Barely contained outrage: what the Europeans really think about America's regulatory blunders.

• Author: Engelen, Klaus C.

Today there is outrage and anger in Europe at those responsible in the United States for setting the world financial system on fire. The issue most upsetting to Europeans is "American rating power" and the misleading high ratings that the "rating duopoly" of Moody's and Standard & Poor's gave to what eventually turned out to be "toxic waste" in bank balance sheets and investor portfolios. Since all major rating agencies--including Fitch--are licensed by the U.S. Securities and Exchange Commission, Europeans have sounded a battle cry for stricter regulation of the rating business and for the establishment of a European rating agency.

There is also anger at those bankers and officials in Europe who helped bring the financial meltdown to their side of the Atlantic by looking for higher yields through off-balance-sheet special purpose vehicles such as SIVs and conduits investing in complex securitized instruments. The contamination of Europe's financial markets with highly toxic materials exported from the United States has left a path of destruction in bank balance sheets and in equity portfolios. Since banks ceased trusting each other, they stopped lending on the interbank and commercial paper markets and put their overnight money in central bank accounts at minimal rates. To be on the safe side is still the call of the day. So far, the 1 billion [euro] guarantee umbrella rolled out by the governments for the money markets seems not to be working on the continent. The liquidity crisis is ongoing. As equity markets tumble, investors not only in the United States but also Europe and the rest of the world are counting their losses.

One reason the U.S. subprime crisis has turned into a time bomb for the international financial system is that a crucial legal difference in U.S. mortgage finance was often overlooked by investors in securitized mortgage debt instruments. The United States has a non-recourse mortgage system under which only the real estate property--the homes bought and financed by a mortgage contract-serve as collateral. Someone who buys a house and takes on mortgage debt is not--as is the case in most other jurisdictions--personally liable to pay back and service the mortgage debt. Mortgage lenders have no recourse to other property or income.

Also overlooked by many outside investors was the debt explosion in the United States in the run-up to the subprime crisis. As analyst Kevin Phillips notes, in the critical period from 2001 to 2007, outstanding foreign debt increased from $872 billion to $1,783 billion, an increase of 104 percent. Outstanding home mortgage debt grew from $4,923 billion to $9,961 billion, an increase of more than 102 per cent. Outstanding domestic financial debt expanded from $8,482 billion to $14,529 billion, an increase of 71 percent. And on a year-to-year basis between 2000 and 2006, the annual U.S. current account deficit increased from $420 billion to $857 billion, or 104 percent.

What makes things worse now: In spite of the buzz of formal and informal interchange between the official side and the private sector, tension and distrust between supervisors and the chieftains of the finance industry are still building. This hampers addressing the financial turmoil and working on initiatives to make global financial markets and institutions more resilient.

Both the official and private sectors are struggling with a credibility crisis of historic proportions. Supervisors and regulators on both sides of the Atlantic are licking their wounds. What happened in the United States under the eye of the Federal Reserve, the Securities and Exchange Commission, and other supervisory authorities has shattered the belief that a decade of reforming the international financial architecture and enhancing market and institutional stability has made global financial markets a safer place. And in view of the "supervision blackouts" in the United Kingdom, Germany, and Switzerland, Europe has also made its share of blunders. Repairing and rebuilding today's global financial model is all the more difficult. One of the few remaining icons on the global financial stage with credibility, former Federal Reserve Chairman Paul Volcker, sums it up rightly: "Simply stated, the bright new financial system--for all its talented participants, for all its rich rewards--has failed the test of the marketplace."

Major reasons the "bright new financial system" failed the test of the marketplace include the blocking of even minimal regulation of over-the-counter derivatives trading by key U.S. policymakers such as former Federal Reserve Chairman Alan Greenspan, former U.S. Treasury Secretary Robert E. Rubin, and former SEC Chairman Arthur Levitt; the tearing down of regulatory barriers in mortgage finance in the United States which paved the way for large-scale securitization and global marketing of subprime mortgage debt; and the SEC waiver of its leverage rules in April 2004. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net capital ratio of twelve to one. The 2004 exemption allowed them to exceed this leverage rule. Only five firms--Goldman Sachs, Merrill Lynch, Bear Stearns, Lehman Brothers, and Morgan Stanley--were granted this exemption. They promptly levered up to twenty, thirty, and even forty to one.

