S&P and the Fraud of Government Regulation

"Oh, what a tangled web we weave, when first we practice to deceive."

So wrote the Scottish poet Walter Scott two centuries ago. Perhaps we should have an updated version for the modern world: Oh, what a tangled web we create, when first we practice to regulate.

There's a connection between these two sayings. Government regulation is a form of deception. It is deceptive advertising, backed by compulsion.

The basic claim behind the regulatory state is that one actor in the markets, the actor designated by the government, is somehow omniscient. They know what investments are safe or unsafe, and their judgment should be elevated over everyone else's and made to rule.

Keep this in mind when you hear the recent complaints about Standard & Poor's and the other credit rating agencies. Some of these complaints have a grain of truth to them. S&P was asleep at the wheel in the years before the financial crisis, passing off AAA ratings on mortgage-backed debt, and now they are desperately trying to regain their credibility by taking a hard line on US government debt.

But these agencies are themselves the creatures of government and of the regulatory state. They were the answer to the problems that regulators previously promised to fix. In order to ensure the solvency of the banks, regulators issued rules about what kind of risks banks could take. But those rules required someone to rate the risk levels of various investments, a job that was outsourced to the ratings agencies.

Here's where we get to the tangled web. Using the ratings issued by private credit agencies as the basis for regulation meant using state power to support private entities. There were two reasons for this. The first was to preserve some element of choice and competition, creating an oligopoly on credit ratings instead of a monopoly. The second was to do things the easy way. The government would not have to create a whole new bureaucracy and put itself in the business of evaluating every single investment vehicle in the world. It could simply ride off of the existing structure of ratings agencies. The power was outsourced to others, but so was the work, the expense, and the responsibility.

The alternative to the power of the ratings agencies is for the government to second-guess the creditworthiness of every investment, or even to create its own credit rating bureaucracy and give it an exclusive monopoly

So you see the dilemma. On the one hand, the assessment of credit was outsourced to agencies that are not directly controlled by government and which could (and did) make bad decisions. On the other hand, the only alternative is to wipe out last vestiges of private competition and choice and take on a vast new job for government that it is not equipped to perform.

And of course there is no guarantee that the government would do any better. In fact, they are guaranteed to do worse, simply by the very fact of dictating credit standards from Washington. The Wall Street Journal calls this the "regulator's dilemma." If regulators dictate a single set of credit standards for everyone, they guarantee that if those standards fail in a crisis, they will fail for everyone, all at the same time. If they encourage everyone to load up on mortgage debt because it is rated AAA by Standard & Poor's, then when a mortgage crisis hits, everyone will go down. This is how regulation creates "systemic risk."

Remember that the new Dodd-Frank financial regulation bill was written by two of the politicians, Senators Chris Dodd and Barney Frank, who were in the forefront of promoting subprime mortgages, pushing for easier loans in the name of "affordable housing," and infamously assuring the public that Fannie Mae and Freddie Mac had no financial problems whatsoever. This is the essence of the fraud of the regulatory state. It creates the illusion of guaranteed safety, the illusion that we have eliminated the risk of institutional failure, but without creating the means that would actually produce such a guarantee, because the means do not and cannot exist.

Hence we are sold the idea that a regulatory framework created and run by all-too-fallible people would somehow be omniscient. We are told that Dodd-Frank will somehow achieve what Dodd and Frank could not.

To put the point somewhat differently, this is an attempt to guarantee a risk-free banking system, run by a government that cannot maintain its own risk-free rating. Which gives you some idea why the defenders of the current system have suddenly turned against Standard & Poor's.

In practice, the attempt to crack down on the supposedly lax policies of the past will not produce super-regulators who know everybody's business better than they do. It will create an army of meddling busybodies clogging up private finance with arbitrary restrictions.

Here's a case in point: the story of a profitable local bank, Main Street Bank of Kingwood, Texas, that is attempting to divest itself of its government-issued banking charter in order to escape strangling regulations. Why?

In July 2010, the FDIC slapped Main Street with a 25-page order to boost its capital, strengthen its controls, and bring in a new top executive. Regulators also said the bank was putting too many eggs in one basket. Mr. Depping says regulators wanted the bank to shrink its small-business lending to about 25% of the total loan portfolio, down from about 90%.

Mr. Depping says he explained to regulators that Main Street has focused on small-business lending since he bought the bank in 2004 with a group of investors.... "We felt that servicing small business is something the country needs and that we're really good at it. I thought the model was working just fine," Mr. Depping says.

Main Street also was required to increase its capital cushion and prohibited from substantially expanding its balance sheet.

Do the regulators at the FDIC know Main Steet's small-business borrowers better than the bankers do? Of course not. This is just a flurry of diktats meant to cover the backsides of the regulators, so they can't be blamed if anything goes wrong. And what did Main Street do in response to these orders? "Main Street bolstered its capital levels by getting smaller." And then the geniuses in Washington wonder why the banks aren't lending and the economy isn't growing.

This story reads like a parable or morality play. This is a profitable bank, it specializes in lending to small businesses, and it's even called "Main Street Bank," as if to make sure that we get the point. Could you devise a better symbol of what is stifling the economy?

Main Street Bank is struggling to escape this web of regulation, and to do so, they have to give up on the government guarantee of federal deposit insurance. Now that the guarantor behind that insurance is no longer rated AAA, perhaps that's not much of a loss. The only loss will be to the general public. Without FDIC insurance, Main Street will no longer be open to taking deposits from the general public. All of the returns it earns will instead go to big private investors: a new entity backed by Microsoft co-founder Paul Allen.

But Main Street Bank is onto the right idea. Give up on fraudulent government guarantees, and go to a system in which everyone assesses risk on their own, without the illusion of government support and without the interference of government minders. Set the market free from the tangled web we weave when first we practice to deceive the markets about the risk-assessing power of government bureaucrats.