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Regulatory Reform: Change We Can Believe In – A Guest Blog by Tom Berner

With the focus in Wash­ing­ton on bank bailouts and stim­u­lus pack­ages, we have yet to hear about any seri­ous pro­pos­als for new reg­u­la­tions. Nev­er­the­less, they will come, and any­one who thinks that a Pres­i­dent McCain would have treated Wall Street any less harshly than Pres­i­dent Obama must have been asleep dur­ing the Pres­i­den­tial cam­paign. Indeed, since Wall Street’s cam­paign con­tri­bu­tions went to Pres­i­dent Obama by a wide mar­gin, it is clear that Wall Street, for one, didn’t expect mercy from the GOP. Stronger reg­u­la­tion was in the cards no mat­ter who dealt the hand. The tricky part, how­ever, is deter­min­ing the kind of reg­u­la­tion that will have a ben­e­fi­cial effect on any part of the econ­omy other than the pock­ets of the legal pro­fes­sion. There are sev­eral pit­falls to design­ing a sat­is­fac­tory reg­u­la­tory reform program.

First, reg­u­la­tions are inher­ently polit­i­cal. A Wash­ing­ton lawyer once told me that the dif­fer­ence between New York lawyers and Wash­ing­ton DC lawyers is that New York lawyers think that it is what you know that wins the day, whereas DC lawyers know that it who you know that makes the difference.The SEC has been AWOL for the last two stock mar­ket bub­bles, 1999 and 2008 and nei­ther the party then occu­py­ing the White House nor the Loyal Oppo­si­tion made much of an effort (or had much of an incen­tive) to stop the good times from rolling. You have to go back to the 1980s to find any spir­ited effort to con­trol a bub­ble form­ing in the finan­cial sec­tor, and that had more to do with Rudolph Giu­liani than any ini­tia­tive from his supe­ri­ors in the Rea­gan Administration.

Another prob­lem is that reg­u­la­tory agen­cies, like bad gen­er­als, tend to fight the cur­rent war with the strat­egy and weapons of the last one. As the world changes, they stay mired in the past. So we are approach­ing the cur­rent cri­sis as if it were 1932 and the best way to recre­ate those times is to behave as if we still lived there.

At a recent sem­i­nar on bank­ing law spon­sored by the Amer­i­can Bar Asso­ci­a­tion, the fac­ulty agreed on two things: the most effi­cient and effec­tive finan­cial reg­u­la­tory regime in the world today is that of Aus­tralia and that we will never fol­low their exam­ple. Instead, we will add another layer of reg­u­la­tory agen­cies to the grab bag of agen­cies that have been pop­ping up since 1862. This will fur­ther bog down deci­sion mak­ing at banks and bank hold­ing com­pa­nies with­out mak­ing the sys­tem sig­nif­i­cantly safer.

A third prob­lem is that reg­u­la­tions have a nasty way of sup­port­ing bad ideas. The sub­prime mort­gage cri­sis was encour­aged by reg­u­la­tions pro­mul­gated by the Office of the Comp­trol­ler of the Cur­rency as well as a law passed by Con­gress called the Com­mu­nity Rein­vest­ment Act, which encour­aged banks to make mort­gage loans to peo­ple who would not oth­er­wise qual­ify for a loan. Not that the cur­rent cri­sis was entirely caused by unqual­i­fied bor­row­ers: when a solu­tion to allow banks to avoid the con­se­quences of sub­prime lend­ing – secu­ri­ti­za­tion – was cre­ated, the same sloppy under­writ­ing per­vaded the reg­u­lar mort­gage mar­ket, as hap­pened in the “buy to rent” seg­ment of the market.

Fourth, reg­u­la­tions are bet­ter at sti­fling good ideas than they are at pre­vent­ing bad ones. The Shared Appre­ci­a­tion Mort­gage (SAM), invented by Amer­i­can banks 40 years ago, would be a use­ful vehi­cle for deal­ing with fam­i­lies who can’t pay their mort­gage. It allows banks to rene­go­ti­ate a loan by reduc­ing the prin­ci­pal to an amount that the fam­ily can afford and in exchange, the bank gets to share in any increase in the value of the real prop­erty. This keeps the loan alive, the fam­ily in their home and the prop­erty occu­pied and main­tained. Unfor­tu­nately, the IRS can’t make up its mind whether such a trans­ac­tion is an equity invest­ment or a debt instru­ment, so it has cre­ated a vast body of rules before such a mort­gage can be cre­ated, mak­ing the trans­ac­tion costs so high that a SAM is fea­si­ble only for large com­mer­cial transactions.�

