New Regulations Really Do Not Fix Problems: Reprint Of A 2009 Blog Post

Reprint of my March 2009 blog post, "New Regulations Really Do Not Fix Problems:"

Wednesday, March 18, 2009

New Regulations Really Do Not Fix Problems

Posted By Milton Recht

It is unclear that new regulations fix a problem. The causative events of the problem often cease to exist before regulations are proposed. Additionally, many problems that require government intervention to protect the public are usually those that receive a lot of public media attention.

The public and the entities modify their behaviors prior to any regulatory effects. For example, peanut butter sales are down due to the recent salmonella problem [NBC News] and the responsible company closed [CDC]. Peanut butter companies across the US have or are modifying their production processes to prevent a recurrence and parents are choosing other foods for their children.

Undoubtedly, the government will issue new food production regulations and take the undeserved credit for "fixing" the problem. The reality is that regulations are often parallel to the corrective change in behavior, but not the cause.

Since there will be an industry and consumer change in behavior after a negative event prior to regulations, the concern about regulations becomes whether they match (codify) the natural reaction of the public and the industry or whether they distort the natural reaction and cause new problems. In addition, sometimes other industries use similar methods or inputs for different purposes but must modify their behavior and cost structure to comply without any of the benefit.

As for the current financial crisis, the first cause is not yet determined despite the public media and politicians. Most mortgage defaults and foreclosures are limited to a few states, California, Florida, Arizona, and Nevada. Yet house price declines are a national problem even in areas of the US with below historical average defaults and foreclosures, such as the Northeast. Supposedly, we were in a housing bubble, yet the areas of the US with the greatest appreciation were the areas with the greatest increases in the number of new housing stock. Since when does economics allow for price increases when there is an increase in supply and more than enough to meet demand?

Similarly, studies of subprime mortgages (see St. Louis Fed) show that at the end of three years, eighty percent of these instruments cease to exist through refinancing, repayment, etc. Due to their high loan to value ratios, when house prices declined subprime defaults dramatically increased because the homeowner could not refinance the mortgage or repay the mortgage through a sale of the home. In other words, house price declines happened before the defaults happened and were in fact a cause of the increase in subprime defaults.

If defaults did not cause the decline in house prices, what did? What structural changes were occurring in the US economy to make homes worth less across the US and not just in areas of overbuilding and high mortgage defaults?

Bear Stearns went bankrupt about a year ago for liquidity reasons. It was unable to continue to post collateral to fund its revolving debt. The market value of Bear's mortgage collateral declined substantially in value. It no longer had sufficient collateral to continue its operations. The mystery is that on a cash flow basis at that time and currently, the collateral is worth much more than the market price. What other factors besides mortgage defaults and foreclosures depressed and continue to depress the price of mortgage securities?

[See my Oct 21, 2008 blog post, "Home Values Were Not In A Bubble."]

Until the underlying causes are determined, any regulatory response "fixing" the financial system has an excellent chance of missing the mark and causing significant future structural problems for the US economy.