As the Dodd-Frank financial regulation bill nears a vote in the U. S. Senate, it is difficult to fully understand its mission. Supposedly, we are responding to the “big culprit” in the recent meltdown, which has been identified as the deregulation of the financial markets over the past 30 years or so, in spite of the fact that it was the U. S. mortgage market, the most heavily regulated element of the system, that created most of the problems. I don’t see anything in this bill that will address the moral hazard of “too big to fail”; to the contrary, if the $50 billion bailout fund remains, this hazard will be institutionalized. There is nothing in the bill that touches Freddie Mac and Fannie Mae, the biggest boondoggles in the entire meltdown scene, which continue to receive massive taxpayer subsidies of negative cash flow, continue to represent approximately one-half of the nation’s mortgage market, continue as a huge dispenser of political patronage, and continue as the largest purveyor of “affordable housing” at any cost, the mission that got us where we are today.
I do see in the bill aspects of another version of the “search for cosmic justice” in the form of seeking social utility for derivatives, the so-called “side bets” that many believe serve no useful function. In spite of some abuses, it is a mystery to me how reasonable observers see no useful function in the market allocation of risk to those who choose to assume it at their own peril and in particular when this mechanism, properly understood, is an integral part of the ability of well-informed investors in the market to correct pricing imbalances and performs a valuable service in recognizing and sending signals on overpriced assets. If we hadn’t had a John Paulson, we would have needed one, and it would have been even better if someone had shorted Fannie and Freddie before they got completely out of control.
There remains the question of failing firms and, having had considerable first hand experience here, I favor the resolution process offered by the FDIC for failing banks, including the approach that avoids complete liquidation but wipes out shareholder equity and dismisses management, without political judgments based on which firms constitute “systemic risk” and are too big to fail.
Six months before the free fall of September 2008, I used the following quote from Allan H. Metzler of Carnegie Mellon University: “If the government underwrites all the risks, call it socialism. If it underwrites only the failures, call it foolishness.” These sentiments are clearly applicable today and we are dangerously close to both outcomes with the legislation in its current form.
