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Why Didn't Regulators See the Current Crisis Coming?

In his second post, Mark Thoma says that "we did a very poor job of monitoring the buildup of systemic risk that caused the crash." That is certainly true. But another, perhaps even bigger problem, was that the "we" included regulators that did not stop banks from taking huge risks that should have been obvious.

In her 2003 book on structured finance, Janet Tavakoli laid out the fundamental problem in the banking sector years before it came to roost, noting that "many investors who thought they owned AAA credits will discover to their dismay that their investments are riskier than they realized." In February 2009, Tavakoli further argued that it wasn't mistakes or unforeseeable "black swan" events that caused the financial crisis:

Our financial malaise was caused by bad behavior deliberately hidden behind the opaque veil of models and hard-to-pronounce financial products like collateralized debt obligations and credit derivatives.... Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, misleading loan documents, failed business models, overleveraged hedge fund clients, shoddy ratings on Wall Street deals, and more.
Employees of credit rating agencies also seemed to have known about the big risks. Even the apparently risk-numb group at AIG Financial Products stopped selling credit default swaps in 2005, according to AIG's primary regulator, "based on their general observation that underwriting standards for mortgages backing securities were declining."

If the massive risks building in the system were obvious to financial professionals, then giving regulators more responsibility by broadening the kinds of companies they must look after seems to make little sense. Instead, we should be encouraging far more aggressive private risk management by the parties that got duped by Wall Street. But the more these investors rely on regulators or others to monitor risk instead of doing their own due diligence, research, and risk-management, the more complacent they'll become. Investors tend to keep a closer eye on risk when they know they can't rely on third parties to do the dirty work for them.

How credit default swaps were traded
Let's take a look at hedge funds that trade credit default swaps, or CDSes. Here we have lightly regulated companies trading lightly regulated financial instruments. Two facts stand out. First, although banks could have lent more short-term money to credit strategy hedge funds, a 2007 Fitch Ratings study found that "most hedge funds were reported to be financing their positions at levels well below maximum leverage permitted " by the bank's prime brokers (emphasis added). Second, parties that trade credit default swaps with hedge funds kept the funds on a tight leash by requiring the funds to post plenty of collateral.

Now compare hedge funds with AIG's unregulated subsidiary that sold too many CDSes to banks. When AIG Financial Products entered into CDS trades, it posted no collateral whatsoever. Parties relied on the high credit rating of the subsidiary's parent company and the ability of credit ratings agencies to monitor AIG's risk and the risk of the mortgage-backed securities referenced by the CDSes.

Hedge funds' healthy risk management practices likely came about because there is no pretense that their risk is directly policed by federal regulators, parent companies (they typically don't have parent companies), or credit ratings agencies.

None of this means that there is no room for more regulation and vigilant oversight by regulators. There certainly is when it comes to banks' off-balance sheet entities, as I argued on Monday, and also in better enforcing the laws against fund manager fraud. Regulators should also focus on preventing the large risks that many market participants were aware of by, for example, continuing their efforts to require banks to hold more capital in reserves.

As we look to make the financial system more stable, we should encourage banks to limit the credit they extend and make sure that parties that trade derivatives use lots of collateral. Preventing too much reliance on third parties is one way to do just that.

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