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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
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.
Michael Barone is a resident fellow at AEI.
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