TOPICS IN POLITICAL ECONOMY

"SYSTEMIC STABILITY" - THE CASE FOR HEDGE FUNDS

What prominent group of risk-taking financial intermediaries posed the least threat to the financial system over the past two years? 

Consider the much-maligned hedge funds.

Like many others, they lost billions for their investors over the past two years, as the above chart from a recent BNY-Mellon report shows.  However, no one shed a tear or a taxpayer bailout dollar for them.  Their "lockup" clauses prevented investors from withdrawing en masse during those scary weeks following Lehman Brothers bankruptcy - when the $3 trillion money market fund sector had to be bailed out by the Treasury Department. As 2009 drew to a close, they apparently are growing again, leaner and wiser.

It wasn't the largely unregulated hedge funds that had to be bailed out - in the U.S., it was the SEC-regulated investment banks and the Federal Reserve-regulated mega bank holding companies that were re-floated with taxpayer dollars and Fed credit. Overseas, all manner of over-leveraged banks were propped up by their central banks.

Why Hedge Funds Are Not a Threat. It wasn't the hedged funds who were leveraged up to the moon in 2008.  As Andrew Haldane (Executive Director for Financial Stability at the Bank of England) and Piergiorgio Alessandri point out in an important recent paper, "most hedge funds today operate with leverage less than a tenth that of the largest global banks."  In other words, hedge fund managers (and their bankers) remember the fate of LTCM, the highly-leveraged mega-hedge fund that blew up in 1998.

Further, as Haldane and Alessandri point out, large hedge funds typically have assets of less than $40 billion, compared to global banks with assets in excess of $3 trillion. About 1 in 20 hedge funds goes out of business in any given year - with little disruption (post LTCM) and no taxpayer expense.  As their chart below shows, the top five hedge funds now have roughly 8% of total fund assets, e.g. none are "too big to fail" (TBTF). The five largest global banks account for almost 30% of global bank assets. Few doubt that they have been deemed by their governments as TBTF.

Why Hedge Funds Are a Threat - To the Banks. The history of financial institutions is replete with examples of how regulatory restrictions stimulate innovation and new competitors.  So it is not surprising that, continuing a long-standing antipathy towards "disruptive" hedge funds, the European Commission appears determined to drag them into a vast regulatory thicket, starting with restrictions on managements' compensation. No doubt the Commission is listening to commercial banks' concerns that, with the likelihood of being forced to lower their leverage, increase their liquidity reserves, and pay top performers less, they will lose additional business and talent to unregulated hedge funds. 

The same fears appear to be at work in the sausage factory on Capitol Hill in Washington, DC, where pending financial reform legislation in both House and Senate attempt to drag the funds further into the regulatory web.  

Bottom Line. The "bottom line" for hedge funds from the Bank of England's Executive Director for Financial Stability should be carefully considered by all those involved in the policymaking process:  "it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation." 

In other words, maybe what is needed for "systemic stability" is less, not more regulation, and far less willingness to bail out the imprudent when the going gets tough.

CAN WE CONTROL THE FEDERAL DEFICIT?

An action event is in the offing: 

Congress will need to increase the debt ceiling limit before the end of the year.  When this legislation comes up, the budget hawks in the House and Senate will attempt to add legislation which would appoint a powerful commission to specify cuts in spending/tax increases to reduce the massive deficits in the offing from Medicare, Medicaid, and Social Security - not to speak of the massive unfunded outlays implicit in both House and Senate health care reform legislation.  (If you know of a better mechanism to deal with the issue, please let me know.)

Read how the major players in Washington are trying to deal with this issue in today's Wall Street Journal. Don't be surprised if Nancy Pelosi thinks this is a bad idea. 

Beat your drum and cross your fingers.

TWO BIG HOLES IN FINANCIAL REFORM LEGISLATION

Financial regulatory reform draft legislation is making its way through the Congressional sausage factory: 253 pages in the House version and 1,136 pages for the Senate's (Senators tend to be more wordy than Representatives).

