Fast and Loose
Peter J. Wallison, a codirector of AEI's program on financial policy studies, researches banking, insurance, and securities regulation. As general counsel of the U.S. Treasury Department, he had a significant role in the development of the Reagan administration's proposals for the deregulation of the financial services industry. He also served as White House counsel to President Ronald Reagan.
Have less-regulated firms like hedge funds fared better than those that were monitored?
Peter Wallison: We don't have the full data yet. I'm sure that will come out. The data I have seen has to do with hedge funds. Hedge Funds lost about 19% in value during the time of the financial crisis, banks, which are regulated heavily lost about 30%-40% in value. So, the suggestion there is that unregulated institutions did better than regulated institutions and that does not surprise me at all. Regulated institutions are looked at by people in the market as though the government is protecting investors against risk, that's called moral hazard, wheres investors in hedge funds know that they have no protection fromt he government. They have to protect themselves and they are much more careful in their lending of their financing of hedge funds.
So, I'm not surprised if there's a difference. And it ought to teach us something. And what it ought to teach us is that as soon as we have some sort of problem, the answer is not always to get the government involved in regulating financial institutions. We ought to think before we do that because marekt discipline has shown that hedge funds can be far more effective than government regulation.
Should the government have done nothing in repsonse to the crisis?
Peter Wallison: Certaintly not nothing because I think the financial crisis was probably caused by government policy and housing. Government policy created, or caused the creation of 26 million sub prime loans. A huge number of sub prime and alt A, that is highly risky loans. And that's almost 50% of all loans in our financial system. And when it's those loans started to fail that we went into the financial crisis. It's a very simple argument. Very clear.
So, the answer is not to regulate the rest of the financial industry the way the administration wants. They want to regulate the hedge funds and the securities firms and insurance companies and financial companies and so forth. The answer is to get the government out of the housing business. If we are successful in doing that, we will not create the kind of weakness in financial institutions that is what we call thefinancial crisis.
Which of the administration’s plans concern you most?
Peter Wallison: Well, the most damaging, I think, are two of the administrations proposals. The first, was to give the Federal Reserve the authority to regulate all, what they called, systemicly significant companies. What did that mean? What they were trying project by that idea is the notion that one can identify a very large company as dangerous in terms of creating a systemic collapse of some kind if it fails. Frankly, impossible. We have no idea what a systemicly significantly company is. We have no idea which companies would create a financial crisis if they failed. And so, the whole idea that identifying these companies in advance would be a mistake. But if we did it, if we actually named them, we would be creating Fannie's and Freddie's in every sector of our economy. Fannie Mae and Freddie Mac came to dominate the housing sector simply because they were viewed by the market as too big to fail, and backed by the government. And if we designate these other companies, whether they are hedge funds, insurance companies, bank holding companies, securities firms, whatever they might be, as systemically significant, we will be signaling to the market that they are backed by the government and will be protected by the government because, if they fail, the government believes they will cause some sort of systemic collapse.
So, if we were to actually identify these companies, we would be creating Fannies and Freddies throughout our economy and they would have serious adverse competitive effects on all other companies that are not so designated.
So, that idea was a disasterously bad idea. An unimaginably, ill-thought through by the government. I can't imagine how sophisticated people who know anything about finance and about competition could have come forward with such an idea.
Another idea that came forth from the administration was the notion that the FDIC ought to be given the authority to bail out or unwind these very large systemically significant companies. Now, even if we don't name the systemically significant companies, but just give the FDIC the authority to take them over when it believes they are failing, or might fail, we don't name them in advance, we just give themthe authority to take over these large companies when they want, we'll be doing almost exactly the same thing as if we named the companies in advance because the market will look at the very largest institutions and they will assume that the very largest insitutions are the ones that will be taken over. And since we don't know the difference between a firm that will actually cause the systemic breakdown and one that will just cause some sort of disruption, we will always be in the situaiton we have been in recently with say, General Motors. Where no one ever said that General Motors was a systemically significant company, but the government decided to rescue it using TARP funds.
And why did they do that? Not because it was systemically significant, but because it would cause some kind of disruption and it was politically powerful and the labor unions and others involved with GM were politically powerful. And so by giving the government the kinds of authority throught he FDIC that the administration wants, we would be creating moral hazard by signalling to the market that very large financial institutions will be taken over, will be treated differently from the smaller ones, will not go to bankruptcy, will not involve the same risks as the smaller ones, and we will involve ourselves with a lot of political decisions, not economic decisions aboutwho to rescue and who not. It will do grave damage to our economy again.
So those are the two things that the administration has proposed, which I think are disasterously bad and I am quite hopeful that Congress, in working through the various proposals that it has before it will drop both of those.
Wallison notes that unregulated entities, like hedge funds, fared much better in the crisis.
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