Friday, April 10, 2009

Finally, a Regulatory Change that Makes Sense

Self-responsibility is a good thing

Part of the reason for the crisis of today is that finance houses were not able to manage their own risks because the Basel II accords (harmonized international banking standards for risk management) and other accounting rules meant that people couldn't account for their own assets in a reasonable self-determined way. All of the many $$ trillions of mortgage-backed assets held by all the banks and insurance companies and merchant banks had to be all priced together, uniformally, as set by regulation. Local knowledge and firm-specific risk management was usurped by these international standards.

This 'standards harmonization' meant that it was the regulation itself which caused the systemic risk that regulation is supposed to alleviate (this is one of the main points missed when people say that 'the market' caused the crisis - it wasn't the market that made the crisis, it was regulation. There are many other regulations which caused the crisis, not least of which was the increasing pressure put on banks to lend to more risky borrowers in order to get their deposits guaranteed by the FDIC and the over-investment in mortgage-backed bonds due to 100% government guarantees of many of these bonds. We won't even get into the tax code which encourages people to take on debt, because, that as they say, is another story.)

When you factor in the moral hazard to not take losses because of the bailout authority given to the FDIC and Fed, and now, it seems, the Treasury, there was no incentive for the market to work for the financial sector to unload the bad assets piecemeal in order to honor their agreements with each other, one contract at a time. So as the housing market started its downward adjustment the value of the mortgage-backed assets declined due to the non-sales (why should the banks take the profit losses of selling assets at declined prices if they know the government will bail them out?). Thus the assets turned 'toxic' and taxpayers and dollar-holders are stuck footing the bill.

The good news is that the Financial Accounting Standards Board has now removed one of the systemic risks which worsened the crisis. The mark-to-market pricing rigidity is being removed so it is now the underlying contracts which will determine the price of the assets. This creates a more coherent pricing and planning structure for the finance sector, and we should add, creates a more solid rule-of-law because regulation now does not get in the way of people honoring their contracts with each other. As they say, an agreement is an agreement, now people have perhaps more incentive to live up to their agreements.

All of course would be hunky-dory if we could get rid of institutionalized moral hazard (not least of which is the central bank's "too big to fail" doctrine and the 100% government guarantees of the mortgage-backed bonds). However Workers is not holding its breath as there are too many entrenched interests for that vestige of the long-standing welfare state to be abandoned and for something more logical, local, rational and responsible to take the place of central-planning (however well-intentioned) gone awry.