"Deregulation"

During the most recent election cycle Barack Obama and the Democrats advanced the idea that much of the blame for the country's financial crisis could be laid at the feet of deregulation (with greed being another top culprit). They pretty much had to. They philosophically can't bring themselves to say that regulation doesn't work, so instead they are forced to argue that the real problem is that there isn't enough of it.

The problem with this line of thinking is that when subjected to actual evidence it seems to fall apart. Whether measured in terms of regulations enacted or funding for regulatory agencies, the Bush Administration can hardly be described as leading the charge for laissez faire:

Since Bush took office in 2001, there has been a 13 percent decrease in the annual number of new rules. But the new regulations' cost to the economy will be much higher than it was before 2001. Of the new rules, 159 are "economically significant," meaning they will cost at least $100 million a year. That's a 10 percent increase in the number of high-cost rules since 2006, and a 70 percent increase since 2001. And at the end of 2007, another 3,882 rules were already at different stages of implementation, 757 of them targeting small businesses.

Overall, the final outcome of this Republican regulation has been a significant increase in regulatory activity and cost since 2001. The number of pages added to the Federal Register, which lists all new regulations, reached an all-time high of 78,090 in 2007, up from 64,438 in 2001.

...The Bush team has spent more taxpayer money on issuing and enforcing regulations than any previous administration in U.S. history. Between fiscal year 2001 and fiscal year 2009, outlays on regulatory activities, adjusted for inflation, increased from $26.4 billion to an estimated $42.7 billion, or 62 percent. By contrast, President Clinton increased real spending on regulatory activities by 31 percent, from $20.1 billion in 1993 to $26.4 billion in 2001.

...The data also show that, adjusted for inflation, expenditures for the category of finance and banking were cut by 3 percent during the Clinton years and rose 29 percent from 2001 to 2009, making it hard to argue that Bush deregulated the financial sector.

Regulation in the U.S. suffers not only from an excess of quantity but also a dearth of quality. For example, much has been made over the role played by the rating agencies that assigned high marks to some very dubious investments, most notably securitized mortgages. But how many of you knew that the role played by the rating agencies is actually sanctioned by the government?

The rating agencies have been widely criticized for their role in the financial crisis. It is said that they wrongly assessed the risks on trillions of dollars worth of bonds backed by residential mortgages. And indeed they did. But this is hardly surprising.

Rating agencies employ quite ordinary mortals to analyze the credit risk of bonds, just as firms like Goldman Sachs and Merrill Lynch employ quite ordinary mortals to analyze the outlook for stocks. No one is shocked when equity analysts' recommendations don't pan out. Why should we expect any more of the rating agencies?

We should not, but the regulators have, and that is the problem. Regulators of banks, insurance companies and broker dealers have all incorporated the work of the ratings agencies into their regulations in myriad ways. Most importantly, bond ratings determine -- as a matter of law -- how much capital regulated institutions need in order to own the bonds.

For every dollar of equity that insurance companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme.

The Bank for International Settlements also uses ratings to drive capital requirements, so the rating agencies have the same role in global capital markets that they have in the U.S.

For money market funds, ratings are equally critical: They are typically barred altogether from investments rated lower than AAA. In short, the ratings agencies are like a Consumer Reports for financial instruments -- but with the force of law behind their ratings. It is as if you were forbidden by law from buying an iron or a toaster unless it is rated "Excellent."

Thought exercise: If that last sentence were true, and the ratings performed by Consumer Reports carried the force of law, do you think that they would be exactly the same? Or do you think companies might throw lots of money at CR and try to persuade them through various means to make their ratings more favorable?

Even if you dismiss the idea, there can be no doubt that the ratings helped spur investments in the housing market. If housing investments were rated AAA, and you were required by law to park at least a certain amount of your assets in investments that had attained such ratings, it stands to reason that at least part of your money would wind up in housing.

Since the ratings determine required capital, they have a profound influence on how financial institutions invest their assets -- in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating.

Indeed, that is the entire raison d'être of the $6 trillion structured-finance business, which serves little economic function other than as a rating-agency arbitrage. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a "junk" rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade -- thus turning dross into gold by a sort of ratings alchemy.

This ratings alchemy created enormous demand for dross -- in this case, dodgy mortgages. Credit was extended to countless dubiously qualified purchasers of homes, which in turn drove dramatic increases in house prices.

The dubious quality of some of this regulation should come as a surprise to nobody. After all, if you had a gifted mind that enabled you to design the perfect system you probably wouldn't be employed by the government anyhow, preferring to cash in on your expertise in the private sector.