Public Policy Analysis & Opinion
A dirty, diseased and mean flock of chickens
The effects of financial deregulation are becoming apparent
By Kevin P. Hennosy
As World War II came to a victorious close for the Allied nations, diplomats and finance ministers met to shape the post-war world. At places like the Mount Washington Hotel at Bretton Woods in New Hampshire, these leaders agreed to an integrated economic and banking system. The negotiators hoped that countries that engaged in fair trade, maintained a convertible currency, and fostered transparent accounts would live in peace.
There was a concern in the back of the minds of most negotiators that some day the integrated economic system would expand to some country that lacked a commitment to affirmative regulation of business practices, competitive markets and accounting. Such a country could undermine the entire system by unleashing a contagion of doubt where trust is necessary.
As I read the financial pages of the newspapers, I get the uneasy feeling that those concerns have become reality. Worse yet, I think I know the name of the offending country—the United States of America.
For nearly 30 years, regulation of the financial system in the United States has been effectively dismantled by a well-funded lobbying campaign. Now I believe that the proverbial chickens are coming home to roost, and the flock looks particularly dirty, diseased and mean.
Writing for a monthly magazine means filing columns for publication around six weeks in advance; therefore, one has to be careful to pick issues to write about that show some persistency of interest. There is a risk of filing a column based on a huge story that can be history by the time the magazine hits the reader’s desk. A columnist runs the risk of looking like a fool. Since this column is designed to discuss current events in the regulatory arena, I tend to file later than my colleagues, which makes life more difficult for my editors. Call it my own effort at risk mitigation.
In addition, there are certain issues that a columnist tries not to write about in the hope that conditions will improve. The failing strength of the American economy is one such story that this commentator keeps wishing would heal itself.
So let me preface this column by saying this: I hope that by the time you read this commentary it sounds hopelessly out of date because job numbers have increased, consumer confidence is soaring, foreclosures are rare and the stock market is roaring to new highs.
And yet there is a strong chance that the lousy economy of March 2008, will not look much better in May of 2008. This topic is germane to a column on insurance regulation because, thanks to the Gramm-Leach-Bliley Act (GLBA), the United States has a highly integrated financial services sector. The old “firewalls” that separated insurance, banking and securities under the Glass-Steagall Act were knocked down by GLBA in 1999.
The domino-like relationship among subprime mortgages; mortgage-backed securities; securities rating agencies; bond insurers; turmoil in securities, currency and commodities markets, spastic central bank moves coupled with anemic fiscal policy might finally demonstrate to policymakers that a few firewalls between financial service sectors were a prudent thing to build. But, then again, maybe not—it is hard to see the truth after 30 years of drinking the deregulatory Kool Aid cocktails.
Absent affirmative regulation, which means going out looking for trouble rather than waiting for trouble to show up in the newspapers, bond insurers have gotten themselves in a heap of trouble. The record of inaction, and the promise of more inaction, by the New York Department of Insurance offers little for investors, policyholders and consumers to be hopeful about.
In testimony before the U. S. House Financial Services Committee, New York Superintendent Eric Dinallo said, “The primary goal of insurance regulation is to ensure that the insurer maintains an adequate level of solvency and is able to honor policyholders’ claims.” In addition, Superintendent Dinallo opined that his department would work to preserve the “financial creativity that is essential to maintaining our position as the world financial capital.”
With all due respect to Superintendent Dinallo and his office, that statement reflects the kind of failed rhetoric that is undermining this country’s economic strength. It is the kind of statement that I would expect to hear in testimony delivered by a hired-gun lobbyist, and not a New York superintendent of insurance. That statement does not fulfill the charge delegated to the states under the McCarran-Ferguson Act, and it seeks to achieve goals that are not contained in the act.
The purpose and scope of insurance regulation was enunciated in clear terms by the Supreme Court nearly 40 years ago, and it goes far beyond solvency oversight. In SEC v. National Securities, Inc., 393 U.S. 453 (1969) Justice Thurgood Marshall wrote the opinion of the court which interprets what Congress meant when it delegated power to the states to regulate the “business of insurance.”
“The relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement—these were the core of the ‘business of insurance,’” opined Justice Marshall writing for the Court.
In addition, the Court’s decision invalidated a corporate merger because the Arizona Insurance Department had approved it in the interest of the shareholders. In reversing the Arizona regulator’s action, Justice Marshall reminded state regulators that shareholders’ interest lay outside their jurisdiction over the business of insurance. Therefore, I would observe that the desire to allow for “financial creativity that is essential to maintaining our position as the world financial capital” is a concern that remains outside the jurisdiction of the New York Insurance Department.
The New York State Insurance Department has delivered several rounds of “things went terribly wrong” testimony with regard to the sorry state of bond insurance companies, which has damaged municipal bond markets, which will force municipalities to cut services across the country.
The lack of effective bond insurance regulation is also part of a series of events which is undermining economic growth around the world. Public officials charged with making or enforcing regulatory policy failed to do their job. The collapse of what became known as the “subprime” (high-risk) mortgage sector seems to be playing the same role that the commodities bubble and stock market collapse did in the 1920s. A great number of people were hurt as a direct result of the high-risk mortgage scandal, far beyond that relatively small percentage of home buyers who were affected by the subprime debacle.
