Government Intervention Run Amuck No. 19: the SEC vs. Madoff

The Madoff scandal has the damaged investors looking for scapegoats--other than their own cupidity and Mr. Madoff himself, of course. Sooner or later the question had to be asked: Where was the SEC?


[Thanks to Ca.uky.edu for the image.]

Now, goodness knows I am the last person in the world to defend the Securities and Exchange Commission. I don't know what there record is today, but in the 1980s one would have been hard-pressed to find a case where the SEC saved an investor a penny.

This may not be true today, I don't know. But what is certain is that they didn't do their job in the Madoff case, as Christopher Cox seems to be admitting publicly.

But is this really the SEC's fault? Yes of course it is; but it is also the fault of voters who elected the legislators who created the SEC in the first place.

Just like the FDIC, the SIPC, the PBGC, and (hiccup) now even the Federal Reserve, federal guarantee agencies can be grouped under the common heading "Lenders of Last Resort," a kind of national insurance policy for each risk involved (banks, brokerages, pension funds, and ... well, everything else).

The problem with national insurance policies is that, unlike private entities entering into any other venture, the government has no bottom line to manage.

A private insurance company would only insure risks it felt certain it could insure and survive. The government, on the other hand, insures whatever risks it thinks it must to protect the electorate, whether or not the government budget exists to pay for it.

This leads us to what economists call "Moral Hazard," where market players--who are not stupid--take into account the fact that what they are about to do is insured by the government, which allows them to take on more risk than they ordinarily would.

This backfiring of intent is a well-known phenomenon in economic research. For example, wearing seat belts actually causes more accidents because people feel safer and take more risks while driving. It distorts the incentives, as economists say.

Thus the government that started out to be the protector of the consumer becomes a kind of Risk Devil, encouraging more risk-taking than is healthy, eventually guaranteeing havoc in the marketplace, creating its own program's ultimate failure, and harming the very constituents it intended to protect.

Government oversight may sound like a good thing; but it often ricochets. We might do well to abolish these entities and create in their stead citizen watch-dog groups that will use current legislation to police the bad guys but guarantee nothing and no one.

Read more about the hubris of the financiers who were hit by Mr. Madoff's game in this great piece by John Kay in the Financial Times today. Also, read how Madoff investors are looking for people to sue. It'll just be a matter of time before they decide to sue the SEC--which is us, by the way; and instead of abolishing the SEC, just watch: Legislators, responding to your demands, will strengthen it.

Good grief. We'll never learn.

Oh, So That's Where They're Getting the Mortgage Money

If you're like me, you've been wondering: Okay, if credit markets have seized up, where are these new mortgages and refinancing deals getting the money? Why isn't Countrywide going bankrupt? I know they've received a $2 billion infusion from Bank of America, but that can't be enough.

The answer is, it's coming indirectly from you and me. Our tax dollars have just become collateral behind newly created bonds that the government has made available to the likes of Countrywide.


[Thanks to solomonsrose.com for the image.]

When companies like Countrywide found in August that they could no longer continue their operations for lack of funds to borrow, the government got busy trying to find a way to unlock the situation, and they found one. The solution they hit upon is to open the wallets of the Federal Home Loan Banks and of two semi-government entities, Freddie Mac and Fannie Mae.

These banks and mortgage institutions are basically government-guaranteed semi-private companies that deal in mortgage loans. Heretofore reticent lenders believe that the government (i.e. your tax dollars) are behind these companies. This means that these entities will manage to sell bonds to these reticent lenders, whereas other market operators won't be able to. With the cash in hand from these bond sales, the government can offer hard-to-find money to the real estate lenders who need it, backed by your and my guarantee. Without this deal, Countrywide might be dead by now.

This brings us to the question of whether or not the government should be saving the hind end of those like Countrywide who made bad business decisions. Personally, I think not, because it creates what economists call "moral hazard." In other words, the government is acting on what we believe to be good intentions (saving the general economy), when in fact we all might be better off if they just let Countrywide (and numerous others) bite the bullet (perhaps the economy could withstand it, and even should withstand it).

But the government does not like to be in power when things go awry; so they fix it, get the credit for fixing it, and then allow a changing of the guard, so that the next government can take the blame for the more long-term fallout (potentially: inflation through excessive credit creation, the survival of unsavory business practices like the poor-quality lending that went on up until 2007 and the housing boom/bust, and a flight from the dollar).

The details are explained in my previous post, and in this article at Bloomberg by James Tyson and Jody Shenn.

Other problems can also arise from two different sources: First of all, the semi-governmental companies who are doing the lending were themselves already overextended before this new lending began. All of them have been readjusting their accounting and books to correct severe past mistakes, and are only recently back in the clear (or at least we believe they are).

Secondly, if the new loans default, the only remedy will be for the government to spend your tax dollars to cover the hole.

Opinions differ about the degree of risk involved; but personally, I hate it when someone promises to pay their debts with my money, don't you?

Where Have I Seen This Before? Remember Hoover's National Credit Corporation?

Reuters published this article on October 15, that brings back memories of the 1930s. According to the article, "Major banks including Citigroup Inc are looking at setting up a roughly $80 billion fund to buy ailing mortgage securities and other assets, in a bid to prevent the credit crunch from further hurting the global economy, sources familiar with the matter said." The article says that Citigroup, JP Morgan Chase, and Bank of America are in on these discussions, as are government regulators from various countries including the US.

The funds would be used to "bail out" SIVs ("structured investment vehicles," complicated financing instruments that would scare the pants off any CPA, but that some of our biggest banks have been trading with abandon).

According to a document published at the American Institute for Economic Research back in 1995 (EEB, September 1995), Herbert Hoover tried to get banks to do likewise in 1931 and form a private corporation (the National Credit Corporation or NCC), "to help banks in need and to loan against the assets of closed banks, so as to melt large amounts of frozen deposits and generally stiffen public confidence." [Quoted from Hoover's memoirs about the 1929 Great Depression.]


[Thanks to historicalvoices.org for the photo.]

Unfortunately, Hoover didn't stick to his guns about keeping the government uninvolved, but rather opened Pandora's Box by suggesting that, if his NCC idea didn't work out, he might restructure the WFC (War Finance Corporation) so as to take over for the NCC if necessary.

Well it didn't and he did. He restructured the WFC as the Reconstruction Finance Corporation (RFC), and that got warped by the New Deal into some of our back-up lender-of-last-resort institutions of today (the FDIC, PBGC, etc.)

What Hoover let out of that Pandora's Box was the Genie of the taxpayer as the ultimate payor of the errors of legislators and bankers. They will find it difficult to get that bad idea back into its box.

The G-7 is meeting this weekend. Will they discuss the present credit crunch? You bet. Is this making the markets nervous? Yup. Dow's down 350 points. That, plus the Pakistan, Kurdistan, and Iranian unrest is making for some unsettling times.

Thank goodness, the business cycle is still relatively strong, and all of this does not coincide with high unemployment and a negative GDP. But in the end, no one can predict this one, just as they couldn't predict any of the past sticky situations. We'll just have to ride it out like all the others.