it out for periods as short as overnight. They will make a far smaller interest rate than if they had loaned it out for a year or more, but when you are talking hundreds of millions or even billions of dollars, a small interest rate still means a nice little pile of cash; by loaning the money out for a short period of time the ﬁrm retains the ﬂexibility to deploy the money elsewhere as soon as the opportunity arises. This is a far more efﬁcient use of the money than leaving it uninvested. On the other side of the transaction are ﬁrms that borrow money over a short duration to avoid long-term commitments that reduce their ﬂexibility. When they borrow in this way, they do so by pledging securities or other collateral they don’t need in the short term. C01 06/16/2010 11:13:51 Page 3 How Systemic Risk Works & 3 This type of overnight arrangement is known as a repurchase agreement or repo. The advantage of overnight repo ﬁnancing is that it gives both sides the ﬂexibility of short-term commitments and still allows the efﬁcient use of otherwise idle funds and securities. The disadvantage is that it results in a ﬁnancial system that needs to reﬁnance itself every day. As long as things go well, or even reasonably well, there is no problem. There is very little credit risk (risk that the money will not be repaid) since the securities held as collateral are being held only over a very short term—how likely, after all, is it that the collateral will fail in one day? How a Problem Goes Systemic But things can go wrong, as they did during the ﬁnancial crisis that led to the Great Recession. Some of the assets held at Bear Stearns, for instance, were linked to mortgage-backed securities or other difﬁcult-to-price assets. When conﬁdence drops on securities like these, it can fall right off the map and take their market price with it. No one wants to be holding the bomb when it goes off, and so the pressure to sell the securities turns into pressure to dump them and a rush for the exits. And since no one is committed for long periods of time, they can rush to the exits at the ﬁrst sign of a panic. Thus, the trigger for a systemic problem is the uncertainty that arises as the result of one ﬁrm’s collapse, not merely the ﬁnancial difﬁculties of that ﬁrm itself. As one com- mentator put it, ‘‘Runs occur on solvent banks during panics because there is insufﬁcient information in the public domain . . . to discriminate between the 1 strong and the weak.’’ A decline based on a loss of conﬁdence isn’t usually a straight line, but looks much like a downward-sloping curve that gets steeper as it goes. This reﬂects panic. The risk of ﬂuctuations in the overnight price of an asset used as collateral in the repo market is normally accounted for by requiring slightly higher value of the collateral than the value of the money loaned. But steep drops are a different matter, and if a large proportion of a ﬁrm’s ready assets are of questionable value, it will face a situation where some ﬁrms will ask ever- increasing amounts of collateral for each dollar loaned (effectively anticipating a larger and larger drop in the value of the collateral) or simply refuse to engage in overnight repos with that ﬁrm. The latter makes a lot of sense, since there are plenty of other ﬁrms to do business with instead. The failing ﬁrm ﬁnds that it has to pay higher and higher interest rates and post more and more collateral to 1 Christopher T. Mahoney, ‘‘Market Discipline Is Not the Answer,’’ Barron’s, November 30, 2009. C01 06/16/2010 11:13:51 Page 4 & 4 Meltdown in the Markets: Systemic Risk entice other ﬁrms to keep doing business with it—just as any individual with credit problems must do. This reinforces the vicious downward spiral that could ultimately lead to collapse. ‘‘At the Mercy of Rumors’’ In the uncertain environment that builds around the potential failure of a big ﬁnancial institution, rumors start to swirl. In the eyes of many, the rumors are what cause a crisis. In December 2008, nine months after the implosion of Bear Stearns, its former Chairman Ace Greenberg said in an interview that the investment banking model is now dead, that ‘‘that model just doesn’t work because it’s at the mercy of rumors,’’ and later added that a rumor can put any of these ﬁrms at peril. . . . (Even Goldman Sachs and Merrill Lynch) had to convert over the weekend to banks, had to have infusions of capital because they couldn’t withstand the self- fulﬁlling prophecies of the rumors. 3 Bank runs and rumors—underlying it all is the crucial, though somewhat slippery, issue of conﬁdence. Once a ﬁrm’s ability to raise money and to meet its obligations is questioned, its entire business can seize up almost literally overnight. The downward spiral picks up speed when those responsible for assessing the ﬁrm’s value or its ability to pay its debts—research analysts and credit rating agencies, respectively—downgrade the ﬁrm’s stock and credit ratings. Doing so may be an entirely accurate reﬂection of the state of things: Counterparties are reducing overnight funding to the failing ﬁrm or demanding increased collateral, and so the ﬁrm’s ability to meet its obligations is in fact shrinking. But when the downgrades are announced, the failing ﬁrm is hit with a double whammy. First, the downgrade lends an air of objective conﬁrmation that the ﬁrm is indeed having liquidity problems and gives thus credence to the rumors. Second, the ﬁrm’s problems are no longer merely a matter of rumor control and market psychology, since many of its counterparties’ risk man- agement controls prohibit or restrict dealing with a counterparty that has a ‘‘speculative’’ (junk) bond status. They have no choice but to pull away from the failing ﬁrm and its debt, given the legal covenants governing their investment practices in order to protect them. These measures have the ironic 2 Elizabeth Hester and Peter Cook, ‘‘Greenberg Says Death of Bear, Lehman Means Wall Street Finished,’’ Bloomberg.com, December 9, 2008. 3 Interview, Frontline, ‘‘Inside the Meltdown,’’ PBS, February 17, 2009, transcript available at www.pbs.org/wgbh/pages/frontline/meltdown/interviews/greenberg.html. C01 06/16/2010 11:13:51 Page 5 How Systemic Risk Works & 5 unintended consequence of spreading the panic, and, as was the case with Bear Stearns, a rating agency downgrade can easily turn into the tipping point from which there is no return. One of the lessons of the ﬁnancial crisis is that avoiding this tipping point is crucially important. This is how a ﬁrm can ﬁnd itself falling from the top of the heap to the bottom of the pile with dizzying speed. Still, in many cases the problem corrects itself eventually when an investor with a higher risk tolerance sees the value of the collateral as undervalued, or the higher interest rates extorted from the failing ﬁrm as a good investment. The market creates a ﬂoor at which point investors come in, and the market stabilizes. Of course, if all else fails, the government could step in and play this supporting role—in other words, give a bailout. Either way, once the market sees that the ﬁrm is not on the verge of collapsing overnight, the process tends to reverse slowly. But in rare cases, the uncertainty as to the value of the assets prevents the ﬂoor from being created, and the ﬁrm goes poof. Discussions among policymakers regarding systemic risk have focused largely on one factor, and that is the size of the ﬁrm. A big ﬁrm tends to owe big
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