The risk of financial loss assumed by mortgage firms and banks was quietly distributed throughout the world’s economy through sneaky means. When the weight of risk caused the collapse of one relatively small financial sector, it pulled down other economic structures. Those collapses reduced job creation, suppressed spending, and undermined consumer confidence in saving and investing.
Winston Churchill once described Soviet foreign policy as “a riddle wrapped in a mystery inside an enigma.” Mortgage-backed securities became a bag of risk, locked in a black box, wrapped in plain brown paper. Regulators looked the other way while financial institutions booked short-term profits and distributed long-term liabilities to sophisticated buyers around the world.
I still cringe every time I hear the term “sophisticated buyer” used in testimony or policy development. After many years of watching advocates for large institutions argue for weak regulatory frameworks, only to come back years later to explain why “things went so terribly wrong,” I say regulate the sophisticated buyers first because they tend to be blinded by greed and self-delusion.
Regulators basically ignored bond insurers for decades, with the exception of monitoring their claims-paying ability. The monoline business was a money machine, so no one regulated “the type of policy which could be issued, its reliability, interpretation, and enforcement.” The problem is that regulators had no way to gauge potential claims because they had little or no idea of what kind of risk was being underwritten by the insurers—a state of ignorance that the insurers seem to have shared. New York regulators seemed content to simply look at the financial ratings assigned to bond insurers by private rating agencies. Again and again, New York regulators are far too deferential to private rating agencies.
One would think that after a scandal that has shaken financial markets around the world and raised the cost of borrowing money for nearly every municipality in the United States, the New York insurance department would not be so trusting of bond insurers. Yet the rhetoric of the superintendent seems crafted to please the sensibilities of the financial services lobby.
I believe that some day the business schools and other academic institutions will look back at this time and see the current economic downturn (be it a recession or a long-term realignment of world economic leadership) as driven by failed regulatory policies.
The failed policies were actually a massive philosophical fraud. Contrary to a great deal of uninformed rhetoric that works its way into trade association testimony in the halls of government and which implies that regulation is anti-American, regulation preserves economic and political freedom. As with the conservatives who dominate talk radio, I have heard many lobbyists for financial institutions appeal to American freedom in defense of deregulation.
Even the most fervent advocates for deregulation seem to understand that they are selling something harmful and damaging. They no longer even use the word “deregulation.” Instead, they use the deceptive phrase “regulatory modernization.” The GLBA moved financial regulation back in time to the 1920s, but sponsors referred to the bill as The Financial Services Modernization Act. This amounts to the Big Lie at work.
We are facing a very dicey economic world because regulators did not regulate. Regulators did not say “no,” which is the first and most important job of any regulator. In order to say yes or no, regulators cannot close their eyes to rates and forms and expect to monitor claims-paying ability. Regulators cannot assume competitive markets as the National Association of Insurance Commissioners advises them to do. There is also a place for criminal prosecution and long prison sentences in the regulatory framework.
A good regulator serves the same role that the founder of Nationwide Insurance Companies, Murray D. Lincoln, advocated in the management of organizations: “What every big organization needs is a ‘vice president in charge of revolution’—somebody on the staff who’d spend full time keeping everybody and everything stirred up; somebody who knew when to nag and when to inspire and who could do both equally well; a kind of professional ‘needler’ who, by timely reminders of the organization’s fundamental objectives, would keep leadership on its toes and on the right track.”
Of course, the problem that undermines Mr. Lincoln’s model is the question of compensation. The value of a vice president in charge of revolution cannot be driven by a quarterly bonus because his or her value will be measured only in the long-term results—or more correctly, absence of expensive failures and scandals. In the near term, the vice president in charge of revolution looks like deadwood, a storyteller enamored with the old days.
Regulation is the public incarnation of the vice president in charge of revolution. Regulators nag. Regulators question. Regulators play defense to protect the fundamental objectives and keep things on the right track.
We are dealing with a massive constriction of purchasing power, which has been the bane of the American Economy dating back to the Age of Jackson. The United States economy produces goods and services—and someone has to consume that production. The United States has always relied on a powerful domestic market to consume its production, while international markets consumed enough excess production to make the United States rich.
A failure to regulate in the consumer’s interest results in a predictable economic slide. When failures or scandals either reduce consumers’ wealth or confidence, the demand-side cannot absorb what the supply-side produces. Suppliers seek to eliminate surplus supply by cutting production, which often has the collateral damage effect of firing workers—and out-of-work wage earners do not demand much. Those who still have jobs live in fear, which makes them less likely to consume.
The Great Depression of the last century came about because of a lack of purchasing power. Lightly regulated commodities markets after WWI allowed a speculative bubble to form and burst, which destroyed wealth and wage-earning ability in the agricultural sector. The 1920s brought drought and flood, pummeling purchasing power in the American Midwest, South and Southwest. Capital markets went on an unsupervised bender largely fueled by fraud, which resulted in a stock market collapse that made fortunes evaporate and investor confidence disappear for a generation.
More important than the direct investment losses as a cause of the Great Depression was the indirect loss in wages when producers cut back production to reduce supply. Until the combination of New Deal programs and war production spending reinvigorated domestic demand for products and services, the United States economy was locked in a death spiral.
An efficient and effective financial regulatory framework is preferable to trying to escape an economic death spiral. Insurance regulators should “regulate the relationship between insurer and insured”—nothing more and nothing less. *
The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate. He is currently writing a history of insurance and its regulation in the United States and is an adjunct professor of political science at Avila University.