More Regulation for the Financial Services Industry?

October 28, 2010

By Chuck Dyer

More Regulation is just more government, which is always bad. A popular theme today is that government just can’t get it right. When polled, more than half of Americans are for less government, not more. Of course, those polls ask the generic question. When asked about specific programs, the polling changes.

People are generally for less of the government that affects other peoples’ lives, not that government that touches their own. We want more police on our streets, better fire protection for our house, better schools and libraries in our town.

We don’t want potholes in the roads we drive to work on and we want parks for our children to play in. We want Social Security and Medicare for our families. It’s all that other government that we want to get rid of.

Investments are too heavily regulated, except when our 401k tanks and then we want some rules, not just rules in place, but rules that are enforced (by the government) against the people who have gamed the system leading to inflated prices (and later crashes) of our stocks; or rules (regulations) that would apply when our retirement funds, managed by trained and experienced managers, have been sold a position by a leading Wall Street firm in a mortgage security that said firm is simultaneously, pitching to the fund and, betting on the same security to fail. Not only is the Wall Street firm betting on the product to fail, the Wall Street firm is conspiring with another firm charged with creating the security. The second firm is actively arranging its failure by helping to choose the instruments most likely to fail. We want some government to take care of that too. The examples are almost endless.

If you believe ideologically that government is good for national defense and nothing else, or, if you believe that the private sector will always do a better job than the government, skip the rest of the article. Wait for your own personal crisis and then read it. My grandmother has always told me that everyone, who isn’t already, is just one personal crisis away from being a liberal. We should let the market sort things out.

Really? Even Alan Greenspan backtracked on this one.

There is an enormous gulf between absolute laissez faire capitalism and socialism or communism. The United States has never been completely on either side of the chasm To many, free capitalism and markets means free from all regulation. That is an ideological statement. It’s not close to practical.

Never has been, never will be. If a market is completely free, then it will be subject to monopolization by a few players (monopolies would be legal without regulation to prevent them). It will be free to be gamed by insiders and cronies of those in power. I prefer a form of capitalism where players operate on a level playing field, where entrepreneurism and innovation are encouraged. Too much power and money in the hands of a few lessens both innovation and the ability of entrepreneurs to flourish. Crony capitalism and lack of transparency are bad things. Here are some examples.

Years before he kick started the leveraged-buyout craze by issuing debt for Drexel Burnham Lambert for corporate raiders, Mike Milken was already making a fortune trading junk bonds. His admirers would tell you it was the long hours and dedication to his craft. His detractors would tell you it was because his trading desk was the also the market maker for most of the securities he was selling. Spreads of up to 50 percent of the face value of the bonds were not uncommon. Compared to the fraction of a cent difference between the bid and the asked on the New York Stock Exchange, I would say the old junk bond market lacked transparency and efficiency. It could have used some regulation. A good portion of that spread made Milken a billionaire. He still is, now that he is out of prison.

Hedge funds have always found a safe haven in the exception to investment regulation carved out for well-heeled investors who are supposed to know what they are doing and don’t need the protection of regulation. Do you remember Long Term Capital Management?

The rocket scientists at this hedge fund leveraged up and bet heavily on derivative securities. So much so, that at the end, they held positions in derivatives of some foreign currencies that exceeded the actual float for the underlying currency. The taxpayers paid to wind up its financial deals to stave off systematic failures.

Early in the Bush administration, the vice president met with energy industry leaders behind closed doors to discus energy policy. We will never know with whom he met. We will never know exactly what was said.

It is speculated but not speculative that several of the individuals with whom he met were leaders at Enron. The same Enron that ran the largest fraudulent scheme in the history of the energy business. At every turn, Enron’s traders gamed markets that others thought were honest and hid things from Enron’s own investors and auditors. Part of what Enron did was allowed by a lack of regulation.

It wasn’t illegal, just bad policy. They also committed fraud, made allowable by a lack of enforcement of existing regulations. Enron’s schemes hurt consumers and investors alike. None of which should have been a surprise, less regulation and lax enforcement were the backbones of the Bush Administrations energy policy.

