Exporting hazardous products

Suppose a large trading nation is found to export huge quantities of products which have not been subject to proper regulatory oversight at home and create important risks for the buyers. And suppose further that importing nations have had to face serious repercussions as a result. When pressure is brought on the exporter of hazardous products to tighten its act and to increase regulatory cooperation with other nations, the country scoffs and says: "this is a domestic matter; we do not need any international oversight or pressure."

No I am not talking about Chinese toys. I have in mind instead complex financial instruments sold by the U.S.--which having been improperly evaluated by U.S. rating agencies and hence mispriced, and having been marketed abroad in huge quantities, are now wreaking havoc in financial markets everywhere. 

The New York Times reports today that other countries are calling for a say in U.S. regulatory practices:

Politicians, regulators and financial specialists outside the United States are seeking a role in the oversight of American markets, banks and rating agencies after recent problems related to subprime mortgages.

Their argument is simple: The United States is exporting financial products, but losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks.

...

In general, Washington’s reaction has been that it wants “no form of oversight,” said Kenneth Rogoff, an economics professor at Harvard and a former chief economist of the International Monetary Fund.

...

Banks and investment funds from China to France suffered losses after buying mortgage-related securities and complex financial products based on them in the United States.

In many cases, investors were caught by surprise because American rating agencies had given the products top ratings, leading buyers to believe there was little risk. International investors are also asking why American lenders were allowed to give mortgages to home buyers who could not repay them.

The NYT does not note the parallel with Chinese exports of hazardous toys and other consumer products, but the parallel is too obvious to miss.

Once again, the globalization trilemma rears its head: If you want more economic globalization, you must either accept more global regulation or be willing to pay a higher political cost for adverse side-effects. 

Comments

[robertdfeinman]

Or you can use your economic and military strength to force others into lopsided deals (at least until they gain enough power to resist).

The US is a bully and only changes its behavior when forced to. Look at the behavior after the WTO talks stalled. The US just went around the organization and made bilateral agreements. This allowed them to divide and conquer.

[Per Kurowski]

The misled investors, who should blame themselves too, need not to come to the United States to express their complaints since for that they could just to turn to their own central bank and bank regulators who all, hand in hand with the IMF, played a role as fervent collaborationist with The Bank for International Settlements (BIS) in promoting that crazy idea of empowering the credit rating agencies through the standardized approach for capital requirements set out in BASEL I.

I have been writing on this issue since 1997 and as I happened to become an Executive Director at the World Bank I got invited to make some comments "Risk Management Workshop for Regulators: Assessing, Managing and Supervising Financial Risk" arranged by the World Bank in Washington during the week 27 April – 2 May 2003. This is what I told them about the credit rating agencies.

“I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

Of course, I never got invited to speak to them again.

[Kenji]

It's baffling to me that so-called sophisticated investors have continued to rely on credit-rating agencies' ratings, after the Enron debacle. Maybe, they need to feel more pain before they realize that they should do their own due diligence work.

[Justin Rietz]

Dani -

Why would regulation have controlled the situation any better? If we assume the credit agencies were acting in good faith, then is there any reason to assume government regulators would have recognized issues sooner? If the credit agencies were negligent, they, along with conspiring financial institutions, will face massive lawsuits (and if they were willing to risk massive lawsuits, I am guessing they would have taken the risk to find a way around regulations).

Per Kurowski - Would you provide a little more detail as to what regulatory power was given to credit agencies?

From a slightly different perspective, the U.S. legal system has at its foundation the belief in innocence until proven guilty. Regulation, on the other hand, assumes "you will do something bad, so I am going to take preventative actions to stop it".

[Per Kurowski]

Re Kenji: “It's baffling to me that so-called sophisticated investors have continued to rely on credit-rating agencies' ratings, after the Enron debacle”

Do not believe for a second that the credit rating agencies have grown into the big monsters they are just by doing there job right.

Re Justin Rietz: “Would you provide a little more detail as to what regulatory power was given to credit agencies?”

