End the Credit Rating Monopoly
Earlier this week, SEC Chair Mary Shapiro appeared before Congress to suggest ways to fix the failings in our credit rating agencies. Sadly her proposals miss the market, although that shouldn’t be so surprising as her suggestions appear to rest upon a misunderstanding of the problem.
The thrust of the SEC’s current approach is more disclosure, such as releasing “pre-ratings” that debt issuers may get before final issuance. Additional disclosure of ratings methodology and assumptions is likely to be useless. Almost all that information was available during the building housing bubble. The problem is that the rating agencies had little incentive to go beyond the consensus forecasts of increasing to at most modest declines in home prices. These same assumptions were the foundation of almost all government economic forecasting as well, yet few believe that forcing CBO or OMB to disclosure more of their forecasts will cure our budget imbalances. What is needed is a change in incentives.
Too Big to Fail
One of the most pernicious public policies aggravating the financial crisis is that of “too big to fail.” The doctrine states that some banks (now financial institutions generally) are so large that their failure would incur “systemic risk” for the financial system. That sounds terrible and it is intended to. Financial services regulators and Treasury secretaries use it to frighten small children and congressmen. How can an elected official vote to incur systemic risk? He must vote to approve the bank bailout of the day. In fact, people who use the term cannot even agree among themselves as to what it means, much less what causes it and, therefore, what the appropriate response would be. I suggest the reader substitute the phrase “too politically connected to fail” whenever he sees “too big to fail.” What follows will then be rendered intelligible.
Banks, Bailouts, and Political Pressure
The Washington Post reports:
Sen. Daniel K. Inouye’s staff contacted federal regulators last fall to ask about the bailout application of an ailing Hawaii bank that he had helped to establish and where he has invested the bulk of his personal wealth.
The bank, Central Pacific Financial, was an unlikely candidate for a program designed by the Treasury Department to bolster healthy banks. The firm’s losses were depleting its capital reserves. Its primary regulator, the Federal Deposit Insurance Corp., already had decided that it didn’t meet the criteria for receiving a favorable recommendation and had forwarded the application to a council that reviewed marginal cases, according to agency documents.
Two weeks after the inquiry from Inouye’s office, Central Pacific announced that the Treasury would inject $135 million.
As we’ve said here many times, going back to 1983, when government is in the business of making economic decisions, you inevitably get more lobbying, more campaign spending, and more political influence on economic decision-makers.
Administration Reform Plan Misses the Mark
The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crises. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.
Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.
Instead of addressing our destructive federal policies aimed at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However, such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.
While the Administration plan recognizes the failure of the credit rating agencies, it appears to misunderstand the source of that failure: the rating agencies’ government-created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the outsourcing of their own due diligence to the rating agencies.
The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.
What Is “De-Identified”?
On a post at the TechLiberationFront blog, I discuss the fluidity of important concepts in information policy — and catch a friendly organization disagreeing with itself.
The upshot? “Until more intellectual groundwork is laid, information policy arguments before regulators, lawmakers, and courts will not rest on solid footing.”
New at Cato
Here are a few highlights from Cato Today, a daily email from the Cato Institute.
- Dan Ikenson and Scott Lincicome argue in a new study that restoring the pro-trade consensus must be a top priority for the Obama administration.
- In the DC Examiner, Gene Healy discusses Obama’s first 100 days and argues that he’s massively expanded the power of government in a short period of time.
- In the Asia Times Online, David Isenberg discusses private security contractors in the war in Iraq.
- Watch Patrick J. Michaels discuss energy on CNBC.
- In Tuesday’s Cato Daily Podcast, Peter Van Doren discusses the interaction between Congress and regulators on the issue of food safety.
Real Regulators: Madoff’s Accomplices
In his “Talking Business” column, Joe Nocera explores Bernie Madoff’s accomplices: the victims themselves, and the SEC. He quotes James R. Hedges IV of LJH Global Investments:
“It is a real lesson that people cannot abdicate personal responsibility when it comes to their personal finances.” And that’s the point. People did abdicate responsibility — and now, rather than face that fact, many of them are blaming the government for not, in effect, saving them from themselves. Indeed, what you discover when you talk to victims is that they harbor an anger toward the S.E.C. that is as deep or deeper than the anger they feel toward Mr. Madoff. There is a powerful sense that because the agency was asleep at the switch, they have been doubly victimized. And they want the government to do something about it.
Nocera ably acknowledges the hurt and suffering of Madoff’s victims while pointing out their thoroughgoing irresponsibility — especially in the suggestion that someone else should pick up the pieces.
I’m less sanguine: The more thoroughly their cascading delusions of government aid and protection are shattered, the better. And yours, too. And mine. No bailout.
(Earlier posts in this “real regulators” thread here and here.)
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