“Deregulation” has become a dirty word for politicians to sling at each other, much like “dishonorable” or “corrupt” — as evidenced by Obama’s use of the term to vilify John McCain at Tuesday night’s debate. The polls reflect that voters are becoming disenchanted with the “fundamentally-a-deregulator” McCain and, rightly or wrongly, the free-market brand of economics. Financiers now appear too greedy and rapacious to state their own case, so perhaps legal experts can best shed light on the perils of overregulation.
House Speaker Nancy Pelosi submitted the most rancorous denunciation of pro-market regulation immediately before the first, failed, bailout bill vote. But Pelosi should have first learned that government oversight also had a hand in the market’s downfall. John Berlau, the director of the Center for Entrepreneurship at the Competitive Enterprise Institute, explained to TAS that strict regulation leads to a “check the box mentality,” which caused financiers to “be overly cautious in the wrong areas.”
Berlau noted the example of Countrywide Financial, which he said was the “poster child in obeying regulations” before its eventual collapse and fire-sale to Bank of America. The problem, he said, was their strategy often hinged on “avoiding being sued as opposed to creating value for shareholders.”
Even more immediately damaging, Berlau added, was the requirement of mark-to-market accounting for banks. This practice requires accountants to write down assets to the price they are currently selling for on the market, regardless of the underlying value of the instrument. “You could say that mark-to-market created a lawyer/accountant based contagion,” he asserted.
Financial firms already face constricting regulatory hurdles. Ted Frank, a legal expert at the American Enterprise Institute, explained by email, “We now have stronger disclosure controls than any time in history thanks to Sarbanes-Oxley, yet the credit crunch happened anyway.” He pointed out that hedge funds, which are not subject to Sarbanes-Oxley (the regulations passed in reaction to the Enron scandal of 2001), have fared better than investment and commercial banks.
APART FROM the economic costs imposed by these regulations gone awry, the explicit legal costs of regulations already on the books are high. The Office of Federal Housing Enterprise Oversight (OFHEO) alone, which was created specifically to oversee Fannie Mae and Freddie Mac, had a $66 million budget for the 2008 fiscal year, and over 230 employees. We now know that money wasn’t well spent, even by government standards.
The OFHEO is just one small entity among a host of federal and state regulators with overlapping oversight and poorly defined roles.
The Securities and Exchange Commission, the most important regulatory body, might be overvalued as a regulator as well. As D. Bruce Johnsen, a professor of law at George Mason University, explained to TAS, the Investment Company Act of 1940, which provided many of the standards for financial regulation, granted the SEC blanket exemptive authority in matters of oversight. The SEC used this authority to exempt companies with legitimate cases against it. As a result, there has been no development over time of common law guidelines through the usual process of repeated litigation. Without a common law basis for regulation, the SEC is left on its own to administer arbitrarily to the enormous financial industry.
“Compare this to antitrust law, where litigation is routine,” Johnsen added. “Over time […] antitrust law has evolved toward a set of reasonably clear and increasingly sane rules about what firms can and can’t do.”
It’s “increasingly sane rules” that current financial regulation seems to be lacking.
IF, AS PELOSI SUGGESTS, the toothlessness of current financial oversight is at fault, then what improvement can we expect from new Obama’s policies that stiffen capital requirements, reshuffle agencies, or create an oversight committee to report on market risks?
Walter Olson, senior fellow at the Manhattan Institute and editor of the blog Overlawyered, outlined some of the weaknesses of these new plans for TAS. As for Obama’s centralized oversight committee in today’s circumstances, “a cynic would say that that would just have provided one more Washington voice for Fannie/Freddie and their friends to buy off or neutralize,” Olson noted.
Even less viable is Obama’s plan to have the Fed oversee any firm it might later be called on to help in a liquidity crisis. “So is this a blank check to regulate any entity that (undisprovably!) ‘might’ later ask for a bailout?” Olson wondered.
One such proposal failed to make it into the provisions of the bailout bill, but could pass in a separate bill or, in one form or another, under the next presidential administration: allowing bankruptcy courts to restructure the terms of home mortgages. According to Ted Frank, such a practice would create “tremendous litigation expenses, since adverse parties would have to battle for the judge’s favor over how to value the underlying real estate asset.”
More generally, Frank is fearful of overzealous prosecution by regulators. He gave as an example the Bear Stearns executives who merely “incorrectly rejected pessimistic speculation about the future of funds that ended up crashing,” but now face allegations of fraud.
He predicted, “Down the road, we can expect to see other scapegoats.” Spitzerism, anyone?
Professor Johnsen sees widespread problems with some of the proposed regulations on lending and borrowing. He noted that the art of “financial engineering” is advanced enough to circumvent the most complicated set of rules. “One can prohibit borrowing, but a good MBA student can figure out how to arrange puts and calls to create the same payout structure as borrowing. If done carefully, the firm is able to borrow without looking like it is borrowing.” The government has better things to do than playing these games with Ivy League grads.
Scapegoating deregulation might be politically expedient, but winning the election isn’t as important as the future of the economy. Increasing government oversight of financial markets and imposing stringent capital requirements will result in more deadweight offices like the OFHEO, and financial instruments even more complicated than the ones at the heart of the current crisis. In this climate, any sensible regulatory policy is likely to get thrown under the bus.