Platt Perspective on Business and Technology

Considering a cost-benefits analysis of economic regulatory rules – 2

Posted in in the News, macroeconomics, outsourcing and globalization by Timothy Platt on April 6, 2012

This is my second installment in a series on cost-benefits analysis of economic regulatory rules (see Part 1, in which I began this discussion with a case study example drawn from United States history. My case study began with a brief outline of some of the factors that led to the banking crisis that developed as a core component responsible for the Great Depression of 1929 and following years. This led to a discussion of the regulatory response that was put in place, and both to help address that crisis and to help forestall a repeat of it in the future. I focused on one of the principle regulatory tool sets enacted in that effort: the Glass-Steagall Act. And I briefly outlined some of its successes and how it has been disassembled – and in ways that significantly contributed to our more recently experiencing the Great Recession. And this overall discussion led me to some fundamental observations that I simply noted then, stating that I would address them in more detail.

Reiterating them here as points of orientation for what follows, in a fundamental sense:

• The absolute levels of potential risk and benefit are not as important as the symmetrical distribution of risk and benefit shared – equally at least ideally, by all involved stakeholders.
• The real risk of instability and crisis comes from risk and benefits distribution asymmetry.
• And not all regulatory control works and not all of it is beneficial – and that symmetry of benefit and of perceived benefit from regulatory control becomes important too. (Note: I focused on the benefit side of risk/benefit here for a reason, which I will explain.)

And I turn in this posting’s discussion to a developing story literally taken from today’s news (see Floyd Norris’ New York Times column, High and Low Finance for March 9, 2012 – An Industry’s Failure to Verify After Trusting; on pages B1 and continued on B8.) Briefly outlining a few of the details shared in that News analysis piece with some background information of my own:

• In mid-2008 as the financial crisis of the Great Recession deepened, MBIA, the largest monoline insurance company at that time realized it was facing significant potential risk from some of its investment business. Note that MBIA being a monoline insurer is very important here. That means that MBIA offered guarantees to issuers of the portfolio investments it took on. A monoline insurer would do this to boost the ratings of their debt issues and/or ensure that those debt issues retain higher credit ratings – meaning the investment portfolios they offered to investors would hold and retain high creditworthiness ratings and be appealing to the marketplace for that. The ratings of debt issues that are securitized in this way reflect the insurer’s own overall credit rating and I add that any actual risk that is inherit to those investments is carried over to the insurer for its securitizing them.
• When monoline insurers first started doing this, they pretty much restricted this practice to safer investments such as municipal bond issues. Then they began taking on the risk of securitizing higher risk investment classes such as mortgage backed securities and collateralized debt obligations. Note that a collateralized debt obligation is a form of structured finance in which securities backed by mortgages are pooled – and for which it can be all but impossible to see inside in determining the actual levels of risk inherit to the individual investment component parts – so there is no way to see how much of what is included, goes into these investment instruments as high-risk mortgages and how much as prudently financed, reliable for pay-off mortgages. And to make this much worse, collateralized debt obligations were themselves pooled into even larger and even more opaque structures: secondary collateralized debt obligations and no one actually knew even how to even begin to determine true risk involved in those investments. But at least some monoline insurers began to securitize all of these potential investment instruments and more.
• The agents and traders who set up and sold these investments and shares of them stood to gain tremendously from these investments as they were personally exposed to the potential upside of their returns on investment. But they were not personally exposed in that same way to any potential loss, from failure of these investments to retain value let alone yield returns.
• MBIA realized that at least some of its major investment offerings were heading into trouble, so they hired the services of a major investment bank to review certain portions of their portfolio to determine their actual risk exposure from them They selected Lehman Brothers to do this for them and they received their report just days before Lehman Brothers themselves filed for Chapter 11 bankruptcy protection on September 15, 2008.
• Lehman’s report stated that MBIA stood to lose more than $7.7 billion from the 15 collateralized debt obligations that it had reviewed. This represented a small proportion of MBIA’s overall portfolio, but as Floyd Norris noted in his news analysis piece, it is telling that they would have hired Lehman Brothers to conduct this audit review for them, given how little due diligence research they must have done in determining who to third party-outsource this task to. And this is where this story gets really interesting – in what comes next.
• MBIA decided to split off its structured finance business as a separate company – basically separating all of its toxic holdings: mortgage backed securities, collateralized debt obligations and the rest from its more fiscally sound and secure holdings in municipal bonds – its original, traditional business. And they needed regulatory oversight approval to do this. On December 5, 2008 they filed with the New York State Insurance Department (now a part of the Department of Finances, hence the link offered here) and without holding any hearings or offering any public notifications, the then State Insurance Commissioner agreed – on February 17, 2009.
• The beneficiaries of the MBIA insurance policies that were built at least in significant part on these now known to be toxic investment instruments – mostly banks and hedge funds who found themselves holding these structured finances, began to file lawsuits in New York’s Supreme Court. And it is likely that one of these legal challenges will soon become the first major civil law case from the Great Recession to go to trial.

I have taken some details from Harris’ column piece and I have added a lot more in the way of background information to flesh out the portion of this story that connects to what I have been writing about in this series. But together, this tells an important and insightful story and both as to the consequences of deregulation stemming from the enactment of law such as the Gramm-Leach-Bliley Act of 1999 and from failure in due diligence in following or enforcing regulatory oversight still in place. And this brings me to the three bullet points I began this posting with that I carried over from Part 1 of this series. And at this point I simply note that MBIA and I add Lehman Brothers found themselves in trouble because the people who developed these toxic investment strategies and who traded and invested in them saw themselves as immune to the risk that might be inherent to them, while being open to the positive gain that they might bring as long as they succeeded. The managers and investment agents, I add, who built and managed the portfolios that held these investments, and at all levels made very large salaries and much, much larger bonuses from that – until the house of cards collapsed.

I am going to pick up on this story in my next installment, where I will delve into the Volker rules and the controversies that surround them. I am also going to at least briefly discuss executive and senior management compensation bubbles, and a number of other and related issues. Meanwhile, you can find this and related postings at Macroeconomics and Business and also at Outsourcing and Globalization.

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