The American Spectator : Improving the Financial System for the Next Cycle

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The Public Policy

Improving the Financial System for the Next Cycle

By Alex J. Pollock on 1.12.09 @ 6:07AM

A half-dozen proposals you won't hear from the regulators.

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The right synthesis of the historical lessons is for securitization to continue to address interest rate risk, while simultaneously encouraging retention of significant credit risk by the original mortgage lender. The superiority of this combination makes it well worthwhile to try to overcome the regulatory and accounting obstacles involved.

4. Remove Government Sponsorship of Rating Agencies. The credit rating agencies say that they are in the business of publishing opinions about the future. In this I believe they are right, and in the course of financial events, inevitably some such opinions will prove to have been mistaken, even disastrously mistaken. So when it comes to opinions about the future, more opinions and competition is likely to uncover new insights into credit risks and new methods of analysis.

A particularly desirable form of increased competition would be from ratings agencies paid solely by investors, as opposed to those paid for by the issuers of securities.

Moreover, since all opinions are liable to error, and opinions based on models are liable to systemic error of vast proportions -- as the subprime bust makes apparent -- why should the U.S. government enshrine certain opinions as having preferred, preferential, indeed mandatory, status? It shouldn't. Government sponsorship makes the rating agencies a concentrated point of potential failure, which in the subprime mortgage collapse, indeed failed.

All regulatory requirements to use the ratings of certain preferred rating agencies should be eliminated. Banks and other regulated investors should instead be responsible for developing their own prudent standards, which would probably entail the use of credit ratings as part of a credit management system -- but without government sponsorship of any ratings firms.

5. Drop the Government's "Confidence" Slogan. A constant theme in public statements is that the government needs to promote "investor confidence." This is simply assumed to be a good thing, but it isn't. Every professional investor knows the key investing virtue is not confidence, but its opposite: skepticism. The right idea is for the public, faced with financial stories, investment advice, earnings releases, Wall Street pontifications, and official government assurances, never to let their skepticism slip.

6. Study Financial History. Why do financial crises and busts keep happening? Why don't we learn from the numerous blunders of times past?

"The mistakes of a sanguine manager are far more to be dreaded than the theft of a dishonest manager," wrote the celebrated banking thinker, Walter Bagehot. The best protection against deceptively sanguine beliefs is the study of financial history, with its many examples of how easy it is to be plausible, but catastrophically wrong, both as financial actors and as policy makers. We need a required course in the recurring bubbles, busts, foibles and disasters of financial history for anyone to qualify as a government financial official or as a manager of any financial firm.

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topics:
Financial Crisis

About the Author

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

Letter to the Editor View all comments (8) | Leave a comment

Bob| 1.12.09 @ 8:05AM

Alex, I am usually a thorn in the side of most of the bloggers here because their posts lack reason. However, you are so "right on" with these thoughts -- they are the same I have been posting now for months. I worked in sub-prime and prime financial services in the 90's and early 2000's and there was no "skin in the game". Your solutions basically give originators a piece of the action so they will self regulate. This has the benefit of letting the market work to help the problem instead of hurting it. We used to make 125% loans and verification was minimal. Emphasis was placed on initial monthly payments on variable loans and not on what may be required in 2 years. As long as the risk could be transferred, the company did not care. And the people who bought the CDO's didn't care as long as housing prices continued to rise.

This is the right solution -- kudo's....

Pat| 1.12.09 @ 7:00PM

All good ideas, all about as likely to be adopted as a sudden outbreak of world peace. How can we induce the Feds to embrace such ideas? We can't. That's the point, where's the fun (or the insider profits) in a rational market/govt. interraction?

What would work in a more pragamatic sense? Leavenworth Penitentiary, long prison sentences for Wall St. moguls and their joined at the hip helpmates in the federal govt. called "regulators" and our beloved elected employees who deal in favors, hard to trace but unabashed graft, the entire gamut of petty and not so petty swindles involving trading legislation for personal wealth.

Long, healthy walks in the prison yard, explaining to your new roommate Big Leroy that you're already in a committed relationship and don't want to be his "girlfriend", not worrying about what suit to wear to the office or trying to get a last-minute dinner reservation - all those benefits could be realized by former Wall St. slicky boys and their federal govt. friends while on their way to permanent rehabilitation. Of course, wishful thinking is a pleasant way to pass the time, but none of these so-called "rational" remedies ever work - they're not supposed to.

Paul Nelson| 1.12.09 @ 9:14PM

About ten years ago, I tried to interest the FBI in fraudulent mortgage apraisals in Kankakee Illinois. I recall telling the agent that I was unconcerned if the lenders lost money , but that I thought that in the end the gummint would be stuck with the losses. If I, a poor humble slumlord in a corrupt decaying midwestern mill town, could see the coming trainwreck many others should have been just as aware.

Marcia C| 1.13.09 @ 12:02AM

A particularly desirable form of increased competition would be from ratings agencies paid solely by investors, as opposed to those paid for by the issuers of securities.

Yeah, let the foxes be in charge of the chicken coop. In fact that is exactly what happened. The companies want nothing more than that the rating corporations and the other corporations are all in it together.

Regulations when applied to human beings, are called LAWS. The Republicans think that there should be no laws for financial criminals, who destroy the economy in fits of rightwing-supported greed. Yet America, thanks in large part because of privatized prisons, has the biggest prison population in the world. After 28 years of mostly rightwing government and catpulated propaganda.

If you want to end booms and busts, it's easy: take back all the ill-gotten money ceo's who presided over the bust took from us, and be forced to work at WalMart as cashiers for the rest of their lives. Only being forced to find out how their victims feel and being totally humiliated can stop the endless boom/busts that Marx told us is one of the huge capitalist flaws.

Marcia C| 1.13.09 @ 12:06AM

Paul Nelson | 1.12.09 @ 9:14PM

Millions of Americans could see this coming from the time of Reagan's Class Warfare against the majority of Americans - Class Warfare that has intensified immensely since then- Americans who really work hard to make ends meet.

Only the Republicans seem to be mystified about how it happened "overnight". Because they can't and won't ever admit that they did it.

Bob| 1.13.09 @ 9:26AM

Marcia, I was in this industry in the 90's and early 2000's. I can tell you there is plenty of blame to go around on both Republicans and Democrats. Much of this is due to the fact that both hard core Democrats and hard core Republicans depend on ideology over pragmatism and facts. Republicans since Reagan believed so much in deregulation that they overlooked necessary regulation. Democrats felt so good about the lower socioeconomic group being able to own their own homes they overlooked poor verification and sales practices. Certainly the greed of Wall Street Republicans AND Democrats loved the fact they could get the fees and unload the risk.

The entire system lacked personal responsibility at every level -- and that's what this article addresses. When you make someone responsible for their actions, they tend to self regulate because they understand the limits of their business better than anyone else.