Two news stories this week inform us just how fragile the financial system still is. The longest appeared in two parts in the Seattle Times and traces the demise of WaMu, a major mortgage lender that went broke last year link here and here. The other story concerns the re-emergence of Maurice Greenberg, the "financier" who built AIG, lost it in a bid for control several years ago, still owns a lot of its stock, and is now fashioning a competitor, C V Starr, which apparently replicates AIG in its activities, in its style and its complex organization designed to obscure what is happening, and is now acquiring many former AIG employees link here.

The WaMu story shows how it went from profitable but healthy mortgage lending to increasingly risky subprime high interest paper that was sold by agents and approved with increasingly lax WaMu reviews. Recognizing that the profits depended on ever-rising real estate prices, WaMu moved to dump its own holdings of these mortgages through securitization but got caught with billions in mortgages it couldn't unload in 2007 when that market froze up in recognition of how poor these securities were.

The worrisome aspect of both these stories is that the financial regulators were oblivious of what was happening and that nothing has yet been done to prevent it from happening again. Read these stories and beware.

John,

Given the institutional incentives of regulators and the fact that they don't have much "local knowledge" (in the Hayekian sense) of markets and their ongoing, shifting real time data, we shouldn't be surprised that they didn't act to prevent or mitigate what was happening at WaMu and other firms. Aside from the regulatory capture dynamic (and I don't know how strong it was at WaMu), regulators are constrained by the fact that they simply don't have the information that would guide them to do what an omniscient and presumably omnipotent superman would do, and never will.

After the Madoff Ponzi scheme unraveled, the press was full of hand wringing about the regulators--where were they? A couple of sharp-eyed analysts warned the SEC several years before it came unstuck, but their reports were ignored. It's always like this--several short sellers figured out what Enron was all about while the regulators fiddled. That's what speculators do--they speculate ("spy out") based on a detailed analysis of the facts and a desire to profit in the market. Regulators do none of this. They basically pine for bigger budgets and more authority, and guard their political turf.

Government regulation of markets is problematic, because it's the result of a philosophically flawed pretense of knowledge, a "fatal conceit" as Hayek put it, that markets can be controlled from the center or top.

Regulation begets unintended consequences, and this was shown in the financial markets. Regulation A leads to action B (which wouldn't have happened without the regulation), which leads to bad consequence C, leading to regulation D, then action E, followed by bad consequence F. Jonathan Macey pointed out another one in the WSJ a couple days ago: in the early 1990, Congress put a cap on executive pay by limiting the amount that could be expensed annually to one million dollars. So on cue, many public firms changed their compensation mix to a higher percentage of option-based pay; and we know how that played out in the late 90s and since. The ratio of executive to non-executive pay also increased. Congress (America's only native criminal class, per Mark Twain) is fiddling with executive compensation again, and who knows what the unintended consequences will be? What we know is that there will be some. Call it the Hayek Effect.

The overarching institutional problem was the replacement of a less (but still fairly heavily) regulated money and banking system by the Fed 95 years ago. George Selgin has written and spoken about this recently. This led to even worse macroeconomic performance than what had gone on before. The Fed was the prime mover in the housing, commodities, and stock bubbles and busts. As long as it exists, we are going to have repeats, albeit with different specific empirical effects, of the last decade's macroeconomics.

Bill- Regulations don't force corporate management to defraud investors and the public. The have free will to either be responsible or to irresponsible. The did not choose wisely. Free market greed (like regulation) also has unintended consequences. Complex accounting gimmicks that turned out to be nothing more than smoke and nearly wrecked the economy.

On the question of where were the regulators? How about the acknowledgment that they did not feel that they had regulatory jurisdiction! Essentially we had the unfettered free market corporate executives demanded and dream of. And what did they do with their freedom, they poisoned the entire financial system in pursuit of their unrestrained greed.

It amazes me that when the regulators are doing their job, they are vilified for stifling the free market. When the economy goes sour, blame the regulators for not regulating. Give me a break.

So when will those whining for less regulation recognize that they need to act responsibly? I still hear the shrill mantra of "Don't regulate, trust us", but never a commitment to be responsible to that trust.

Please see my post: "Legalizing Theft - The New Capitalism III"

Steve,

Whatever we had, it was not an unfettered free market. On the contrary, the Federal register of regulations was bigger during the meltdown than at any time before that. As Charles Calomiris points out in his history of regulation of American banking, bank regulations have had many untoward consequences, including putting the "Great" into the Great Depression. State prohibitions on interstate banking combined with federal and state prohibition of private note issue, on the back of bad monetary policy (worsened by the Fed's raising reserve requirements in 1937) and terrible protectionism (Smoot Hawley), were the culprits. Calomiris has written since then about the bad consequences of more recent government intervention in the banking industry. Banking is very far from a free market in the U.S., so the institutional conditions were all in place for more more more government control. That's precisely why the too big to fail fallacy was all the rage with regulators and politicians, and why the State bailed out the big banks (with one regulatory/interventionist consequence being that a credit squeeze was placed on small banks and their Main Street customers. Thanks Ben and Hank!

I agree that regs don't force firms to commit fraud, but to the extent they raise their cost of capital and reduce their profits and cash flow, they do skew the incentives to indulge in creative accounting, usually within GAAP rules (which are somewhat squishy anyway). Creative accounting itself can be a slippery slope, as some firms might want to massage their numbers to meet Wall Street's expectations. Just today I was reading Jordan E. Goodman's eye opening book _Reading Between the Lies_, which has a riveting chapter on the accounting shenanigans used by Enron, WorldCom, Cendant, Lucent Technologies (a cool quarter billion in shareholder value went down the drain with Lucent), Tyco, Waste Management, and others. (If you read that and Hewitt Heisermann Jr's superb _It's Earnings that Count_, you'll never get snookered by another Enron. Get the paperback edition, as the hard cover has errors.)

I also disagree with the notion (believed in also by Krugman) that complex accounting nearly wrecked the economy. If anything "nearly wrecked" the economy--and it did not--the Fed's monetary central planning is the culprit.

Markets are just people exchanging goods and services at prevailing prices. That's the reason that there is no such thing as "market failure." Institutional failure, yes, and this sort of failure, which is the product of government intervention/regulation and only government intervention/regulation, is a monkey wrench in the working of the market.

So let's get rid of the Fed, and all the other regulatory apparatti, and have a rule of common, libertarian law. That is sufficient regulation for the working of the free market. And no bailouts needed!

Lucent's market cap declined by $250 billion. A billion here, a billion there...

From the weekend Wall Street Journal, "Madoff: SEC Agent was a 'Blowhard'."

A report "found that the SEC received six substantive tips over 16 years but still failed to detect the fraud because of inexperienced staff, delays and a lack of communications." They left out "brain-dead bureaucrats."

Not bad for government "work."