Finance Regulation or Deregulation?

A handful of leading politicians claim that financial deregulation was responsible for the U.S. financial calamity.  But, informed consumers should take pause and look at the facts.  As Dr. Darby pointed out in a recent blog, there has been a lot of meddling going on to promote special interests at the expense of consumers and at the expense of efficient markets (see blog post here).  For instance, the collapse of Fannie Mae and Freddie Mac was largely based on Congressional promotion of affordable housing for low-income buyers, many of whom were unable to payback their loans.  Last month, we blogged on how congress was attempting to lower credit ratings for risky drivers, who pay more for insurance.  However, the net effect of this legislation would have been to increase premiums on good drivers effectively asking the good to subsidize the risky — leading to more accidents, claims, losses and traffic fatalities — and higher consumer prices (see blog post here).  Below, is another piece by Dr. Larry Darby discussing yet another attempt by Congress to mess with financial institutions — artificially helping munipal bonds at the expense of other markets investments.  These are not examples of deregulation, but represent how Congress has ignored the risks of moral hazard and, instead taken on politically popular causes that impose hidden taxes on all consumers, including a $700 billion check.   Please read on and give us your comments ….

 Municipal Bond Fairness

 Who can argue with that title?  Nobody, really.  Who can define what it means?  Well, anybody, and that is the problem and our source of serious reservations about the proposed Municipal Bond Fairness Act (H.R. 6308) introduced by Representative Barney Frank (D-MA), Chairman of the House Financial Services Committee.

             The proposed Act would put in place innocuous sounding requirements governing how credit rating firms assess and label risk for government-issued debt.  The reasons for the proposed Act look to be grounded principally in local government officials’ desires to reduce borrowing costs and the Chairman’s desire to support local government spending by making credit available to them more readily and on better terms.  Some critics aver that to be the only reason, in view of sparse evidence of market failure. 

             Credit rating agencies play an important role in providing information about the risks to lenders of debt instruments issued by a wide variety of private and public institutions.  Economic growth and consumer welfare are to a large degree linked to the ability of investors to make sound decisions.  In making those decisions, investors often look to assessments of risk by unbiased and competent analysis, such as that provided by rating agencies, free of well meaning, if misguided, government intervention.  

             The consumer impact of credit rating regulation of the kind encouraged by the proposed Municipal Bond Fairness Act is not negligible.  In effect, the proposed Act could subsidize local government capital projects, by lowering risk related debt service charges.  But, concurrently, the proposed Act could raise the cost to other borrowers for other purposes by reducing the supply of capital available for them.

             We need not look beyond the cascading costs of the recent sub-prime mortgage situation for evidence of the perils of changing credit risks for particular debt instruments.  

             Are bond rating agencies perfect?  Of course not.  But, there is no evidence of systematic, repetitive biases in their assessment of credit risks for government issues.  Indeed, of the two kinds of errors rating agencies might make – overestimating risk or underestimating it – there is powerful evidence suggesting higher costs if they err on the side of underestimating risk. 

             Since Orange County stunned financial markets and entered bankruptcy after announcing $1.6 billion in losses in 1994, there have been several cases of municipalities defaulting, or risking default, on their obligations despite having previously received solid credit ratings.  For example, Vallejo, California, a suburb of San Francisco, recently filed for bankruptcy because it was unable to meet its obligations in the face of declining local real estate values and increasing costs for public services.  Bonds issued by Jefferson County, Alabama are currently under review for downgrade by Moody’s as the county continues negotiations with bond holders and insurers.  All of this is happening as the county tries to avoid filing for bankruptcy.   

             The proposed Act comes at a particularly inopportune time when viewed in the context of prospects for dramatically rising deficits in state and local government budgets.  The deficits are often the result of declining revenue associated with changes in economic fundamentals.  Meeting the fiscal challenges of balancing local government budgets will raise creditworthiness questions that must not be shrouded by ill-advised federal mandates on rating agencies. 

             The proposed Act is a form of hidden taxation on consumers of other, non-municipally produced goods and services who will be burdened by higher credit costs.  To the extent that the proposed Act would encourage municipal capital projects with ratings that do not reflect the rating agencies’ independent view of their relative risk, taxpayers are exposed to the potential costs of more and larger local government default rates.

             The role of government should be to monitor credit rating practices and to act to offset abuses if and when identified.  The proposed Act does not pass that simple test, and, indeed, goes beyond to dictate outcomes favoring some borrowers at the expense of others.  Congress has neither the time, nor the inclination, nor the ability to micromanage this important feature of the allocation of scarce capital to its best use.

             Efforts like those reflected in the Municipal Bond Fairness Act, as presently written, would undercut rational investors, diminish the utility of information provided by ratings agencies, and would create unnecessary uncertainty in an important subset of US capital markets. 

 Consumers deserve unbiased information on market risks. 

 Dr. Larry F. Darby

(Dr. Darby is a Senior Fellow for the American Consumer Institute, Center for Citizen Rearch, a nonprofit 501c3 organization)

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