Public Policy Analysis & Opinion

When the buzzards come home to roost

The deregulatory fervor is now paying all of us negative dividends

By Kevin P. Hennosy

Where to begin? How about here: I told you so—financial deregulation was a very bad idea.

The rabid pursuit of deregulation undermined confidence in the world’s most successful con game: Wall Street. When the con collapsed, the banking, insurance and securities sectors were pulled into a vortex of mistrust. For a commercial sector that depends on trust, this swirling mess is particularly damaging.

The crisis at hand never had to happen. Until 1999, there were statutory firewalls in place to insulate problems in one sector from spreading to another. The Glass-Steagall Act’s firewalls were based on more than a century of experience with financial booms followed by busts. The Act established a framework for competition for consumer dollars among banks, insurers and securities firms because each sector offered different products designed to provide unique attributes.

But in 1999, that competitive framework was dismantled by the Gramm-Leach-Bliley Act (GLBA), which carried the fraudulent name of The Financial Services Modernization Act. Contrary to its Orwellian name, the GLBA had nothing to do with “modernization.” The GLBA reinstated a framework that would have been quite familiar to the robber barons of the 19th century. Once in place, a cohort of self-loathing regulators refused to utter the most important word that any regulator can say: No.

It appears that the chickens came home to roost in September 2008—or were those buzzards?

Until and unless the United States restores an effective regulatory system over its financial services sector, the Greenback will continue to garner the respect of the Confederate Dollar.

The failure of American International Group (AIG) and the fairytale “instruments” that the company sold to banks like so many magic beans was the fruit of deregulation. Through the alchemy of securitization, all kinds of financial impurities—including but not limited to bad loans—were sold in plain brown wrappers.

The “securitized” instruments fogged up the transparency which the “magic of the marketplace” demands. Institutions that were engaged in unsafe or unwise business practices were shielded from any repulsive reflex in the marketplace because securitized instruments hid the true nature of their enterprise.

These institutions retained the profits while concealing and transferring the evidence of their business indiscretions by selling little packages of financial risk in those plain brown wrappers. And the purchasers of those securitized instruments shielded the true nature of the investment portfolios. It was as if they had a warehouse full of nuclear waste, but they marked all the containers “POWDERED MILK.”

What Congress and the courts have named “the business of insurance” was never supposed to be a flashy commercial sector. Among the financial services sector, insurance has served the same role that a milk cow played on a family farm. Old Bossy was not much to look at but her milk provided the family an important source of nutrition, and maybe a little income at the market. In addition, even her manure could be worked into the soil and improve the production of cash crops.

Of course there have always been insurance executives who have wanted to dress up Old Bossy and make her something she was not. Fred Carr comes to mind with First Executive Life, a story that ended in massive insolvency.

In that vein, Maurice “Hank” Greenberg followed the same pattern at AIG. First of all, I believe you can go to school on a man who rejects his own name and adopts the moniker of a baseball hero—this guy is just not comfortable with reality. Like the ambitious little man named “Jack” in the informative story of the Beanstalk, Hank Greenberg traded the largest cow in the world for a bag full of magic beans.

Greenberg specialized in the collection and distribution of magic beans. Just a few years ago he lost his control of AIG in a scandal over a magic bean known as Finite Reinsurance, a product that, contrary to its deliberately misleading name, did not limit or transfer risk.

Greenberg was able to sell these magic beans because he committed a great deal of time and money to lobbying public officials. The AIG lobbying team that worked over the NAIC during the past 20 years was a particularly arrogant bunch. The AIG lobbying corps might try to cajole regulators if they had to start the attack in a civil manner; however, they seemed to enjoy pushback, which allowed them to adopt a confrontational manner.

The AIG specialty of Credit Default Swaps was just like insurance, but they were not technically “insurance”; therefore, the company entered a netherworld bereft of oversight. The Credit Default Swap concept was a magic bean among magic beans. In the mid-1990s, before the bean merchants polished their sales pitches, this kind of transaction was still known by the name “synthetic asset.” While the term “synthetic” can have several meanings, if the term simply means “human made,” there would have been no reason to modify the term “asset” with the term “synthetic.” It is not uncommon for an asset to be made by human action. No, here the phrase “synthetic asset” refers to another meaning: “fake, mock, unreal, and imitation.” The NAIC wasted years discussing the merits of fake, mock, unreal and imitation assets rather than just saying NO.

Credit Default Swaps were synthetic on so many levels. The swaps were an insurance-LIKE transaction that fell outside of insurance regulation. It was an investment instrument that fell outside of the jurisdiction of securities regulators. The swaps could be sold like a product but took no physical form beyond a series of mathematical formulae written by professors who stood to gain financially from what the proof “proved.” A cottage industry of mathematical camp followers went to work producing papers to lend scientific gravitas to the sale of magic beans.

