The Politics of Financial Reform

Frank Rich writes a hard-hitting piece in the NYT. But he gets one piece wrong:

.. Those who shorted the housing market shorted the country.

There were many things that went wrong with the housing market – people were being given loans who had no chance of repaying it, homeowners were outright lying and the lenders were encouraging them or looking the other way, Wall Street was concocting securities that were several layers of complexity away from the real, underlying assets and the credit rating agencies were designing their models so that they could stamp their approval on these securities. And a bunch of other stuff related to Fannie and Freddie and the absence of any regulatory checks.

But the thing that was not going wrong, enough, was that there weren’t enough people shorting the heck out of these securities. An asset bubble is created when there are too many people in the market willing to buy at higher and higher prices and not enough people betting on the prices to go down.

Goldman Sachs and Paulson & Co. made money as the sub prime market was collapsing around it. Good for them. There’s nothing wrong with that. Goldman didn’t make much since they were late in the game. Paulson made out like a bandit because he was betting against subprime when no one else was. Unless these deals involved cheating or fraud, there is nothing wrong with making money in a collapsing market.

To the common voter, this won’t make sense. It isn’t fair, it isn’t right to be able to make money off of other folks’ misery. To get huge bonuses when people are losing their houses. You can almost see the special feature on CNN – an interview with an old couple who lost their home and their savings immediately followed by some charts on average bonuses at Goldman Sachs (assuming that nobody at Goldman will be stupid enough to give an interview to CNN on this subject).

This is the narrative that is playing out across the US today. Also perhaps the UK, Iceland, Spain, Ireland and a few other countries where the housing crash was particularly severe. This makes the task of lawmakers very difficult (or very easy, depending upon how you look upon your job as a lawmaker).

If the healthcare debate involved complex issues, financial regulation is almost impenetrable to the voter. If you were a lawmaker and wanted to simply do Joe Blow thinks should be done, you’re going to end up banning short sales and capping banker compensation. Neither is useful and thankfully are unlikely to be implemented.

If lawmakers chose to ignore Joe Blow, and none of them had any scruples, Wall Street would have a field day. They can throw so much money at this thing that the lobbyists will make sure that all that comes out is a bill that sounds ground breaking, but does very little in terms of real reform.

Even if you did want to do the right thing, it is terribly difficult to regulate the market in a way that protects the good stuff while preventing the bad stuff from happening. Always assuming that our legislators really understand the issues at hand. After all, what amounts to the fog of finance for Joe Blow, at the minimum is reduced visibility driving for the Senator.

I am not very hopeful that a good bill can come out of this fog. Another thing that makes me pessimistic is that the most important consequence of this bill, the one that voters really care about, is the avoidance of the kind of crash that would need government bailouts. Whether the bill achieves that or not cannot be determined immediately. Or even in the next three years. If you assume that all politicians want is to be reelected, there is almost no incentive to make a law that really achieves that objective.

On the other hand, punishing Wall Street is popular and the payoff is immediate. So it is in Wall Street’s interest to protest, express pain and anguish and ultimately sullenly take their medicine or appear to do so. And it is in the lawmakers’ interest to appear to be combative and outraged at Wall Street’s excesses while watering down the bill. In this regard the divisions between the left and the right are almost a side show. It might be played up but only to take attention away from a weak bill. Of course there is the matter of the media and experts and what they say about the bill. It’s easy to spin the news networks, especially since they know even less about this stuff than legislators. Experts and financial bloggers are another matter. But then how many voters read Brad Delong?

I will be quite surprised if a good bill comes out of this. There is still some ways to go, and perhaps I should be more optimistic, but politicians as a class are trained to raise expectations and then disappoint.


  1. Bharat says:

    Basab – This is a brilliant piece of analysis. I think you have hit the nail on the head. The whole "Goldman sold a Paulson-designed-lemon to ACA and then they and Paulson made a killing at the expense of the poor buyer" is over simplistic. But I was phenomenally disappointed at the defence put up by Mr Viniar and, more, so, Mr Blankfein. You would think they would come out hitting with simple to understand analogies to make their points. But they didn't. They stuck to how "market making" required them to do this or that – as if Joe sixpack or, for that matter, the senators would get it. I remember that hearing only for senator Levin & Co repeatedly hammering the "do you see no conflict?" question but not one of the responses registered.


    1. Bharat – I actually thought Goldman execs did a good job. They were respectful – Blankfein was and sounded remorseful. They were well prepared and did not commit any headline grabbing errors. And they ran out the clock.


  2. Pradeep says:

    Buffet's very logical and a classic reply to a question posted.

    Q: But the SEC complaint focuses on fraud and says in large part it's because Goldman, the SEC alleges, did not let on that John Paulson was on the short side, betting against this, and he was helping structure the deal.

    A: We had many deals presented to us. For example, there was a municipal bond deal that was presented to Berkshire. And eight billion of municipal bonds and a Wall Street house came to us and said, "We'd like you to insure these bonds." And we said, "We'll do it for USD 160 million." And you'll see that the state of California is a couple of hundred million and Texas is a billion. And when that firm came to us, it happened to be Lehman Brothers two years ago, and we were to insure these bonds for 10 years.

    There were four possibilities. Lehman had these bonds and was hedging them. Lehman had an opinion that municipal bonds were overpriced and they were shorting them. They had a customer on the bonds that was hedging them, or the customers were shorting them. We didn't care. Our job was to decide whether to insure the bonds. I never asked who was on the other side of the transaction. Obviously, somebody is on the other side of the transaction.

    But if Ben Bernanke was on the other side of the transaction, I still would have insured the bonds. It was my job to figure out what I wanted to insure. There's always somebody on the other side of the transaction. And John Paulson could have been on the other side of that transaction and we still would have insured the bonds.

    On the other hand, if the premium was wrong, we wouldn't have insured the bonds. So a bond insurer runs the risk of loss when they insure bonds. It shouldn't make any difference to them who owns them, who is hedging them, who is shorting them. They should decide what the risk is and charge an appropriate premium. And ACA charged the wrong premium.


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