The case for fragile regulation

April 7, 2009

Arnold Kling has a very interesting piece on regulation. Crises are endogenous, as economic agents and market participants learn how to game the system. He argues, that we are facing two alternatives: a system that does not break easily, but when it does it is costly and difficult to fix, or a system that breaks more frequently but is easier and cheaper to repair.

Kling argues that measures taken following crises are pivotal in creating the next one. He draws his examples from the mortgage markets from the Great Depression of the 30s, to the Savings and Loans crisis of the 80s, to today’s securitization dead end.

After the Depression it was acknowledged that mortgages with balloon payments are too sensitive to credit shortages. Balloon mortgages have a short term, say 5 years, but the monthly payments are similar to a long term mortgage, say 30 years. This means that in the end of the 5 year period there will be a substantial part of the capital still in place (the balloon), which has to be refinanced. If there is a credit crisis, refinancing might not be an option, leading to foreclosures. To this end long term fixed rate mortgages and adjustable rate mortgages (where refinancing is essentially mandatory) were subsequently encouraged. Such mortgages were given by Savings and Loan associations in the US, or Building Societies in the UK. Fannie Mae was established to promote and guarantee mortgages to families with lower income.

But this shifts the maturity mismatch from the mortgagor (borrower) to the mortgagee (lender). They would borrow short (from their depositors) and lend long in the form of mortgages. In the high inflation and interest rate period of the 70s and 80s, they would receive low cashflows from past mortgages, while at the same time they had to pay higher interest rates to their depositors in order to cling on their deposits. This eventually led to the crisis, where it was made clear that such maturity mismatches were also unsustainable. What emerged from the crisis was securitization, as a means of offloading the long component of their assets. In an ideal world, institutions that had long term liabilities (like insurance companies) would be the buyers of these long term assets.

Unfortunately, it didn’t work as intended with the current crisis being a direct result. Rather than insurance companies, it was investment banks and hedge funds that were left with mortgage backed assets. Also, the originating mortgage providers lost the incentive to monitor the quality of the mortgages they were granting.

The bottom line is that regulation, albeit well meaning, cannot be all encompassing and accommodating. Market participants will eventually work their way around, and there will be unforeseen consequences. It would be better then to have a fast moving framework that keeps the spirit rather than putting rigid constraints.

This is al good in paper of course, but how would such a flexible regulatory framework look like? What capacities should regulatory bodies have to make sure that the system does not descend into chaos? In a world run by politicians that want to cover their bases, the easy option is to talk big and construct a rigid international financial system. Which will probably take us back to the 1930s.



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