Thanks to the legislative handiwork of former Senator Phil Graham, the Grand Wizard of Deregulatory Enchantment, all regulatory agencies were banned from asserting authority over these risk transfer products.

From AIG, the so-called instruments spread like a contagion, undermining safety and soundness as they moved through the international financial system. It will take a long time and a lot of effort to find out just how unsafe intercourse took place which allowed the contagion to spread, but in the absence of Glass-Steagall Act’s prophylactic firewalls the contagion became a pandemic.

It also must be noted that a whole cohort of regulators who served in office over the past two decades showed a punishing lack of curiosity, which did direct harm to the public interest. There was no concerted effort by insurance regulators to investigate and police the “synthetic” assets being reported on insurance company financial statements.

In fact, the NAIC even stayed efforts by its own Securities Valuation Office (SVO) when the staff raised questions about some valuations being placed on insurer-held investments. Former Illinois Commissioner Mark Boozell pummeled the SVO until serious professionals were run away from the staff, only to be replaced by obedient minions. In addition, the NAIC changed its rules to make the SVO deferential to private rating agencies, which we now see were doing little more than rubber stamping investment instruments for a fee.

This is not to say that AIG was the central actor in the financial meltdown, but the company was a particularly active player in cajoling, pressuring and bullying the public’s referees to look the other way, while their business operations ran in the open field carrying scissors in both hands. I guess it was fun while it lasted.

But of course it did not last forever. The Utopian world that proponents of deregulation promised has come crashing down.

There are numerous other insurance companies and related institutions that are still engaged in activities that invite trouble. For instance, there are large portfolios of mortgage-backed securities being carried at par value on insurers’ annual financial statements. The rule that allows this fraudulent reporting to carry on dates back to the 1930s, when life insurance was a product based on fixed premiums and fixed payouts.

That is not an accurate description of today’s life insurance products, but the old rules still remain. If the life insurance sector was required to mark its investments to market, which is readily defensible for today’s investment-oriented products, there is no reason to doubt that there would be a solvency crisis. We have to continue to lie about the health of the sector in order to preserve its survival.

Furthermore, the breaking down of the venerable “firewalls” between financial sectors has proven to be a singularly stupid idea that Phil Graham and his cronies never should have been allowed to act upon.

Contrary to allusions being drawn by political speechwriters and others, Wall Street is not a casino. In a casino, the house always wins. It’s more like a gathering of drug addicts. Most of those who fancy themselves operators on Wall Street are merely addicts looking for their next buzz.

The brokers, the investment managers and other users like to talk about the freedom, but they are some of the least-free people on the planet. They work for the thrill of the next fix. Sure, there is excitement and short-term reward. But once they know that feeling, the users will do anything they need to do to get their next fix. Any moral or ethical framework that they might have been given through rearing, education or mentoring simply melts away. The users serve the interests of their Pushers—financiers who control major financial institutions, which includes banks and insurance companies.

The user’s primary job is to convince large numbers of people of relatively meager means to give part of their wealth to the fabulously wealthy Pushers. This counter intuitive exchange is the basis of all commercial activity that we have come to call financial services.

The Pushers make money as long as they do not make the fatal mistake of using their own products. When they cross the line and become users, they die. Without strict and constant regulation of their activities they ALWAYS cross the line. Temptation is too great.

Now does this mean that I want to ban “Wall Street” and all the feeder activities that collect money for it? No, far from it. I reject Aquinas and his phobia of usury. As was the case in the prohibition of alcohol, banning activities only serves to drive them underground and make them more dangerous.

For example, I prefer the existence of licensed establishments to speakeasys. The former are subject to health and safety regulations and even some level of taxation. The latter are subject to ownership and control by shadowy figures who may cut costs through augmenting the product with chemicals, ignoring fire codes and pocketing proceeds of a cash business.

People can still have a good time in a licensed bar or tavern; they just might not have as much fun as they can have in a speakeasy—but they tend to live longer in the former than the latter. Investors could still make plenty of coin on a regulated Wall Street, but they could patronize Wall Street with reasonable certainty that they would not be served a Mickey.

The near-death experience that the financial sector entered in October 2008 should put an end to the utopian lie of financial deregulation. A new, efficient and federal regulatory framework should be constructed to serve as a stabilizing counter-balance to financial institutions and markets. If we do not learn from this experience we invite disaster.

After the stock market crash of October 1929, reporters asked the economist and former life insurance executive John Maynard Keynes whether he was aware of a comparable instance in history. He hesitated for a moment and then answered: “Yes, it was called the Dark Ages and it lasted 400 years.” *

The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.