These were the Wall Street firms that provide the largest portion of campaign financing to Republicans and Democrats. And it was the millions of dollars flowing from the U.S. finance industry into the political system in Washington that helped tear down the remaining regulatory barriers and keep regulators at bay. Wall Street's "Masters of the Universe"--the five major investment banks and the globally operating commercial banking giants such as Citicorp, JP Morgan, and Bank of America--might have brought their downfall on themselves. But as it now looks as if they may have caused the worst global financial meltdown since the 1930s Great Depression. During the securitization boom they set themselves on the path to becoming multimillionaires. Now the political system they used to finance in order to keep markets free and unregulated has to socialize their staggering losses while helping to secure their private gains. The losers are the taxpayers, investors, and the unemployed.

Policymakers around the world who are struggling with today's economically and socially destructive global financial meltdown are learning the hard way that "regulatory capture made in the USA" can be more destructive and more costly than George W. Bush waging war in Iraq.

"Regulatory capture" is a term used to refer to situations in which a government regulatory body created to act in the public interest instead acts in favor of the commercial or special interest that dominates in the industry or sector it is charged with regulating. This theory, developed by Nobel laureate George Stigler and others, can be helpful in explaining at least partially how the worst global financial meltdown in our lifetime came about.

The levers of regulatory capture are not only influencing national regulatory and supervisory agencies but also international monetary and financial institutions. So one can ask: Did the International Monetary Fund or the Bank for International Settlements warn in time that the securitization boom with its frighteningly huge derivative volumes might end in a global financial meltdown? Was either caught by surprise?

Well, yes and no. Their staffs can argue that capital market experts at both institutions have published dire warnings for years. But they were not allowed to shed full light on the mountains of SIVs and conduits outside of bank balance sheets and what this may have meant in terms of systemic risk. In recent years neither the International Monetary Fund nor the Bank for International Settlements have provided aggregated overviews of the staggeringly large speculative investment flows through off-balance sheet special purpose vehicles that would have shocked market supervisors and policymakers. It didn't happen because it would have ruined the major segment of growth and profits--the securitization boom.

Here are some concrete examples from insiders of the International Monetary Fund and the Basel-based Financial Stability Forum on how regulatory capture works in such international bodies on issues that are sensitive to the interests of the world's biggest debtor.

"High on the priority list for the U.S. Treasury and the Federal Reserve Board was to keep the International Monetary Fund, the Financial Stability Forum, and other international bodies from assessing the U.S. financial system," says an IMF insider. "Since the International Monetary Fund started its Financial Sector Assessment Program in 1999, the world's biggest debtor country, the United States, is still playing the role of the 'Untouchables,' keeping the International Monetary Fund from having an in-depth look at the exploding debt that has been underpinning the U.S. housing and spending boom during recent years." The IMF website offers FSAP assessments for Uganda, Ukraine, United Arab Emirates, the United Kingdom, and Uruguay under the letter "U." The United States, whose financial sector absorbs a large part of the world's savings and capital surpluses, so far doesn't appear on the FSAP list. This may also explain, argues the IMF insider, "why in recent years U.S. policymakers made sure that not much aggregate global data on the so-called 'shadow banking' structures, flows, and leverage trends was gathered and published by the major financial institutions."

According to insiders, this policy of the "invisible hand" to limit IMF surveillance of exploding U.S. debt went farthest under the reign of Anne O. Krueger as first deputy managing director (September 2001-August 2006). To make sure that discussions of the vulnerabilities of the U.S. financial sector would not be showing up in IMF Article IV...