So the cur­rent cri­sis was caused by a toxic com­bi­na­tion of bad reg­u­la­tions, which encour­aged banks to make ques­tion­able loans, no reg­u­la­tions, which allowed them to foist those bad mort­gages on the rest of the econ­omy, and com­pli­cated reg­u­la­tions, which have removed at least one rem­edy from the finan­cial industry’s med­i­cine kit. If a new regime of reg­u­la­tion is to put any­one back to work other than lawyers, you can­not just layer on addi­tional regulations.

There­fore, let me sug­gest two prin­ci­ples which should guide Pres­i­dent Obama’s reg­u­la­tory proposals:

1. You can­not improve or reg­u­late the way the mar­ket sys­tem works, but most of the world econ­omy oper­ates in a bas­tardised form of mar­ket sys­tem where psy­chol­ogy and pol­i­tics, insti­tu­tion­al­ized by the exist­ing struc­ture of the econ­omy, alter the way the mar­ket func­tions. It is on the inter­face of mar­ket forces and exist­ing insti­tu­tions that real reform can be acheived and that’s where reform ought to be focused.

For instance, an ideal mar­ket requires the seller to take pes­onal respon­si­bil­ity for his prod­uct. That is pre­cisely what Wall Street stopped doing many years ago. Per­haps the most hor­ri­fy­ing aspect to the cur­rent cri­sis are the emails that have sur­faced in promi­nent invest­ment banks and rat­ing agen­cies where the writ­ers acknowl­edge that the prod­uct they’re sell­ing is rub­bish and express the hope that they will have dumped it on some sucker and col­lected their bonuses before it blows up.

The solu­tion is sug­gested by the prob­lem itself. Make invest­ment banks take most of its fee in the secu­ritries they have designed and mar­keted. Pre­vent them from sell­ing these secu­ri­ties until the matu­rity of the instru­ment (or in the case of equi­ties, a long enough period to cover any inher­ent flaws in the secu­rity itself). These should be put in an account on behalf of the then cur­rent employ­ees of the bank. Let invest­ment bankers earn a good income, but not the sort that allows them to retire as megamil­lion­aires in their 30s. Instead, let their per­sonal eco­nomic future depend on the health of the secu­ri­ties they have shoved down the throat of investors. It is a pretty good bet that the qual­ity of aver­age secu­rity com­ing out of Wall Street will be vastly improved.

2. The immor­tal Roman ques­tion, “Quis cus­todiet cus­todes?” (“Who will watch the watch­dogs?”) should never leave Pres­i­dent Obama’s con­scious­ness. Too many laws are reg­u­la­tions of the peo­ple, by the lawyers and for the lawyers.  Ide­ally, laws should be designed by mechan­i­cal engi­neers, or at least peo­ple who share that discipline’s goal of design­ing the sim­plest solu­tion to the prob­lem at hand. Lawyers, on the other hand, profit by pro­mot­ing reg­u­la­tions so com­plex that you need to hire a lawyer to inter­pret them.

The place to start here is to reform Civil Ser­vice and allow elected offi­cials to impose some degree of dis­ci­pline on the Fed­eral bureau­cracy, some­times called the “per­ma­nent gov­ern­ment.” In his new book “Pres­i­den­tial Com­mand,” Peter Rod­man exam­ines the efforts of every Pres­i­dent since Richard Nixon to con­trol his own for­eign pol­icy and finds that every Admin­is­tra­tion has been stymied by the State Depart­ment bureau­cracy. Although Rodman’s book focuses on for­eign pol­icy, the same phe­nom­ena can be found through­out the gov­ern­ment. Per­haps the most dis­turb­ing rev­e­la­tion of the Bernard Mad­off affair is that although many com­plaints about him have been filed with the SEC for the last fif­teen years, the staff never referred the mat­ter up to the polit­i­cal deci­sion­mak­ers, mean­ing either that the staff is incom­pe­tent or corrupt.

If the Pres­i­dent can make the reg­u­la­tory sys­tem more user friendly and respon­sive, that would be change we can all believe in.

Click here for Tom Berner’s bio

Posted in: economy, Finance, Law, Politics, Public Policy, REGULATION, Regulatory Reform, Tom Berner

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