Re-Regulation Musings

Obviously, after we take our medicine and spend historic amounts of bailout money for the banks, we're going to need some serious re-regulation. This crisis was caused through a bipartisan failure to rein in runaway capitalism, and an unwillingness to set limits on the financial industry, until it grew too big to fail. The economy became unbalanced, driven by a sector that didn't produce goods but financial services, and when it made mistakes, we all paid the price.

There are some proposals already floating around. Some top Democrats want a new agency to regulate financial products.

On Tuesday, House and Senate Democrats, joined by Elizabeth Warren (who heads the commission overseeing the disbursement of bailout funds), announced a bill to create a Financial Product Safety Commission. The body would have oversight of mortgages and other financial instruments just as other commissions regulate the safety of toys, drugs or airplanes [...]

Warren, who has been singled out for seeing the roots of the economic collapse before it happened, highlighted how the commission would work and how it could have prevented the current crisis.

She offered the example of a loan with a low "teaser rate" and an obscured prepayment penalty. "Prepayment penalties are a way to try to fool [borrowers] into thinking the price is $1100 dollars a month -- that's the teaser rate -- when in fact the real price of this product is the equivalent of $1900 dollars a month. And if you try to refinance out of the product, you'll pay a prepayment penalty. That's how the company will make its money. You'll either pay higher interest later on, or you'll pay a prepayment penalty to get out of it."

When the price rises to $1900 a month or higher, the borrower can't refinance, can't make the payment, and goes into foreclosure.

"If there had been an agency, like the Financial Product Safety Commission, that had said, 'You just don't get to fool people on pricing,' then what would have happened is," she said, "there would have been millions of families who got tangled in predatory mortgages who never would have gotten them."

The idea of cooling down bubbles, which this would do because it would mean that not everyone with a pulse would qualify for a loan, strikes at the root of the crisis of the past 30 years with the US economy. It's also true that a new agency would have certain advantages, because it could be imbued with a certain stature and credibility (Obama could go far to help this along). But there are also steps that the current regulators could take, which could also get at this problem of discouraging bubbles and reckless activity from the banks. Simply put, the Fed could tie capital ratios to economic growth.

Capital ratios basically regulate the amount of leverage a bank is allowed to take on, and what Bernanke is suggesting here is that in good times, when animal spirits are high and anyone with a pulse is offered a no-down loan, capital ratios should be increased, thus reducing bank lending and keeping leverage within reasonable bounds. In bad times, when animal spirits are moribund and deleveraging shuts down the credit pipeline, capital ratios should be decreased, allowing banks to loan more money.

This has always struck me as a good idea. But Bernanke doesn't say how he thinks it should be done. Would a board of some kind make these decisions twice a quarter, the way the Fed does with interest rates? Or would there be some kind of automatic mechanism involved? If the former, what confidence do we have that they'd really be willing to take the punch bowl away during boom times? The Fed sure wasn't willing to do so during the 2002-07 expansion. Overall, this is a good suggestion, but it could bear some fleshing out.

There are lots of suggestions out there, like reinstituting Glass-Steagall, and killing the shadow banking system. Or setting a hard limit for leverage allowances. What would be unacceptable is just fixing the near-term crisis and going home. One of the reasons Tim Geithner does not reassure me is that he has such a close relationship to the banking industry and might be unwilling to place the necessary constraints on them.

...you actually know how important re-regulation is by seeing that Alan Greenspan doesn't think we need it.