Some thoughts about SOX II

The government is going to throw a lot of money (up to $700,000,000 “outstanding at one time,” which could be repeated purchases up to that amount followed by sales at lower amounts). Comforting to know there’s a “possibility that taxpayers could profit from the effort.” (CR notes the humor.)

But unfortunately that trillion bucks or so is only the beginning of the problem.  It's going to be surrounded and followed by lots of regulation. See my Bubble Laws, 40 Houston L. Rev. 77 (2003). In other words, get ready for SOX II.

There’s a general view that recent events show a failure of the capital markets to deal with their problems, necessitating government interference. At the risk of shouting into a noisy wind, let me suggest that it’s not so simple. Yes, the capital markets have floundered. But that doesn't mean we want or need another SOX. 

The big problem we face now is finding out how much assets are worth. Only markets can do that.  Surely the government hasn't a clue.

Some say that it’s evil over-complex derivatives that got us into this fix. Well, if the problem is over-complexity, we might ask why the market would produce more complexity than it needs. Tyler Cowen links an old Jane Galt post that provides part of the reason: 

Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people . . . don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship. * * *

I strongly suspect that substantive regulation of the derivatives markets will lead to still more complexity by inducing the markets to work around the additional regulation.

The above post goes on to suggest we need more disclosure.  I wonder. The market is already buried under a mountain of disclosure. Clearly ordinary investors can’t sort through this, and the sophisticates probably don’t need it. For example, while “mark to market” may not have caused all of our problems, I seriously doubt that it helped.

Is this really a disclosure problem? As I have discussed, the problem was really fairly simple -- the mortgages on which the derivatives were based were valued based on patently unrealistic assumptions about real estate prices. This wasn't as much a disclosure problem as a governance problem with the managers who were buying all this junk.  The response is better incentives.

As I noted in my post, a possible answer to governance problems is partnerships like hedge funds, which have actually had fewer problems than financial corporations in this whole mess. For much more on this, and must reading, see Houman, Shadab, The Law and Economics of Hedge Funds. Houman will be making an exceptionally timely presentation of his paper in my Illinois Business Law and Policy Colloquium tomorrow.

Despite these considerations, expect hedge funds -- a perennial scapegoat -- to be a potential target of regulation in the aftermath of this crisis.

We do need more information.  Efficient securities markets could provide that information even without more disclosure laws.  This makes it all the more surprising that regulators should seek to clamp down on short selling.  Always seeing the glass as half full may be a nice comforting philosophy, but it's not going to illuminate the way out of the current crisis.

So we need is better managerial incentives and more information. Yet by regulating short-selling and hedge funds, we might get less of both. In other words, unless we really try to understand what went wrong, throwing more regulation – more disclosure, more regulation of hedge funds, more government ownership of overpriced assets -- at the problem not only won’t help, but is likely to hurt.

At the end of our book, The Sarbanes-Oxley Debacle, Henry Butler and I suggested some guidelines for better future regulation: Periodic review and sunset Provisions, optional rather than mandatory rules, nuanced regulation focusing on the specific problems that cannot be dealt with by optional rules, investor education and deregulation.  We might consider these recommendations now.

SOX was sold as the way to prevent future market bubbles and crashes. Obviously, in addition to imposing huge costs, it utterly failed to deal, not only with some indefinite future, but with problems that were already brewing at the time SOX was enacted. Indeed, SOX may well have hurt by helping to make investors complacent. Enough is enough. Let’s try to think before we leap again off the regulatory cliff.

Comments

[logsk]

The idea that the taxpayer may see a positive return on "their" investment is ludicrous. If this were so, the market would have taken note of such potential and we wouldn't be discussing how best to nationalize this mess.

[Morgenstern]

OK, maybe we don't need more regulation. Maybe we just need existing bank regulation to cover the whole banking system - i.e., the shadow banking system as well as the sunlit one.

But as long as there is some banking regulation there is going to be a regulated/unregulated boundary that lends itself to financial-engineering-based arbitrage efforts.

Now you could argue that we should go all the way to no regulation - "full retard," in Tropic Thunder terms. That's fine, but what do we know about the performance of unregulated banking systems in non-US countries or possibly in other times?

[Sprizouse]

Did you ever think that derivatives were made complex by the i-bankers to artificially move interest rates and spreads? If nobody really knows what the correct prices are for the derivatives isn't the mark ripe for arbitrageurs?

That's a more likely explanation for the rise in the popularity of derivatives.