Eliminate regulation! Let the market work it out! I’m 99% receptive to the laissez-faire mantra. But examining exceptions is more interesting than repeating obvious ideology, so let’s look at an exception.
Even the most dogmatic laissez-faire advocates, if reasonable, will acknowledge the need for transparency to permit markets to function efficiently. For example, you need access to accurate financial statements to estimate the value of a company’s stock. Thus LF advocates agree with regulations that enforce transparency.
But what is transparency? The usual definition is to make more information publicly available. But this misses a fundamental observation: complexity diminishes transparency. To appreciate this, consider an example we have all experienced.
In the past year, you have probably clicked through dozens of license agreements in various software programs and Web pages. For example, on a Mac you clicked through more than a dozen agreements last year simply to run system software upgrades.
These are binding contracts. But have you read all of them? Any of them?
Of course not. There isn’t time. It could take 100 hours a year — about two weeks of work time — just to read your clickthrough agreements. So you don’t. Now you have a somewhat opaque business relationship with your software and Web service vendors, because the aggregate complexity of all such agreements exceeds your real-world capacity to absorb their meaning.
Similar examples include credit cards and insurance policies. The typical homeowner has a half dozen of each, each with a binding agreement of 10,000 words or more, which is typically modified one or more times per year. No one reads them, because no one can.
It turns out that the end buyers of mortgage-backed securities were in a similar position, but with a difference: they typically had a fiduciary duty to understand what they were signing. Faced with the real-world impossibility of understanding the wildly complex MBS agreements — some of which are more than a thousand pages — they could have chosen not to buy. Instead, they laid off the fiduciary responsibility to the rating agencies, simply assuming that AAA meant “safe,” as it had for the century prior to about 2004.
One could argue it was reasonable to believe the ratings, and that rating agencies blew it. Or, one could claim (as rating agencies now do) that rating agencies were faced with the same problem: the instruments are too complex to rate with confidence, and thus the buyer should fend for themselves. But either way, the central problem is that the instruments themselves are so hard to understand that even professionals don’t get it.
This illustrates the complexity vs. transparency issue vividly. By the traditional definition, MBS are utterly transparent, because you can obtain and read the entire agreement before buying. But by any practical definition, they are opaque, because real-world buyers — even fiduciaries like bank investment managers — don’t have enough hours in the day, and possibly not enough theoretical background, to evaluate them. Moreover, there is the well-documented psychological problem that almost everyone overestimates their understanding of complex things.
Caveat emptor? The laissez-faire dogmatist might argue that those who don’t understand should simply not buy. Again, true in theory, but again with a real-world, practical problem: as MBS are currently prepared, if everyone who didn’t understand them didn’t buy, there would be no MBS industry.
“Well, maybe there should be no MBS, then!” some will say. This is like saying, “fire is always bad because it burned me once.” Fire is so useful that we tolerate occasional catastrophes. Similarly, a stable MBS industry has such enormous benefits, from a capital efficiency standpoint, that we have an interest in seeing them presented simply enough to permit real-world transparency, and thus reliable ratings and comprehending buyers. Tame the fire; don’t extinguish it.
I conclude from this that federal regulation may want to focus on a “reasonable man” standard for simplicity in the presentation of financial instruments to certain types of buyer. Not because careless buyers deserve it, but as a way to make complex instruments usable in the real world.
—
