Monday, July 23, 2007

Credit Market Fall-Out #9 – The Role of the Regulator

With the dispersion of risk throughout the financial markets, the question arises as to the role of the regulator. Maybe it should be to make certain that risky loans are not made in the first place. Trying to regulate the financial markets is impossible, because as soon as you make a rule someone will figure out a way around it. Therefore, the regulators should be to make certain that risky loans are not made in the first place. From the WSJ.

The mess in the subprime mortgage market is shaping up as an important test of the globe's new financial architecture.

A generation ago, when the U.S. real-estate market seized up in places like California and Texas, banks and savings and loans felt the pain. The government fixed the problem at a huge cost to taxpayers. Since then, financial markets have replaced banks and regulators. Mortgages get bundled into products with strange names -- like collateralized debt obligations or residential mortgage-backed securities -- and sold to investors around the world.

Because the risk gets spread so widely, regulators can do little but watch and try to reassure everybody it is all under control.

This shift to a markets-oriented architecture has been going on for a long time. But it is hard to overstate how dramatically it has changed in the past decade. During the 1997 Asian financial crisis, Thai and Korean banks were at the center of the problem. The International Monetary Fund and U.S. Treasury pushed them to write off bad loans and get cash. When Long Term Capital Management collapsed in 1998, the Federal Reserve called a handful of banks to the carpet to fix the problem.

Whom do you call today? Subprime problems are popping up all over the place: an Australian hedge fund, a little-known investment unit of Bear Stearns, European banks.

In many ways, this is the beauty of the system. Risky investments are dispersed around the globe the way a sprinkle system distributes droplets of water around a lawn. In theory, when trouble hits, the risk is evenly divided and the overall financial system remains stable.

It seems to be playing out that way so far. Subprime losses could hit $100 billion, yet the Dow Jones Industrial Average reached records last week. "The fears about the kind of spread of this to other markets hasn't really occurred," says Wharton School finance professor Gary Gorton.
But there are worrisome downsides to this financial architecture. The system hides risk and concentrates it in hedge funds that regulators and other investors don't understand. The hedge funds have access to huge amounts of debt, allowing them to make big bets on investments that can go wrong very quickly.

"We don't really know where the bodies are buried until after the fact," says Andrew Lo, an MIT professor who also runs a hedge fund.

A system designed to distribute risk also tends to breed it. At their core, subprime loans and other mortgage innovations -- 'piggyback' loans, Alt-A mortgages, 'no-doc' loans -- brought credit to people who wouldn't otherwise have gotten it. Few of these products would have become so popular if they hadn't been packaged into securities and sold widely to investors.

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