Pruning Shears

Barry Ritholtz emailed about my quote of him on Thursday’s post [emph. his]:

You wrote:

In short, regulation has a spotty track record lately. Economist Barry Ritholtz acknowledged that and pointed to a new approach when he wrote a recent proposal “would not have prevented this crisis, but it would reduce taxpayer exposure to Wall Street speculation.” Since regulation depends on human intervention, it would be good to have a simple mechanism that reduced the public’s exposure to abuse.

Allow me to clarify what I wrote, as I think you may be misinterpreting my perspective somewhat:

The Volcker rule would not have prevented the current crisis; rather, it addresses new taxpayer risks created by the bailouts. Under the Volcker rule, the firms that engage in leveraged speculation should no longer expect Uncle Sam being there to backstop them.

Hence, you must choose: Either you have a proprietary trading desk, or you are a depository bank that benefits from FDIC insurance. Just not both.

As to the actual causes of the crisis, you could (and should) read Bailout Nation, but the short version is here.

My response:

I think the ease with which Goldman became a bank holding company implies that in a crisis it would still be able to extract some kind of backstop protection from the government. Moreover, a full reinstatement of Glass-Steagall (which is how I understand the thrust of the Volcker rule) wouldn’t help in the brave new world of CDO’s, CDS’s, high frequency trading, and other novel developments. Even as (mere) regulation it doesn’t strike me as addressing the current environment very effectively.

The bigger point is that I’ve come to see regulation as a perpetual cat-and-mouse game. Wall Street firms seem almost destined to have the advantage in looking for ever more complex and creative ways to get around whatever rules they can’t neutralize and regulators they can’t capture. The best structure can’t guard against being starved of resources or gorged with cronies and incompetents.

The idea of a public option bank or a CFPA in addition to regulation is appealing because they make no attempt to enforce any kind of good conduct by Wall Street. The former bypasses the system completely and as George Washington wrote about the latter:

Remember, credit default swaps didn’t bring down the economy because they are toxic while all other financial vehicles are pure as the driven snow. CDS brought down the economy because they were the choice du jour of the looters.

If we outlaw CDS (which I have argued for in the past), then the looters would create some other instrument for looting.

What I was trying to get at is that in the current environment proposals for new regulation like Volcker are (relatively speaking) small ball because they play into a system the financial system has already demonstrated it can manipulate. By all means do them, but do them after the non-regulatory changes. I think those are the changes that will best insulate taxpayers from risky behavior by Goldman et. al.

And his:

There was a very specific run of actions that incubated, fed and accelerated the crisis

1. Start with ultra low rates (which caused bond managers to scramble for yield),
2. Permit Ratings Agencies to “sell” their AAA rating to Wall St investment houses
3. Do not regulate, the non-bank, lend-to-securitize subprime mortgage lenders
4. Completely exempt derivatives from normal scrutiny, disclosure and reserve requirements (making them unique when compared with every other financial instrument, thanks to the CFMA),
5. Allow massive leverage of investment houses far beyond historical net cap rules,
6. Put into effect Federal Pre-emption rules that prevent states from enforcing their anti-predatory lending rules.
7. Allow banks to marry WallStreet thanks to the repeal of Glass Steagall,

Some of these changes caused the crisis, others made it much worse.

Note that all of this took place during a 30 year period where the dominant economic beliefs were:

• deregulation was always a good practive;
• markets know better;
• Big firms can regulate themselves