Financial Regulatory Reform: III

The most questionable proposals in Financial Regulatory Reform--the 88-page blueprint for regulatory reform issued by the Treasury Department on June 24--concern the protection of investors and consumers from false, misleading, or "unfair" practices by the banking industry (as always, broadly construed to include the "shadow banking" industry, consisting of financial intermediaries that provide services similar to banking) and the credit-rating agencies. I shall discuss three of the proposals: that originators of mortgage-backed securities and other securitized debt be required to retain a minimum 5 percent interest in the securities that they sell; that oversight of credit-rating agencies be increased; and that a new agency be established, the Consumer Financial Protection Agency, to protect consumers from making mistaken or foolish decisions regarding taking on debt, such as credit-card or mortgage debt.

The premise of all three proposals is that the financial and broader economic crisis in which the nation finds itself is due mainly on the one hand to the irrationality and sharp practices of bankers and on the other to the irrationality and gullibility of their customers. The bankers are fools and knaves and consumers are fools. This is, to put it mildly, an oversimplification. There are fraudulent sellers, of financial as of other services, and dumb buyers of those services, as of other services, but I am unpersuaded that the character and intellectual flaws of the participants in the financial markets were major factors in the housing and credit bubbles and the ensuing disaster. The disaster is more plausibly attributed to regulatory errors, as I have explained in my book and my previous blog entries. But since the Report advocates more regulation, it is unsurprising that it should downplay--to the extent virtually of ignoring--the regulatory errors that are the main underlying causes of the disaster.

Especially implausible is the idea that sophisticated investors were gulled. The specific premise of the proposal that the originators of securitized debt be required to retain an interest in the securities when they sell them is that the requirement will make them less likely to sell securities that they know to be worth less than the selling price. Now it is true that the seller of a product usually knows more about its possible flaws than the buyer, that a security that consists of a package of thousands of mortgages is as a practical matter impossible for the buyer to inspect, and that the seller's retaining "skin in the game" is a conventional method of reducing the risk to the buyer that the product may be defective; in effect, the seller is giving the buyer a hostage--the seller's interest will die if the product explodes.

But all this is well known to the banks, pension funds, sovereign wealth funds, and other buyers of interests in mortgage-backed and similar securities. These interests ("tranches," as they are called) are not marketed to or bought by consumers. They are sold to highly sophisticated investors. If those investors want the sellers to retain "skin in the game" as a guarantor of the quality of the product, they can negotiate for such a provision in the contract of sale--as some did. None of them needs the government's protection, as is further shown by the fact banks that originated securitized debt also often bought interests in such debt from other originators, something they would not have done if they were skeptical about the value of such securities, as they would have been if they were deceiving the buyers of the securities that they originated.

I have a similar reaction to proposals to tighten oversight of credit-rating agencies. It is true that these agencies have a conflict of interest in rating corporate debt, because they are paid for their rating services by the issuers of the debt that they rate. It is also true that they have difficulty rating highly complex securities. But these things are well known to sophisticated investors--if not, their ignorance is culpable. No one is required to buy an interest in a mortgage-backed security merely because that interest has been rated triple A by a rating agency. It is reckless to make a large investment on the strength of a credit rating; and if that recklessness was indeed (as I doubt) widespread before the crash, it will not be from now on; the investors will have learned their lesson. (Much of the Report is about closing the barn door after the horses have escaped.)

What might call for reform, though ignored in the Report, is the SEC's certification of the leading credit-rating agencies as "Nationally Recognized Statistical Rating Organizations." (Ten have now been certified, including the two leaders--Moody's and Standard and Poor's.) Such certification allows the issuers of debt rated by an NRSRO to provde prospective investors with a less elaborate offering document. And apparently some customers of American Insurance Group allowed AIG to substitute its triple A rating for collateral to back the credit-default swaps that it issued. In addition, insurance companies, pension funds, and other investment entities that are permitted to invest only in "investment-grade" securities cannot be sued for failing to comply with this restriction if the securities they invest in are rated triple A by a NRSRO. This puts the NRSROs under greater pressure to give the sellers of securities a high rating, and thus weakens market discipline.

Presented by

Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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