Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

3. The Interaction of Regulations and the Great Recession: Fetishizing Market Prices

3 The Interaction of Regulations and the Great Recession: Fetishizing Market Prices It is doubtful that the U.S. and international financial regulators who, in all three versions of the Basel regime (including the Recourse Rule), assigned a low risk weight to mortgages, anticipated the effect this might have on banks and on the world economy if a housing bubble were to occur—or that they anticipated that this action might have contributed to such a bubble . The same goes for the even lower risk weight that they assigned to securities issued by ‘‘public-sector entities’’ such as, in the United States, Fannie Mae and Freddie Mac; or the equally low risk weight that they assigned, in the Recourse Rule and in Basel II, to highly rated, privately issued asset-backed securities. The regulators were not irrational; they were simply unaware of some of the consequences of their actions under unanticipated circumstances. But perhaps the worst of the unintended consequences of the Basel rules occurred through their interaction with other regulations. In this chapter we focus on two disastrous instances of this type of unintended consequence : the interaction of the Basel rules with accounting regulations that mandated mark-to-market accounting, and the interaction of the Basel rules with securities regulations that had effectively turned Moody’s, S&P, and Fitch into a legally protected ratings oligopoly. These two interactions allow us to lay out in brief form what we think can be known at this point about why, when the financial crisis occurred, it was transformed into the worst economic calamity since the Great Depression. Interaction of Regulations and the Great Recession 87 Mark-to-Market Accounting and the Problem of Human Ignorance Mark-to-market or ‘‘fair value’’ accounting was imposed on U.S. corporations , including banks, by the Securities and Exchange Commission (SEC) in 1993, in the form of Financial Accounting Standards Board (FASB) rule 115.1 European corporations are also covered by mark-to-market accounting under the International Financial Reporting Standards (IFRS). In essence, mark-to-market accounting (MTM) requires that assets be ‘‘marked’’ on the balance sheet of a bank or other corporation in conformity with the current market price of the asset. The purpose of MTM is to provide investors in a corporation with transparency, that is, a clear understanding of the corporation’s ‘‘value,’’ by allowing investors to see the value of the corporation’s assets if they were to be sold immediately. This requires marking the assets to their current market prices. Otherwise corporations could hide losses from shareholders by marking their assets at unrealistically high prices. Edwin T. Burton (2009, 130) writes, The guiding principle of U.S. securities regulation is the concept of ‘‘full disclosure,’’ which translates into a demand for ‘‘transparency’’ by shareholder advocates. Transparency means, among other things, that accounting values should reflect current market values to the extent possible. Or, as Stiglitz (2010a, 156, our emphasis) puts it, No one can ever have all they information they [sic] would like before they make a decision. The job of financial markets is to ferret out the relevant information, and, on the basis of that limited information , make judgments about the risks and returns. But markets on their own seem not able to provide the proper amount of transparency , which is why government has to step in and require the disclosure of information. On those grounds, Stiglitz (156) defends MTM, although he concedes that ‘‘no accounting system is perfect.’’ This concession is as meaningless, however, as his concession that all decision makers rely on ‘‘limited information ,’’ since in the same sentence he contends that markets should be 88 Chapter 3 judged against the standard of ferreting out ‘‘the relevant information.’’ No decision maker needs irrelevant information; the problem facing any decision maker is determining which information is relevant without knowing all possible information, or, in other words, making sure that the limited information she has is the relevant information. But a synoptic perspective on all information, which would allow one to sort the relevant from the irrelevant, is not an option: it would amount to knowing all the information , that is, to omniscience. Therefore, the standard of making merely ‘‘the relevant information’’ transparent is impossible to meet. While verbally conceding our ignorance, Stiglitz is actually trivializing it by contending that as a practical matter, ‘‘the relevant information’’ can be in our grasp— given the right accounting regulations. Our...