To Regulate or Not?

I am working on something for The Economist — its an Oxford style debate on the current crisis.  The proposition being discussed is: "This house believes that it would be a mistake to regulate the financial system heavily after the crisis."

Any comments you may have on this would be appreciated — my final version is due later today.

My biggest problem is trying to cover a lot of ground in just 500 words . . .

DRAFT:

Over the past 30 years, the United States has moved from an
environment of excessive regulation to excessive deregulation. This
philosophical shift was taken to irrational extremes, and it is the
heart of the current financial crisis.

A brief history: Post War World II, the global economy expanded
dramatically. By the late 1960s, the U.S. had an expansive bureaucracy.
Regulatory oversight had become time-consuming, complex, and expensive.
Eliminating this excess regulation started with President Jimmy Carter,
and dramatically accelerated under Ronald Reagan. Originally, only the
most expensive and onerous provisions were targeted. But eventually,
deregulation became a religion, and effective and necessary safeguards
were removed along with the costly ones.

Free-market deregulation became a misguided rallying cry of
conservative ideologues. The U.S. moved from a state of excess
regulation to radical de-regulation.

In 1999, the Glass-Steagall Act was repealed, allowing insurers,
banks and brokerage firms to merge. In 2000, Derivatives were exempted
from all regulatory, supervisory or reserve requirements by the
Commodity Futures Modernization Act.

During the early 2000s, the Federal Reserve, under Alan Greenspan
Fed elected against supervising new mortgage lending firms. This act of
nonfeasance, based upon Mr. Greenspan’s free market philosophy, had
enormous repercussions.

The final act of deregulatory zeal were the net capitalizations
exemptions granted by the SEC to five firms. This exemption allowed
firms to exceed rules limiting debt-to-net capital ratio to a modest
12-to-1 ratio. After the 2004 exemption, firms levered up as much as 40
to 1. Not surprising, the five brokers that received this exemption –
Goldman Sachs, Merrill, Lehman Brothers, Bear Stearns, and Morgan
Stanley – are no longer in existence; they either failed, merged, or
changed into depository banks.

~~~

To show the impact of deregulation, consider the underlying premise
of all credit transactions – loans, mortgages, and all debt
instruments. Over the entire history of human finance, the borrower’s
ability to repay the loan has been the paramount factor in all lending.
With mortgage, this included elements such as employment history,
income, down payment, credit rating, other assets, loan-to-value ratio
of the property, debt servicing ability, etc.

Greenspan’s decision to not supervise mortgage lenders led to a
brand new lending standard. During a five year period (2002-07), the
basis for making mortgages was NOT the borrowers ability to pay –
rather, it was the lender’s ability to sell a mortgage to firms that
securitized them.

This represented an enormous change from the past.

These new unregulated mortgage brokers no longer cared about a
standard 30 year mortgage being repaid over time. In the new world of
repackaged loans, all that mattered was that the loan did not come back
to the originator. By contract, this was typically 90 or 180 days. As
long as the borrower did not default in that period of time, it could
not be put back to the originator.

It turned out that the best way to do that – to put people in houses
that would not default in 90 days – were 2/28 ARM mortgages. Cheap
teaser rates for 24 months, with an eventual large reset.

This monumental, unprecedented change in lending standards led
directly to the key to the current crisis. It also shows what happens
when we remove supervision from the financial sector. Most of these
mortgage originators – nearly 300 – have since filed for bankruptcy.

~~~

Why do we have referees in professional sports? All intense
competition leads to rules of the game getting tested. Refs are on the
field to prevent the game from spiraling into something unrecognizable
to fans.

In business, the profit incentive leads to similar behavior. We push
the envelope, tap dance close to that line, and then blow past it.

Deregulation took the referees off of the field, allowed speculative
excesses to flourish, and reckless short-term incentives to distort
behavior.

That is Human Nature – we are competitive creatures, and we require
reasonable boundaries to protect ourselves from our own worst
instincts. When left to our own devices, we push the envelope, cut
corners, even work against our own best interests in the pursuit of
profits. Every financial scandal over the past decade – corrupt
analysts, fraudulent accounting, over-stating profits, predatory
lending, conflicts of interests, option backdating – are the result of
a legitimate business operation pushed up to the legal boundaries, and
then going far beyond them.

That is the risk deregulation brings: It encourages behavior that
leads to systemic risk. In the present case, the global credit markets
have frozen, threatening a worldwide recession. The total cleanup costs
are scaling up towards $10 trillion dollars.
All due to an excess of deregulatory zeal . . .

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