Blame regulatory lapses for crisis

Crumbling bank facade

I’ve just finished reading the Financial Crisis Inquiry Commission report. That's no easy task.

Much of the report is taken up with examining the role of deregulation and regulatory failures in causing the financial meltdown.

The Commission is split along party and ideological lines. Six members (all Democrats) conclude that inadequate regulation was a significant factor in creating the crisis; three (all Republicans) say it wasn’t.

(A fourth Republican contends that "no significant deregulation of financial institutions occurred in the last 30 years.")

As a first-year law student, I was taught the "but for" test of factual causation. This holds that if, but for A, B would not have happened, then A "caused" B.

Under this test, regulatory lapses clearly caused the financial disaster of 2008.

Take structured finance and derivatives, for instance.

We can all agree -- I think -- that our system almost collapsed when exotic financial instruments, like collateralized debt obligations (CDOs) and credit default swaps (CDSs), involving enormous leverage, went sour.

Just where did this stuff come from?

When I started practicing law in the early 1970s, there were no CDOs or CDSs -- no synthetic CDOs or CDOs-squared. And you couldn’t finance illiquid investments with $40 of borrowings for every $1 of equity.

It’s not that financial professionals weren’t smart enough, or imaginative enough, back then to think these things up.

It’s that they were illegal -- or at least highly questionable -- under laws regulating investment companies, commodity futures contracts, securities and securities credit, and gambling, among others.

Anybody engaging in such financial activities risked being tossed in the slammer.

Slowly, but relentlessly, starting in the 1980s, these legal obstacles were eliminated through legislative and regulatory changes. Previously unknown financial products and transactions, and virtually unlimited leverage to support them, once prohibited or legally dicey, became possible.

Those promoting the changes (including lawyers like me) weren’t overly-concerned about unintended consequences. We agreed with Alan Greenspan that financial "creativity" should be encouraged and markets should be left to regulate themselves.

We were wrong.

Now, I know there were myriad other causes of the financial meltdown, many unrelated to financial regulation or its absence.

But I don’t think downplaying the role of regulatory failures does anyone any good. It’s not true to history, and it won’t help prevent a repeat of what we all so recently suffered through, and don’t want to see happen again.