It is all over the place but let us say that the core of it all lies in their role for calculating the Minimum Capital Requirements according to the regulators in Basel. It is a bit lengthy, sorry, but the following document would give you the most on that http://www.bis.org/publ/bcbs118b.pdf

Re Justin Rietz: “the U.S. legal system has at its foundation the belief in innocence until proven guilty”

Since the credit rating agencies say that they are only giving opinions which are protected under the First Amendment, in that case you might have to go after those who forced you to listen to these mere opinion-makers, namely the bank regulators. You see, the plot thickens.

[hari]

Dani -

I've commented on this subject when you first tried to discuss its ramifications:

I've an uncanny belief that there 's a lot more greed and lack of remorse in US "capitalist morality" when dealing with not only globalization issues (which impinge on national sovereignty) but its own lack of accountability in fianancial markets.

The middle-men have been the swindlers in subprime scandal which Congress should fully investigate and expose to (housing) public.

What Rogoff is referring to is "laissez-faire" capitalism - without any constraints. It'll inevitably come back to foreclose the ruin of the system itself, if care is not taken to avoid the manipulators of the financial derivatives market.

[Per Kurowski]

Re Hari: “The middle-men have been the swindlers in subprime scandal”

It is hard though to identify the middle-men as they could be so many and also after a dirty-war you really do not want to go after the soldiers but you would try to look more towards the generals.

Having said that and had I been investing through a hedge fund in some type of sophisticated derivatives which current values were calculated using a financial model of theirs; I would at least be pursuing someone to get back all the perhaps faulty commissions I was made to pay on what turned out to be purely theoretical profits.

Let us not forget that it is not so much that the market turned against them as the suddenly discovery of some fundamental flaws.

[johnchx]

My sense is that the purpose of credit ratings "agencies" is to defeat claims of mens rea, making criminal prosecutions impossible. If a money manager can say, "I relied upon S&P and Moodys," it's difficult to prove that he knew perfectly well that the securities in question were riskier than advertised and that their sale constituted actual fraud.

[Per Kurowski]

Re Johnchx “My sense is that the purpose of credit ratings "agencies"…”

Absolutely not! If all this had anything with to do with a bad intention on purpose it would be much less dangerous than what it is and it would never ever have the intrinsic power of turning itself into a pure systemic risk.

The truly dangerous part of this is that the whole system was put in place just because the regulators thought bona-fide that they thereby could tame the beast of risks. Now it happens to be that the beast is untamable… just went into hiding for a while, and as the regulators should have known had they not been too arrogant.

[op]

dani
displays a devilish
way with analogy
and
not for the first time

[conundrum]

The analogy is very well chosen but the policy recommendation is the same: There is no need for outside intervention. American importers have plenty of opportunities to inspect their merchandise and will do so when consumer want them do. Similarly, Germany's bank regulator should probably concontrate on the incentives of state-owned 'Landesbanken' to gamble with taxpayer's money before trying to regulate the US mortgage market.

[sbo]

@ conundrum

I believe both are somewhat right - Dani and you (or foreign and US regulatory authorities):

Ofcourse, every state has its right to govern things as he likes - China as well as the US, Iran as well as Israel. And every foreigner getting in contact with that state should inform him/herself about and adopt to the rules applicable. And might risk to run into trouble due to cultural differences if he/she doesn't invest enough ressources in double-checking.

But if there where more international supervision and regulation of financial markets, this would significantly reduce costs for this kind of research, removing or lowering barriers to entry and improving competition. A good example are the efforts of the EU which usually serve well (contrary to common believe it's usually the national policies of the member states that prevent optimal implementation of EU plans).

The time being, there are two conclusions:
a) foreign national regulators should focus on controlling there local banks and impose efficient control on their offshore SIVs.
b) a deeper integration and cooperation of international finance regulators could save significant costs but from an US point of view does not seem neccessary because the USD still attracts sufficient foreign investment without providing better protection for investors.

[jp]

Dani makes an interesting analogy between the export of goods and the export of financial instruments. If the quality of one should be internationally regulated, than so should the other.

The US exports stocks too. And stocks are incredibly complex to analyze... reams of financial statements, complex industry dynamics, as well as uncertainty about the future. Does Dani think stock analysis should be regulated too by an international governing body, since these are risky exports? Or are they not risky enough? How will he define this line?