But, despite their weight, there are two gaping holes in both versions: not a word dealing with the biggest bad actors in the mortgage market (Fanny Mae and Freddy Mac) or with the financial sector that posed the biggest threat to a nationwide financial panic - money market funds.

While there are plenty of issues to debate within the draft legislation, let's focus here on the two missing chapters.

Fanny and Freddy. According to the Washington Post, the federal government's seizure of these two government-sponsored housing agencies  has cost the taxpayers $121 billion.  And more dollars are likely to be needed to keep them afloat. And then there's the issue of the original federal housing agency, the FHA, which now looks like it, too, is going to need a multi-billion bailout.

If Congress and the Treasury can't confront the underlying problems arising from federal intervention in the residential mortgage market (making it too easy for high risk borrowers to get government-subsidized  credit), they clearly haven't addressed one of the principal factors in the credit crisis of the past two years. Of course, that would be a lot harder to do, politically, than beating up on bankers.

Money Market Funds. For some reason, outside of Paul Volcker's vigorous warnings and substantive proposals from The Group of 30, almost no one at the center of policymaking in Washington appears to be seriously concerned about the role poorly designed money market funds (MMFs) played in the credit crisis.

Promising to hold MMF share prices to $1.00, helped by SEC regulations permitting questionable accounting to maintain that price, and acquiescing in SEC mandates to use credit rating agency marks on all their holdings, the MMF sector literally "blew up" last September. That was when one of the oldest and biggest funds, The Reserve Fund, "broke the buck" thanks to its $785 million investment in Lehman Brothers highly-rated commercial paper. 

The money market fund sector has evolved into a trillion dollar "shadow" banking system - but it is regulated by an SEC that is subservient to the investment companies that sell and manage MMFs and is generally clueless about banking issues (and how to catch Barney Madoff). 

While the SEC has requested comments on various proposals dealing with possible MMF reforms, the likelihood of serious, fundamental changes is very dim without a legislative directive.

Bottom Line. It would be most constructive if some of the heavy hitters in the Washington sausage factory could add a little more substance to the financial regulatory reform package that is currently moving down the production line.

FINANCIAL MARKETS, THE G-20 AND UNINTENDED CONSEQUENCES

One year ago, following the collapse of Lehman Brothers, the $3.4 trillion money market fund industry essentially froze up when The Reserve Fund "broke the buck."  That was the real start of the financial crisis, as this blog has suggested in the past.

The best detailed description how this event caught the Fed and the Treasury Department off-guard is now the recent extensively researched article by Bloomberg reporters.

There is a lesson to learn (or relearn, if you have forgotten three hundred years of financial market history) from the article: in a complex financial world with many players, an unexpected, catalytic event can lead to a rush for liquidity which threatens to overwhelm not just all the players, but the customers and spectators as well.

The real danger now is that governments will over-react with poorly thought-out legislation and regulation that will create even greater problems down the road.

While some of the suggestions for reform are sensible (such as requiring larger banks to hold more capital), the list of "further steps" that the G-20 heads of state and ministers are supposed to consider in Pittsburgh later this month contains the potential for substantial amounts of mischief and unintended consequences, e.g. "global standards on pay structure" and "oversight for systemically important firms."  (The latter item has taken on concrete form in the proposed legislation to have the Federal Reserve designate "Tier I" firms, as discussed in my previous blog.)

At Least Lehman Brothers Was Allowed to Fail. Despite much talk of the "mistake" in letting Lehman Brothers fail, there are some astute observers (see Niall Ferguson in yesterday's Financial Times) who point to that event as a much-needed reminder that very large institutions can fail - and all managers, shareholders and creditors of other financial institutions should keep this always in mind.

Never permitting another Lehman-type bankruptcy is the worst possible policy goal of financial reform.  As Ferguson points out, "the real tragedy is that the failure of Lehman has left Wall Street's survivors both bigger in relative terms and more secure politically . . . if only we had learnt from Lehman that no bank should be 'too big to fail', we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year's crisis."

Ferguson is a bit too gloomy, and no doubt the attempt to ensure "a level playing field" around the globe will slow down truly ill-advised initiatives. But never underestimate the ego of determined politicians to "do something."

