Beltway, I hate to tell you this, but regulation doesn't actually work to make the system safer. It does just the opposite. Most of the problem we have with the financial system today results directly from regulation. Before the Fed began regulating banks, they kept higher reserves than the minimums they keep now and most customers cared about safety. Now, the FDIC insures deposits and imposes inflexible capital requirements that worsen crises. Meanwhile, the regulating body carries out the political will - in this case, forcing banks to lend to individuals who are not credit worthy so that the political goal of more "homeownership" is reached. This leads to a dangerous combination of being lulled into a false sense of security by regulation when there is actually far more risk being taken. Regulation is merely government control. It is an indirect control of the means of production. The more regulation, the more the government is in control of decision making in enterprises. If government control of the means of production yielded good results, the Soviet Union would be the most prosperous economy on earth and I would have stayed there instead of moving here.
If the credit default swaps had no regulation because of commodities futures act from Phil Gramm, AND the retail and investment is one bank, that will make the banks take risks with no one looking to see the ratio of capital to the size of their bet. And that bank knows it will get bail out of it blows up.
I understand, but I also know there is zero chance of our pols deciding that less regulation is the way to go or that it would teach people to be responsible if they let them suffer losses from irresponsible behavior. Not going to happen, so we have to come up with suboptimal methods of avoiding another catastrophe. Let's face it, the problem is leverage. A lot of people getting big bonuses for pretending to add value when all they were doing was leveraging up. Unfortunately, you can't get a handle on leverage if you don't know how to value assets. Apparently, relying on models or rating agencies is not a great method. So, I am reduced to saying we need utility banks that will handle checking accounts, time deposits, etc, in total, government-guaranteed safety. The price of that guarantee however is they can't do anything remotely risky.
I completely agree with you here. The politicians have incentive to increase their personal power (power is another form of wealth), so why would they waste a perfectly good crisis by not consolidating power. Whether that power is legislative or regulatory is irrelevant. There's no suboptimal way of avoiding catastrophe. That's the big lie of regulation. You're hoping that if we pay a very high price (economy stifling regulation) we'll avoid crisis. Crisis is part of life and as long as human beings make decisions with imperfect information, we'll have crisis. We'll never be able to avoid crisis but we're all going to be much poorer. That's a bad trade. I don't think the problem is leverage, btw. Regulations and government garuantees in the form of FDIC, capital requirements, Fan & Fred, among other government meddling distorted incentives. Do you honestly think that government is better at valuing assets than private investors? Have you ever met anyone from the SEC? Relying on an oligopoly of ratings agencies is a really crappy idea. Unfortunately, the SEC forced all regulated institutions (including banks and I-banks) to rely on an SEC licensed oligopoly of ratings agencies. No competitor ratings agencies were acceptable, so there was no competition. Fitch, Moody's and S&P were the oligopoly and since regulations forced the banks to accept only their ratings, what incentive did they have to do a good job? And you think the yahoos who came up with the brilliant regulation which created the ratings agency problem to prevent a crisis? The capital requirements at banks are so rigid that banks came crashing down when the crisis devalued their capital. Instead of being able to manage their leverage in response to the crisis, they were subject to arcane capital requirements and came to a complete halt because of them. Lending to individuals who were not credit worthy was not the banks' idea. That was imposed on them by congress to advance the "homeownership" agenda. The banks didn't <i>want</i> to lend to poor credit risks but were forced to by laws like the community re-investment act or encouraged to because they could finally sell those mortgages to Fan & Fred. I don't think you are as aware of how much GOVERNMENT regulation distorted the incentives of these banks. And you want more of it? You fantasize of government guaranteed safety. But it is a fantasy.
I understand your point. Nevertheless the investment banks did consult the rating agencies to tell them how to package CDO's to get the best ratings and they surely were aware that what they promoted as AAA in reality carried far more risk than the AAA rating implied.
So wait Cutten, are you saying the world is not in trouble because of the 55 trillion derivatives market but because of a trillion or two mortgage backed securities? Who do you honestly expect to swallow that shit? Go on Fox business forums. Talk about overleveraged consumers, how do you think the BANKS overleveraged themselves? Through CDS. The slighest shock to the system, whether it's a recession or a bad mortgage causes the whole banking system to blow up because their reserves are paper thin. This "counter party risk" means that you must throw trillions to save every single zombie bank instead of letting them fail because they all crossed derivatives with every other bank in the world.
The Investment banks were FORCED by the SEC to use the three SEC approved ratings agencies (Nationally Recognized Statistical Ratings Organizations) and to accept their ratings. The banks (I-banks included) were REQUIRED to by SEC regulation. The banks were absolutely were NOT aware that the ratings agencies were handing out AAA ratings that they shouldn't have. The assumption was that since the SEC required the regulated institutions rely on the ratings of these three SEC sanctioned ratings agencies that the ratings they were giving out were totally Kosher. Very late in the game, one bank (forget which) finally asked what assumptions were used for MBS and were horrified to learn that one of the assumptions was that house prices can NEVER GO DOWN. But that was after the damage had been done and, since the banks had no choice but to accept the shitty ratings, there wasn't much they could do. That's how regulators work to protect "the system".
Yes. CDO (collateral debt obligation) are the (bonds) that back the morgages. So this bonds are backing morgages in a SPV (Special purpose vehicle) This SPV knows the morgages are not good, so they make 12 classes of bonds to back them, AAA through C rated bonds. They say the AAA bonds are the first to be paid when the people pay their morgage, and down the ladder of ratings. This way they can take a subprime bundle of loan, and make some of it AAA, when they make 12 classes. Now they can sell a risky bad loan with AAA rating. But really it is high risk because the borrowers did not show proofs of income, but were approved for this loan. And the wall street investment banks who made the SPV knows this but does not care.
You make other decent points, but are you kidding with this nonsense? I'm sure the banks that didn't <i>want</i> to lend to poor credit risks were forced by the government to securitize and sell those packaged loans into an incredibly high-leverage otc market insured via an unregulated swap market that underwent unhealthy (cancerous) growth. If all the subprime toxic was never packed and priced based on a critically flawed theorems such as the Gaussian copula that had zero allowance for unpredictable correlations, we wouldn't be in nearly the hole we are. You apparently don't appreciate this incredible cascade of derivative risk.