Regulators failed, all round

Reams have been written about who is to blame for the sub-prime mortgage crisis induced financial market meltdown and global economic recession. The villains have ranged from "greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn't see it coming, and the regulators who failed to regulate". But closer analysis reveals that it was a collective failure of all the different endogenous (risk appetite, moral hazard from various sources, agent incentive arrangements, etc) and exogenous (rating agencies, capital adequacy norms, margin requirements, etc) checks and balances, blown away by an overpowering cascade of euphoria and animal spirits.

Mark Thoma has an excellent summary (also here) of the incentive distortions and market failures that compromised the workings of the sub-prime mortgage market with such devastating consequnces, "Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on."

Fundamentally, the financial market crisis resulted from a failure to detect and even on detection, adequately deal with, a phenomenon of massive mis-allocation of liquidity into one particular sector, real estate, that generated all kinds of distortions. Policy makers and regulators, instead of blowing the whistle or "taking away the punch-bowl as the party got going", so as to put in place the appropriate course corrections, ended up fuelling the upward spiral and its excesses. And the rapid emergence of a shadow banking system, free from any regulatory oversight, unleashed ample opportunities for regulatory arbitrage.

George Akerlof and Robert Shiller have attributed this spectacular misallocation of liquidity to the power of animal spirits (the human psychology and culture at the heart of economic activity) and the waves of optimism, bordering on the suicidal, it generated. The scientific basis for this euphoria was supplied by the complex mathematical models which gave the mistaken "perception that financial innovation could produce higher rewards without increasing risk". All this in turn was under-pinned by the almost evangelical belief among the policy makers and the ruling ideologues that markets are self-correcting. The relative calm and macroeconomic stability of the era of the "Great Moderation" in the eighties and nineties had also aroused the false belief that major economic crashes are a thing of the past and the business cycle had been conquered.

In an incentives driven free market, the complex inter-play of animal spirits, with their self-fulfilling "stories that people tell to themselves - about themselves, about how others behave, and even about how the economy as a whole behaves", market failures and excesses are inevitable, necessary counterparts to innovation and efficiency. It is for the government "to set the animal spirits free and allow them to be maximally creative", by both laying down the rules of the game and then refereeing the capitalist game in the global financial markets.

However, amidst all this plethora of villains and market failures, it cannot be overlooked that most importantly, regulators at all levels were either "captured" or were a "few steps behind" or were plain incompetent. As Mark Thoma writes, "the regulators of these markets were captured by powerful forces that wanted the game to continue. The power of regulators, and the will to enforce the regulations, must match - in fact exceed - the will and power of those being regulated to resist having constraints placed on their behavior." It appears amply clear that even with blame and accusations flying in all directions, regulators have to bear the overwhelming share of the responsibility for abdicating on their duties.

What may make the whole crisis and the regulatory failure even more unpardonable is the growing belief that it was primarily the result of plain malfeasance and not the build-up of systemic risks through complex mathematical models based transactions. It has been claimed that "bad behavior was deliberately hidden behind the opaque veil of models and hard-to-pronounce financial products like collateralized debt obligations and credit derivatives. Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, misleading loan documents, failed business models, overleveraged hedge fund clients, shoddy ratings on Wall Street deals, and more."

This implies that regulators who were put in place to police precisely such contingencies were willing accomplices in its perpetration. It is therefore important, especially to take care of the moral hazard problems, to ensure that those responsible are investigated and brought to book. Further, there is a need to regain what Paul Krugman describes, albeit in a different context, "our moral compass, not just for the sake of our position in the world, but for the sake of our own national conscience... to investigate how that happened, and, if necessary, to prosecute those responsible."