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The Path to Regulation

USC business professor Aris Protopapadakis traces the roots of the country’s current economic ills, warning that regulation isn’t a magical cure.

In the aftermath of the financial crisis that crashed down on America this election year, we are hearing unending demands for regulation to fix actual problems, solve imaginary problems, satisfy pet peeves, and punish the “greedy” financiers. Even as I write, the drumbeat is getting louder.

Former Federal Reserve Chairman Alan Greenspan told Congress of his shock that the “financial tsunami” had occurred in spite of the efforts of smart people. I don’t know why he was shocked. Smart people understand and take advantage of incentives better than most. But if the incentives aren’t properly calibrated, the result can be a big mess.

Before we proceed, we need to look at the financial basics and events that led us to this point.

Greed Is Good

The signal achievement of economic thought is that we don’t need selfless, high-minded do-gooders to achieve economic growth and prosperity. It is enough to have greedy, selfish people trying to do the best they can for themselves, competing with others to get ahead.

Spreading the Risk Is Good

The financial system has two main jobs. One is to funnel your savings to the highest bidder, who then tries to get the highest return from the use of the funds for himself. The second job is to channel the associated risk to those who are most willing to bear it — and, of course, to profit from it.

A job well done means that your savings are put to the most efficient use, and that the entrepreneurs who use that capital pay the smallest premium for the risk to which they expose the capital. This efficient allocation is a central pillar of modern economic growth.

The System Evolves, But Not Always to the Good

Up through the 1970s, most home mortgages came from savings and loan associations (S&Ls). They financed long-term fixed-rate mortgages with short-term floating-rate money (e.g., savings accounts, time deposits). They convinced themselves that short-term money would always cost less than long-term money, and they thrived. Progressive deregulation also allowed these institutions to borrow large amounts of short-term money in the form of CDs.

Then came the Volcker disinflation, started under Fed Chairman Paul Volcker in 1980. Suddenly, short-term money was much more expensive than long-term money. The S&Ls bled to death, and most were bought up by banks. We labeled the whole thing “the S&L crisis,” and vowed we’d never let it happen again. Then we labeled this S&L disease “term structure risk,” and we told banks and the few remaining S&Ls that they had to curb it, manage it and report it.

They did, and they went one step farther. They started getting rid of the mortgages after they originated them; this took care of managing the term structure risk. Fannie Mae and Freddie Mac were there to buy up the mortgages. Collateralized mortgage obligations (CMOs) were created and sold to the market at large. These in turn begat collateralized debt obligations (CDOs), which begat credit default swaps (CDSs), which begat the current mess.

The CMOs were a great idea, and right in line with the goal of spreading the risk and attracting savings from all sources. The same is true of the CDOs. The CDSs were just insurance instruments for those who felt the CDOs they held were a little too risky. Again, an admirable example of spreading the risk and passing it along to those best suited to hold it.

Misaligned Incentives

So how did it end up so badly? Intentionally or unintentionally, we overlooked the fact that a mortgage originator who wasn’t planning to hold onto a mortgage wouldn’t be choosy about who the borrower was. The originator’s income depended on how many mortgages he wrote, and not on whether these mortgages might default. These conditions were ideal for the rise of subprime mortgages, and mortgages to people who would never be able to repay unless their home kept appreciating and they could refinance into another teaser loan. Fraud and negligence stirred the pot.

Once mortgages are packaged up, sliced and diced into CDOs, it’s very hard for individual investors to go back and figure out the soundness of the instruments. So rating agencies were employed to rate the various CDO portions. This way, customers would know the amount of risk they were getting into.

But we ignored the fact that the rating agencies were paid by the issuers of the CDOs, and thus had every incentive to give AAA ratings to as many of them as possible. Add to that the silly and possibly self-serving assumption that home prices would rise indefinitely, and your friendly rating agency could justify its generous ratings.

The history behind this crisis shows that the financiers who are now the focus of such public ire and vilification didn’t create “bad” instruments and didn’t have malevolent intentions. The devil was — and always will be — in the details and the incentives.

We Will Always Have Crises

There are too many misaligned incentives and it is too costly for individual investors to figure out the details of every security, every deal and every product. Thus, laws and regulations are essential for our system to function.

And so we find ourselves in 2008 with a government that, even in transition, is almost uniformly bullish on regulation.

The problem, going forward, is that taxes and regulation can mean riches for those who figure out ways to circumvent them. Even the most well thought out and providential regulations have weak spots and loopholes. This means that the next crisis will come from some crack left uncaulked, some scheme not envisioned in the new regulation. Add to that the complacency that comes with good times, and the unpopularity of suggesting that we curb highly profitable but potentially dangerous practices, and you have the ingredients for the next crisis.

A Call for Modesty

It is easy enough to look back and opine on the type of regulation that should have been in place for the crisis that did erupt. But looming crises are like tropical depressions — most never graduate to hurricane, and you never know which one will.

This column is not a call to give up on regulation; rather, it is a call to modesty. We will not prevent the next crisis, because we are not omniscient. And if we try to eliminate any possibility of a crisis, we will not only fail, but thwart innovation and stunt economic growth for a long time to come.

Aris Protopapadakis, associate professor of Finance and Business Economics at the USC Marshall School of Business, is an expert on monetary and fiscal policy, stock market volatility, and international finance. Contact him at (213) 740-6537 or

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