REAL REGULATORY REFORM: FOR MONEY MARKET FUNDS

 

The Securities and Exchange Commission is supposed to look out for the small investor.  So, how did it end up precipitating the collapse, last September, of the entire money market fund (MMF) sector and the need for the U.S. Treasury to step in and guarantee $3.4 trillion in shares?

 

Take a look at Joe Nocera's outstanding piece, "The Risk in Money Funds," in today's New York Times business section, (normally not a solid source for economic and financial analysis). The massive run on all MMF shares was precipitated by The Reserve Fund's "breaking the buck" (marking down the value of its shares from $1.00) because of its holdings of $785 million in bankrupt Lehman Brothers' commercial paper. The run was aborted by the U.S. Treasury Department's guarantee of the $3.4 trillion in outstanding shares last September. 

 

The SEC Sponsors a Shadow Banking System. Originally, MMFs were not allowed to design and market their shares around a stable $1 @ share net asset value.  However, in the late 1970s the investment companies persuaded the SEC to let them follow accounting rules and marketing pitches that permitted them to do so under almost any conditions - and sell them, in effect, as alternatives to bank checking accounts, complete with check writing features - "turbocharged" bank accounts, as Nocera describes them. 

 

In the high interest rate environment of the 1980s, the MMFs prospered mightily. By the 1990s, they had become a parallel banking system, providing billions of dollars of short-term credit in competition with commercial banks. To further confidence in MMFs, the SEC started, with industry support, to mandate investments only with top credit ratings from the likes of Moody's and Standard & Poor's. Then, during the subprime mortgage boom, they plunged, indirectly, into that lending business, too, which the credit rating agencies facilitated with plenty of AAA marks on mortgage-backed securities.

 

In short, the MMFs had everything but FDIC insurance - and now, as a result of last September, they have demonstrated that Washington will guarantee $1 @ share if another run threatens.

 

Now What?  We can't rewrite history - but we can rewrite regulation so that the true riskiness of MMFs is transparent to investors, and reduce the likelihood of another government bailout.  As Nocera points out, the single best way to do that is to undo the SEC regulations that let them price and market their shares under almost any conditions at $1.00. Insist that MMF shares trade the way all other mutual fund shares trade.

 

Another action to make investors more conscious of risk would be to remove the mandate that MMFs invest only in SEC-defined "eligible" securities, and force fund managers to pay more attention to the creditworthiness of their investments. (S&P gave Lehman Brothers' short-term paper their highest credit rating until the day before that firm declared bankruptcy.)

 

Real reform of the money market sector means it will not enjoy all of the SEC-bequeathed competitive advantages they have had in the past.  But if the agency is more concerned about investor protection than the MMF's market share of  deposits v.v. commercial banks and savings institutions, it will take the steps advocated above. Otherwise, we might just as well force the conversion of MMFs into FDIC-insured banks (as Paul Volcker, for example, has advocated).

TIER 1 AND "TOO BIG TO FAIL" - BEWARE THE LAW OF UNINTENDED CONSEQUENCES

 

The problem of how to deal with very large and failing financial firms is as old as the privately-owned Bank of England’s problems in 1797, when it prevailed upon the British government to permit it to suspend payments in specie (coin) to its note holders.  It was carefully analyzed by the British economist Henry Thornton in 1802.  He saw a role for central bank "bailouts" so long as the rescued institution was solvent (e.g. facing a depositor panic that was based on erroneous fears).   

The bailout problem has bedeviled banking regulators in the United States for decades, most prominently (before the current financial cycle) in the case of Continental Illinois in 1984.   Only 10% ($4 billion) of its funding base was in insured deposits. But everyone, including bondholders, got all their money back.

Despite the Continental precedent, up until recently the Federal Reserve, the FDIC and other U.S. banking regulators have been careful to ensure that a reasonably high degree of “constructive ambiguity” existed to try keep bankers and creditors focused on sound banking practices.  Lehman Brothers was allowed to fail.  In the past 12 months, however, all the old rules have been thrown out and replaced with massive bailouts and federal guarantees on nearly every kind of short-term borrowing that exists.

