NJ Senate Committee Backs Regulatory Bailout of Toxic Assets

• We conclude this financial crisis was avoidable.The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essen- tial to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us.

• We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self- correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.

• We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this cri- sis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institu- tions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a fundamental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activ- ities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling tril- lions of dollars in mortgage-related securities, including synthetic financial products. Like Icarus, they never feared flying ever closer to the sun.

• We conclude a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. Clearly, this vulnerability was related to failures of corporate governance and regulation, but it is significant enough by itself to warrant our attention here.

• We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis.

• We conclude there was as systemic breakdown in accountability and ethics.The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation. The soundness and the sustained prosper- ity of the financial system and our economy rely on the notions of fair dealing, re- sponsibility, and transparency. In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves well.

• We conclude collapsing mortgage-lending standards and the mortgage securi- tization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securiti- zation pipeline that transported toxic mortgages from neighborhoods across Amer- ica to investors around the globe.

• We conclude over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis.

• We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regula- tory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their down- grades through 2007 and 2008 wreaked havoc across markets and firms. (emphases mine).

By extending approvals for toxic assets (failed real estate projects for which there is no market demand and no financial viability) the bill would perpetuates a systemic failure in accountability, governance, and regulatory and market failures.

Bad problem diagnosis leads to flawed prescription.

II)  The Policy Objective of the Bill Are Not Good Public Policy and Undermine Market Forces

The policy of the bill is “to prevent the wholesale abandonment of approved projects and activities due to the present unfavorable economic conditions” (page 3, lines 36 – 37).

The bill sends the wrong signal to the market – those failed projects need to be killed.

The bill would promote moral hazard and reward bad behavior by providing a regulatory bailout for failed projects. Moral hazard is defined as:

In economic theory, moral hazard is a tendency to take undue risks because the costs are not borne by the party taking the risk. The term defines a situation where the behavior of one party may change to the detriment of another after a transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car, because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.

The bill would impeded market correction and prolong the day of reckoning for failed, speculative real estate projects.

The bill would have unintended consequences of increasing home foreclosures. By keeping bad debt (i.e. the worthless toxic assets of failed real estate projects) on the books and financial portfolio’s, basks would be given incentives to shed other debt, like home mortgages.

The same argument holds for keeping toxic assets on the books – it would tie up limited capital financing projects that will never be built, thus starving other good projects of limited financing.

Amendments to the bill adopted by the Committee would lock in previous sewer treatment plant capacity reservation contracts or agreements. This would reserve that capacity for rejects that will never be built, while real projects with financing will be blocked due to lack of finite treatment capacity. That is a job killer, not a pro-growth approach.

This is a big environmental issue at sewer plants with excess capacity to serve environmentally sensitive areas or discharge to high quality waters, like the Sussex County MUA plant adjacent to the Walkill  National Wildlife Refuge which would discharge to the pristine Category One Walkill River.

Last, by locking into approvals that are sometimes 15 years old, the bill would not only undermine environmental protections, but it would defy current  market conditions.

Some of the projects kept alive by this bill deserve to die, and are no longer even in demand.

Example in the car industry are the Edsel and demand for SUV’s at a time of $5 per gallon gas, but real estate has them too: like 6,000 square foot McMansions on 4 acre lots and strip mall nail shops, for example.