By Michael Barone, Thomas Jefferson Street blog
I haven't commented on Timothy Geithner's plan, the one promised for February 10 and delivered on March 23, to clear out the toxic waste assets from the banks and other financial institutions that hold them. I hope it works, and I fear that it won't. But this isn't my area of expertise and I'm not confident enough to make any predictions. I note with interest that it's being attacked, and being defended, by people on the left and people on the right.
But I have noticed what I think is a paradox in the Geithner plan. He is asking the most unregulated parts of the financial system—hedge funds, private equity firms—to bail out the most regulated part of the financial system—the banks. With government help, or subsidy, of course. But of course the government isn't really regulated either, is it? Except, I suppose, through the political process.
Democrats like Barack Obama and Barney Frank, at least on the campaign trail or in sound bites, have portrayed the financial crisis as the product of deregulation. The solution, they say, is more regulation. In that vein Frank, one of the brainiest members of Congress, is proposing that the Federal Reserve become a regulator of systemic risk, with the power to regulate firms that because of their size or strategic position are of systemic importance.
My American Enterprise colleague Peter Wallison has argued powerfully that this is a bad idea. Neither the Federal Reserve or other regulators identified the systemic risk which caused this crisis. Neither did most financial institutions or investors. Systemic risk is hard to identify for the very reason that it is systemic: It results from just about everyone doing what turns out to be the wrong thing. (Housing prices will always go up, therefore there is no risk in buying mortgage-backed securities, etc.) Identifying some firms as posing systemic risk is saying that they are too big to fail, in which case they'll take undue risks and end up having to be bailed out by the government. These strike me as very strong arguments.
Which takes me back to the Geithner paradox. He has singled out unregulated institutions as the only ones to bail out regulated institutions. Yes, financial markets do need to be regulated, in intelligent ways. We need rules of the road and the ability to prosecute fraud. With hindsight, we can identify bad decisions by regulators which helped produce this financial crisis (the government's implicit guarantees of Fannie Mae and Freddie Mac, the unduly high leverage allowed to banks and investment banks). But regulation does not automatically produce safety. It may very well, as Wallison argues, increase rather than mitigate systemic risk.
Geithner, as I see it, is asking the unregulated players—the hedge funds and private equity firms—to do what Wallison recommended that the government do, buy the troubled assets "at their 'net realizable value,' which is based on an assessment of their current cash flows, discounted by their expected credit losses over time." He's trusting the unregulated players, rather than the government, to discover what that value is, by subsidizing their investments while limiting their downside risk. The government provides six-sevenths of the price, gets half the profits, but doesn't have recourse to go back to the investors to recover losses. The unregulated players have great leverage to make profits while their losses are limited to their outlays.
This may work as intended. I certainly hope so. But it does give us some things to keep in mind as we ponder how financial markets should be regulated in the future. We don't want to regulate every player strictly. There is a place for unregulated operators. And tight regulation will never automatically protect us against systemic risk. We need to keep our eyes open for areas where we need tighter regulation and where we don't. As Peter Wallison has kept his eyes open, observing Fannie Mac and Freddie Mac for the last 10 years.
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Dwayne Davis of OH 8:12PM March 26, 2009
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