Federal Judiciary

That is our main concern with Arnold Kling?s NR piece ?Break Up the Banks.? The problem is not bigness but blindness, and it applies to the entire financial sector.

First, the good news. As a respected economist with impeccable libertarian credentials, Kling is just the guy to deliver a message free-market conservatives desperately need to hear: Banks, and especially federally chartered banks, are not free-market institutions. ?Just deregulate? is not a satisfactory answer to the bank problem any more than it is to, say, the lawyer problem.

Deregulating lawyers eased the path to litigation and so expanded the power of the courts over our lives. Similarly, so-called bank deregulation vastly expanded government power. Black-letter law was replaced with regulatory discretion, creating the most politicized banking system in U.S. history and inspiring such great crony-capitalist ventures as that powerhouse firm Fannie, Freddie, Dodd, & Frank.

The market unassisted can?t regulate banks because the banks, as the foundation of the credit system that supports the dollar, are inextricably intertwined with government. Our failure to grapple with this has left conservatives speechless on financial reform. Our admirable instinct to ?just let the market do it? has put us in a box. Kling shows us the box.

Alas, Kling?s analysis falls apart with his vague, poorly supported claim that it was the sheer scale of the banks that made them dysfunctional. The problem goes much deeper. Both the mortgage crisis and the bank panic it precipitated were overwhelmingly crises of lost information.

Markets are made of minds, thinking. But public securities markets, even at their best, have always tended to be rather mindless: speculative, frantic, self-reflexive trading centers untethered to serious analysis of value. Adam Smith saw this; so did the old masters of investment analysis such as Benjamin Graham (Warren Buffett?s teacher), who regarded the stock market as psychotic.

As with a mental patient who sees things that aren?t there, the psychosis is rooted in bad information. Securities markets treat highly complex firms almost as if they were bushels of corn, making billion-dollar trades on the basis of the sort of minimal formalized information one uses to buy or sell a grain future.

In recent decades this tendency has gotten much worse as the financial establishment -- the MBA programs, the great banks and investment houses, the regulators -- was gripped by an ideology proclaiming these most dysfunctional of markets to be the heart and soul of capitalism. So profoundly does this modern ideology worship securities markets that the MBA students who go on to run your bank or manage your money are actually taught that it is dangerous even to try to out-figure the all-seeing market on price or value.

This apparently pro-market outlook became almost Soviet in its preference for centralized information processing over the ingenuity of individual investors and entrepreneurs. As we write in our new book, Panic: The Betrayal of Capitalism by Wall Street and Washington, ?To these#...#markets the priesthood of finance attributed powers of calculation and control far exceeding#...#the fondest dreams of any Communist commissar pecking away at the next Five-Year Plan.?

Unfortunately, conservatives, naturally inclined to cheer on all sorts of markets, have often taken the modern view. Larry Kudlow is a good friend and a truly great economist, so we can pick on him with impunity. Every time Larry proclaims the stock market the ultimate source of truth about the economy, he puts capitalism?s worst foot forward.

The ?securitization? of the mortgage market was driven precisely by this dogmatic worship of securities markets. Bankers and regulators alike truly believed that pushing the mortgage market out of the ?back rooms? of overcautious bank officers and onto securities markets would make mortgage lending more efficient and transparent.

Just the opposite happened. Complex, multiple securitizations made it all but impossible to relate defaults on individual mortgages to the health of the banks that held the securities.

Even worse, moving mortgages onto securities markets put investors with none of the expertise or information available to traditional mortgage bankers in charge of pricing. First the mob priced them too high; then it panicked and priced them so low the banks appeared to be broke.

Were the banks broke? We still don?t know. That?s the other half of the information problem.

Under the reign of modern portfolio theory, too many Americans, especially institutional investors, have been investing almost blindly for decades.

Nowhere has the darkness reigned so powerfully as in the banking system itself. At least since the New Deal, the U.S. government has taken the position that the less the public knows or even thinks about what the banks are doing, the better.

The credit system -- not surprisingly, given its name -- operates on trust. The government?s bizarre position has been that this trust rests more securely on blind faith that government will protect the banks than it would on the informed judgment of investors that the banks were being managed soundly. Government has been asking us to trust but refusing to let us verify.

And that leads us to the one really radical, really earth-shaking, and really effective reform conservatives should be shouting for: Don?t break up the banks --  open them up.

As quasi-public institutions, afforded astonishing privileges in support of their public function of supporting the dollar, banks have zero right to privacy. That?s good, because the one and only new law we need -- and it needs to be a law, not a ?flexible? rule -- is a requirement that the banks fully disclose, at the finest level of detail, every investment they hold on or off their balance sheets.

We don?t mean accountant?s summaries. We mean the name and number of the stock, the bond, the option. Published every Monday morning before the markets open. (We work in the investment industry. Just so no one thinks we are pushing this for our own advantage, we think the rule should apply to all investment firms with at least $10 million in assets.)

The banks would absolutely hate this. But that?s only one reason it?s a great idea. This kind of disclosure absolutely would have kept the mortgage crisis from becoming more than a speed bump and certainly would have prevented the banking collapse of September ?08.

The really bad mortgages, the ones that crashed the system, were written from late 2005 through early 2007 -- after it had become clear that mortgage defaults were rising dramatically. But investors kept funding the banks -- and the banks kept lending and buying mortgage securities -- because investors could not draw a straight line between the general information that defaults were rising and the soundness of any given bank. Had they been able to do so, the worst banks would have lost their funding and the worst loans would never have been written.

By denying markets information, government tries to replace millions of investors with dozens of regulators. It can?t be done. It shouldn?t be tried. The minds of 100 million investors are a terrible thing to waste.

-- Andrew Redleaf and Richard Vigilante are respectively CEO and communications director of Whitebox Advisors. They blog at www.capitalismbetrayed.com.

Full post as published by Bench Memos - National Review Online on April 05, 2010 (boomark / email).