Fixing the financial mess

Dishonest lending practices began the problem. Mortgage loans to buyers who could never realistically pay up, with terms that were deliberately confusing or misleading, represented the creation of new capital (when new houses were built) with inadequate rates of return, or paper wealth that unsustainably relied on flipping existing houses. Securitization increased the moral hazard (making it easier to pass on the bad assets), but the basic cause was failure to enforce existing laws — regulators allowed a lot of straightforward consumer fraud to flourish. The fix at this part of the value chain: Enforce basic consumer protection laws.

The creation of bad loans presented challenges for the securitization of mortgages. Here, there was collusion between the sellers of the securitized loans and the credit rating agencies. Again, there was failure to enforce existing regulations — the Securities and Exchange Commission (SEC), as regulator, had the authority to question the credibility and reliability of the ratings awarded for mortgage-backed securities of dubious quality. A charitable view is that the rating agencies and the regulatory staff were out of their depth in assessing the risks of the new financial products, and just went with the flow. That would be a case of one part of the financial services value chain not keeping up with innovations elsewhere. More probably, individuals knew or sensed the problems, but had no incentive to blow the whistle. In the case of SEC, regulation was poorly enforced, rather than absent. The fix again: Enforce existing regulation, in this case by not letting shoddy rating practices slide by.

The buyers of the questionable securities spread the problems. They could have exercised due diligence — after all, US court rulings say credit ratings are opinions, and the rating agencies have no liability. A homeowner who bought a house where the building inspector was paid by the seller and accepted no responsibility for his inspection report would be foolish indeed. The investment banks in the US that bought without sufficient care constitute an old-fashioned, oligopolistic, old-boy network. These are the institutions that have gotten away with charging 7% of the proceeds for handling initial public offerings, and collecting millions in individual bonuses for being toll-takers and matchmakers for large financial transactions. They thrived by being few and non-transparent.

Perhaps deregulation gave them the rope to hang themselves. Or one can argue that, like the credit rating agencies, they were not up to the task of managing the new complexities of finance. The internal incentive model also proved deficient since individuals could capture large rewards while their employers bore the risks. The fix: Let the old model die, and be replaced by one with more competition, and greater transparency. In a slightly different setting, this is what happened when the Internet and electronic trading destroyed the toll-taking oligopoly of the old-style stockbrokers. The change requires a somewhat different approach to regulation to ensure transparency through disclosure and monitoring, even without an organized exchange.

This is not difficult or new: Indian bonds are not exchange-traded, but trades still clear through a central organization, allowing better regulatory knowledge of holdings and market conditions.

Finally, the regulators of last resort in the US, after lesser regulators had failed to do their jobs, responded too weakly. They tried to create greater overall market liquidity, but did not allow for the fact that, in the case of financial intermediaries, there is a short step from illiquidity to insolvency. Intermediaries without liquidity in borrowing lose liquidity in selling, and their assets can collapse in value. Even hinting at liquidity problems can start the downward spiral. So tackling liquidity alone did not work. Then, a firm-by-firm approach to fixing insolvency failed, and the result was the massive, inchoate bailout plan now being passed. The fix: A smaller, clearer, firmer plan to shore up the capital of threatened financial institutions could and should have been worked out a year ago.

All of the above may seem like easy hindsight, but these recommendations could have been extracted from well-understood economic principles. Ideology got in the way here. Lurching to opposite ideological extremes will not help either. Instead, policymakers can work with known principles of market design, and create financial market infrastructures that support more efficient new entrants and more effective regulation.

Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Your comments are welcome at eyeonindia@livemint.com

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