Regulation: The Missing Word

You know what word we're not hearing enough when people talk about this economic crisis? Regulation.

This is not like the Great Depression. Everyone keeps making the comparison, but there is one fundamental difference. Our real economy, however you want to measure that, is pretty okay. It's not great, but not terrible. Oil prices are still too high, and we're paying way too much for the war that's keeping it that way. There was some crop destruction from the floods in the Midwest this summer. There are other little things, and it adds up. But more or less, the real economy is not so terrible.

We're in this mess because economic speculators- what we call Wall Street- invested lots of money in a few financial products that aren't properly regulated.

By now, everyone knows that banks were giving out too many iffy loans. Credit was too cheap and available. People got subprime mortgages they couldn’t actually afford, because the banks relaxed their lending policies.

One big reason the banks were so eager to give out questionable mortgages is that they could resell them. Mortgages, bad and good, were bundled together to create securities. With the suspiciously enthusiastic cooperation of bond-rating agencies, these securities were approved as safe to trade. Since they were based in part on inappropriate loans, these securities were actually much less safe than anyone would admit. In fact, they were downright dangerous. These securities should have been properly regulated from the start- and so should the commercial bond-rating companies that said they were safe to trade.

Or consider another example of a financial product that needs regulating, credit default swaps (CDS). Credit default swaps started out as a form of insurance for bond investors. People holding bonds would pay a small percentage of the bonds’ value each year to a company that would guarantee to pay the full price of the bonds if the original issuing corporation failed. In this sense, credit default swaps were just another kind of insurance.

Trading these things proved to be very lucrative for a while. People got into trading credit default swaps without even owning the actual bonds in the first place, to the point that this speculative approach became the norm in the CDS market.

The problem is that when the companies that originally issued the bonds actually started to fail, all these other firms that traded in credit default swaps were left owing huge amounts of money to each other. No one actually had the cash on hand to cover these debt obligations, or knew what debts other firms owed, and that led to a meltdown of the big investment banks.

Despite the fact that prominent investors such as Warren Buffet warned that credit default swaps should be regulated just like other forms of insurance, they weren’t. Investment banks successfully argued that since the traders involved with the CDS market were ‘sophisticated investors’, they didn’t need government oversight. In retrospect, it is painfully clear that they did need regulation.

Whoever the next president is (Obama!), he needs to make sure that the regulatory system is reformed to match modern markets. Otherwise, we’ll just end up in this kind of mess over and over again.