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Senate report recommendations—Will regulation work this time?

Financial regulatory reform | Senate report recommendations – will regulation work this time? Anthony Harrington

This is the fourth of four blog posts on the US Senate report on the crash. See also: The US Senate report on the crash (part 1), “Criminalization” of America’s financial system? (part 2), and The demise of Washington Mutual (part 3).

The US Senate Permanent Subcommittee on Investigations report, “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse", came up with a number of very specific recommendations aimed at ensuring that the flaws, mistakes and criminal behaviour that led to the crash will not precipitate a “Mark II” version in a few years time. Many of these recommendations were mirrored in the Dodd-Frank Act which became law in September 2010.

The report identifies and analyses in depth four causative factors of the crash:

"Lenders introduced new levels of risk into the U.S. financial system by selling and securitizing complex home loans with high risk features and poor underwriting. The credit rating agencies labeled the resulting securities as safe investments, facilitating their purchase by institutional investors around the world. Federal banking regulators failed to ensure safe and sound lending practices and risk management, and stood on the sidelines as large financial institutions active in U.S. financial markets purchased billions of dollars in mortgage related securities containing high risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering and promoting risky mortgage related structured finance products…”

No one reading this summary could fail to notice that each of the “four causative factors” is pretty obviously toxic. With the benefit of hindsight and without “exuberant greed” driving things along, very few people would want to take issue here and argue that each or any of these factors was a good thing in its own right. There is never any excuse for a bank betting the farm on high risk products, or for shoddy underwriting practices. Credit ratings agencies are supposed to do their jobs and rate products according to risk. Regulators are not supposed to be dozing at the back of the shop while mayhem reigns, and investment banks - well, investment banks will always seek to stretch the envelope, that’s the nature of the beast.

The most glaring omission from the Committee’s report is the fact that it does not seem to notice the role of low interest rates and easy credit in pumping up the housing market in the first place. Perhaps the Senate did not feel too comfortable pointing a finger at the Federal Reserve. The Fed’s sustained low interest rate regime post the tech crash of 2001 undoubtedly helped to fuel the “hunt for yield” which powered the financial engineering that created the residential mortgage backed CDOs and CDO Squareds, which caused/helped/allowed the ratings agencies to miss-rate risk, which led to the debacle of the crash. But you won’t find any recommendations in the report specifying that the Fed should give itself a slap on the wrist for being too accommodative in monetary policy terms.

What the Senate would like to see, however, in each of the four named areas, makes sense. It has, for example, five recommendations on high risk lending. They are all plain common sense. For example, the Committee wants federal banking regulators to require banks who are issuing negatively amortizing loans (loans where the mortgage holder is not paying back sufficient each month to stop the debt from increasing), to hold “more conservative loss, liquidity and capital reserves”. That is just plain horse sense. If you make it expensive for banks to write this kind of business they either won’t write any of it, or they’ll do a very moderate amount of it. The wonder is that this requirement, or something like it, wasn’t in place before the crash. After Dodd-Frank, much of this is now law, but the US has had laws before that got sidelined when markets began to rev up and profits began to roll.

Clearly, with hindsight, if we'd had better regulation of the US housing market earlier, then there would not have been a housing bubble or a sub-prime mortgage crisis to trigger the bust in the first place. Such measures should have included ensuring sensible underwriting, monitoring and penalising silly loan to value ratios, compelling banks to be more cautious about home equity loans and hammering idiot mortgage policies instead of wishfully thinking that these policies were somehow implementing the American Dream by enabling even the poorest Americans to own two or three homes.

With no more than the “normal” numbers of toxic mortgages going into mortgage securitization packages, CDOs might well have worked as they were intended to and instead of being transformed into “the bankers’ homemade bomb”, they may well have functioned as the innovative pieces of financial engineering they were initially hailed as. The cost of this regulatory failure, in other words, has been huge, and recommending a tightening is a no-brainer. The big question however, is how to ensure that any resultant tightening of regulation continues in force once “animal spirits” start to rise again.  Otherwise all that the Senate Report, worthy as it is, will have achieved, is yet to provide yet another instance of stable doors being slammed shut long after the horses have bolted.

Further reading on financial regulatory reform and the crash:

Tags: regulation , US Senate Report
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