Since 1999, two pivotal moments played heavily in the recent financial fiasco. In both cases, we decided in favor of less regulation and both have cost us dearly. The first was when large banks got their wish and won the repeal of provisions of the Glass-Steagall Act that prohibited bank holding companies from owning other financial companies, such as Wall Street investment banks.

The second was the decision to forego the regulation of over-the-counter derivatives transactions between sophisticated parties as futures under the Commodity Exchange Act. It would have dire consequences related to a derivative security call, the Credit Default Swap.

For years, the mortgage industry operated by the same old stodgy but proven rules. To get a loan without government support, you needed 20 percent down or mortgage insurance.

A borrower needed to have gross income of which 28 percent would cover the principal interest taxes and insurance of a mortgage payment and the total of ones payments including all debts wouldn’t exceed 31 percent of one’s gross income. With minor variations, this worked for years.

Federal backing made for smaller down payments. Home ownership became a reality for the majority of our population. Then the rocket scientists in big investment firms on Wall Street decided that the money was too easy to ignore and furthermore all this loan-to-value and gross-income stuff was old school and unnecessary. If you worked in the business, you saw the result. Instead of 80 percent loan to value, we saw 100-plus percent loan-to-value loans, no-income verification loans, 80/20s, with the 8 percent loan sold as if it were secured with a 20 percent down payment.

These loans could not have been originated if investors didn’t buy them, and buy them they did. So much so that Fannie and Freddie eventually asked in because no one wanted to bother with old fashioned lending of the type they facilitated.

The money used to buy a large portion of the portfolios of these mortgages was borrowed with money backed by the government through the FDIC since now investment banks could own commercial banks and vice versa. Bank regulators overlooked the potential lack of value of these bank assets. Part of the reason no one worried was that the investments were backed up by a derivative security known as a credit default swap. Here’s how they work. A owes B $10,000.00. Company X issues a credit-default swap to B which guaranties payment of the loan if A defaults. It could have been done with insurance, but insurance is regulated. Credit-default swaps are not. The biggest player in issuing credit default swaps was AIG. Heard of them? AIG owes half of all the money the Fed is owed and they are not a commercial bank. In meetings meant to explain the situation, they are referred to as a “shadow bank.” I like my banking done in the cold sober light of day.

A further issue of the credit-default swap problem is that because they are not regulated, no one is sure how many were issued and in what amount. No one has a good grasp on what the final damages might be. Insurance contracts would have had a one to one relationship with the outstanding debt. The potential liability from the credit-default swaps is unknown. Multiple contracts could be and were written for the same debt. The liability on the derivatives is likely more than the original debt on which it was based.

So far, we have only talked about how tearing down regulatory walls indirectly affected title insurance by wrecking the housing and lending business. Let’s look at how it’s affected us specifically.

The end of the Glass-Steagall provisions meant that previously mentioned companies not only originated and sold worthless mortgages, they created in-house title insurance companies to capture the business. It single handedly eliminated what was a fairly level playing field. Was this particular way of doing captive business innovative? Did it lead to advances and efficiencies in the way things are done? Not that I can see. Business captured at the beginning with no real opportunity to shop it isn’t a free market, it’s a very expensive market for consumers. At the height of the boom, we couldn’t identify as much as 50 percent of the recordings in the counties in which we work. The companies that sucked that money out of the system are long gone. The money they made is in the ether. Companies like mine are still here to go about the business of title assurance which is still a necessary function and likely always will be.

While unwise regulations are dangerous, regulation isn’t our enemy. Regulation exists and is necessary, like it or not. The key is not blathering on about freedom but to have the discussion, weigh the options and make good choices based on sound policy and reason. To oppose regulation because all government involvement in private enterprise is bad, is to not enter the conversation. It’s a conversation we must have and that we as title people must take part in.

Chuck Dyer is the owner of Edward Title LLC in Ozark, Ark. He has a juris doctorate from the University of Arkansas School of Law.

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