Can we know what regulations were appropriate pre-credit crisis?

September 23, 2008 at 4:26 pm | Posted in credit, Housing, regulations | Leave a comment
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I don’t believe in much regulation, but we need some framework. And what isn’t regulated (just a little bit) could (and often does) need rescuing.
Its easy to figure what should have been done after the fact. The challenge in doing it right before the fact is two fold –

First – For a variety of reasons, the US thinks home ownership is good and must be encouraged. Therefore there is a reluctance to tighten the screws too much if that means undermining the home ownership objective. So, good luck trying to tighten regulations when lobbyists (and, unfortunately many in the government) would be very vocal about how Congress is denying the American Dream. Yes, Mr. Greenspan, I mean you.

Second – If you come to me to borrow money, and I am willing to lend it to you, without too much inquiry into whether you could pay it back, or what your resources and income are, arguably, that is my lookout. Government has no business legislating caution or prudence or intelligence or even basic common sense on my part. Survival of the fittest will basically take me out of the business pretty quickly.

I do think things were overly lax. But I’m not sure just where the regulation should have come in. I mean, yes, Lehman was overleveraged, true, but some of that excessive leverage is actually a result of asset write-downs destroying equity, so it is an outcome of the credit crisis, not a cause. But the leverage was public knowledge. Equity investors should have known this was a risk, as should creditors.

You can regulate disclosure. You cannot regulate intelligent responses to that disclosure.

So the best that could have been done would have been to have tougher lending standards. Perhaps more responsibility for consequences on the part of the rating agencies would have ensured a more rigorous examination of their models. Perhaps tighter capital norms. There are a few things that could have contained this problem (more on this later).

But ultimately, if a few firms went bankrupt, and others stopped trusting S&P and Moody’s, the taxpayers may have had a few laughs about Wall Street’s follies and hoped that the bankers learned a lesson.

It is only because, after the fact, we realize that the system is at risk that we want to rescue the system, and care about what it would cost us to rescue it.

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