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.

There is no good reason for giving a federal stamp of approval to designated credit-rating agencies, and other privileges denied competitors, just as there is no good reason to have the government sponsor mortgage companies (Fannie Mae and Freddie Mac). But the proposition that NRSRO privileging was a major factor in the financial crash is again dubious, for sophisticated investors--and they are the only customers for tranches of securitized debt--are capable of giving proper weight to an NRSRO's rating, as they are to give proper weight to the designation of a private company as a "GSE" (government-sponsored enterprise).

To go beyond stripping the NRSROs of their privileged status, therefore, seems unwarranted by what is known at present about the causes of the crash. In hindsight the credit-rating agencies may have done a poor job in rating securitized debt, though even this is uncertain, because the consensus view was that securitized debt was safe because it diversified the risks created by the underlying assets (such as the mortgages that back mortgage-backed securities). But if the rating agencies did do a poor job, and not just in hindsight, the market will punish them if the government allows it to, and it is in this respect that eliminating NRSRO status would be a step in the right direction, as it would increase competition in the ratings industry. Generally, the market disciplines even firms that labor under a conflict of interest, as of course many do--insurance companies obviously, but also accountants, lawyers, doctors, and automobile body shops. If credit ratings are distrusted, credit-rating agencies will not be able to extract high fees for rating a company's debt.

The case for the government's protecting consumers of financial products as distinct from sophisticated investors is stronger, but the government's efforts should in my view be limited to protecting consumers from fraud. From this perspective the creation of the Consumer Financial Protection Agency would be a step in the wrong direction. There are plenty of remedies against financial fraud, including criminal remedies, and plenty of enforcers, including not only the Justice Department, the Securities Exchange Commission, and the Federal Trade Commission, and their state counterparts. The new agency, as the Report makes clear, would have the more dubious mandate of protecting consumers of financial products from themselves. There is a telling remark in the Report that oversight of financial markets should be based on "actual data about how people make financial decisions." The authors believe that they do not make financial decisions on a rational basis because they cannot understand financial products. So the new agency if it is created will design "plain vanilla" financial products, such as a mortgage, and require that they be offered to prospective borrowers along with the lender's own product. And the agency is to restrict the terms that lenders offer in their own products if the benefits of the restrictions are deemed by the agency to outweigh the costs. Since no responsible cost-benefit analysis will actually be conducted, the agency will have carte blanche to impose its view of optimal mortgage terms on the housing market.

In doing so it may for example decide to forbid ARMs--adjustable-rate mortgages, thought a culprit in the housing bubble. What is true is that an ARM is cheaper than the conventional fixed-rate mortgage because it shifts the risk of interest-rate fluctuations from the lender to the borrower. But that is a tradeoff (lower rate for greater risk) that a perfectly rational and well-informed homebuyer might make, especially since a fixed-rate mortgage with prepayment penalties (which makes refinancing costly), in contrast to an ARM, makes it more difficult for the borrower to benefit from a future decline in mortgage interest rates. The new agency might want to outlaw prepayment penalties as well, though, again, a mortgage that includes such penalties is cheaper than one without, precisely because it denies an opportunity to the borrower; and once again the tradeoff may be preferred by a rational borrower.

Notice the conflict between the mandate of the new agency, which is to protect consumers from foolish credit decisions, and the mandate of the Community Reinvestment Act, to which the Report pledges allegiance, to encourage home financing in "underserved" communities. If mortgage lenders are forbidden to shift risk to the borrowers, as through ARMs and prepayment penalties, they will charge higher interest rates, and impecunious persons will be prevented from owning a home.

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