By John Carney, Senior Editor, CNBC.com NEW YORK ( CNBC) --As you may have noticed, we specialize in examining the regulatory roots of the financial crisis around here. A lot of people--including the government's Financial Crisis Inquiry Commission--tend to view the financial crisis as a result of a failure of capitalism or a result of deregulation. There's some truth to this. But the role that regulatory constraints on market actors played in the crisis still doesn't get enough attention.
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Regulation AB didn't suffer from either of these faults. It was a bit fuzzy around the edges--some market participants would complain that it was too vague and therefore invited unwitting violations. But it wasn't too complex and most of those issuing mortgage-backed securities found the cost of compliance acceptable. So what went wrong? Regulators appeared not to understand that mortgage-backed securities had been performing a monetary function within the shadow banking system. Short term lending between banks and money market funds, collateralized by mortgage-backed securities, was acting form of private money within the banking system. It is the medium of exchange within this 'shadow' system. But, as Yale economist Gary Gorton has argued, in order for collateralized debt to perform this function, the debt needs to be "information insensitive." Which is to say, the institutions lending the money need to be able to implicitly trust quality of the collateral without investigating to make sure it is sound. "Short-term collateralized debt, private money, is efﬁcient if agents are willing to lend without producing costly information about the collateral backing the debt," the abstract to Gorton's paper "Collateral Crises" explains. But how can lender blindly trust in the quality of collateral? Here the complexity of the collateral comes in to play. In order to prevent borrowers from engaging in adverse selection--i.e. giving a lender junk collateral--the collateral must be complex and opaque enough that it isn't profitable for anyone to produce enough information about the debt to carry out any kind of predatory behavior. In short, predatory trading must be too expensive to work. This has the effect of leveling out the value of collateral. Firms with low quality collateral can borrow and credit booms. The economy roars. But fragility builds up in the system as many deals are made with low-quality collateral. Enter Regulation AB. The new disclosure rules dramatically decreased the opacity of the collateral. It was now possible for market participants to tier collateral. Lenders could not blindly accept collateral based on a quick, one-line description for fear that borrowers would engage in predatory behavior. In short, thanks to the added transparency created by Regulation AB, mortgage-backed securities lost their monetary function. Value of low-quality MBS tanked. But so did the value of high-quality, since it could no longer be used as readily as loan collateral. Shake, pour over ice, and serve as a financial crisis cocktail. None of this was foreseen or intended by the SEC when it passed Regulation AB. Which makes this another cautionary story about the unintended consequences of regulation. --Written by John Carney at CNBC.