Now comes the Obama Administration's proposal for another way to deal with the problem - and it's a very flawed approach: establish a "Tier 1" category of very large regulated financial firms.

 Such firms would be chosen by the Federal Reserve Board on the basis of their potential to “pose a threat to global or U.S. financial stability or the global or U.S. economy during times of economic stress.”  They would be subjected to more stringent standards than other financial firms.

The Tier 1 concept would apply to any “financial company” with more than $10 billion in assets, $100 billion in assets under management or $2 billion or more in gross annual revenue. In other words,  very large insurance  and investment companies, finance companies, and hedge funds, among others,  are to be herded into the Tier 1 corral. 

In effect, Tier 1 firms would be designated “too big to fail” and become a protected class. All their liabilities (except the shareholders’ investment) would be guaranteed by the Federal government.  Depositors, bondholders, and transaction counter-parties need not concern themselves with the financial stability of the Tier 1 firms they are doing business with.  “Let the regulators worry about that” is the message.

 The proposed legislation tries to inject a shred of uncertainty by requiring a bankruptcy hearing if a firm becomes “critically under-capitalized.”  But the whole purpose of the Tier 1 concept is to make sure this never happens and, even if it does, the only parties at risk are going to be shareholders.

Why “Tier 1” is Bad Policy.  Maintaining a sufficient degree of uncertainty about government support for specific financial institutions (“constructive ambiguity”) is a critically important  incentive for financial firms to act prudently –  historically, even more important than regulatory restrictions on capital and bank operations.

When the uncertainty level is low, e.g. government bailout probabilities are high, we end up with imprudent lending  (the “moral hazard” problem) and massive government bailouts – Fannie Mae and Freddie Mac being today’s prime examples.

By making it 99.9% certain that creditors of the largest financial firms will not be allowed to lose their investment, smaller firms will suffer an even greater  competitive disadvantage. (Small banks are already seriously disadvantaged by the largest banks' free ride in the deposit insurance system - as in the case of Continental.) 

Tier 1 makes analytical sense only if the promised “more stringent” standards on capital and liquidity ratios cost Tier 1 firms more than they gain in lower funding costs. Trying to make the cost of such standards equal to the value of the funding subsidy – across a myriad number and variety of financial institutions via regulatory fiat  - will only result in a massive and counterproductive web of paperwork and bureaucratic intrusions.  And it will lead to the establishment of a lobbying powerhouse (“The Tier 1 Toughs”?) that would make sure their clients came out ahead.

A Better Way Forward.  While there are many debatable aspects to the Administration’s package of financial reform regulation, the Tier 1 concept has the highest probability of major, adverse and unintended consequences.

Already the working assumption in financial markets today is that every “very large” financial institution will be supported.  While the Administration’s recent refusal to assist CIT Financial (a $75 billion finance company) helps to distinguish “large” from “very large,” the Tier 1 concept needs to be totally abandoned. 

Instead of Tier 1, all banking firms (including finance companies and government-sponsored agencies, such as Fannie Mae) should face a relatively seamless series of increasingly higher capital requirements as they grow in size.  Regulators should continue using “constructive ambiguity” (e.g. the possibility of large firms' bankruptcy and losses to their creditors) as a way to encourage prudent management - and to offset any tendency by managers to invest in increasingly risky assets as their capital requirements grow.

Nonbanking institutions, such as insurance and investment companies as well as hedge funds, should be excluded from the new regime.  No substantive evidence has been advanced that demonstrates these institutions, as a group, need to be included;  AIG was an outlier, already subject to federal regulatory oversight.

Final Note.  Unfortunately, rather than focusing on the implications of Tier 1, Congressional and media attention has been directed at relatively minor turf fights among federal regulatory agencies  -  and Treasury Secretary Geithner’s irritation about what is going on in the back of the bus. 

It's time for all the players to pay attention to the dangerous economic and political consequences of establishing a "protected class" of mega financial firms.

STRESS TESTS, KEYNES AND THE BANKING SYSTEM

So, the well-meaning civil servants have dutifully ground through the numbers and their politically-attuned Treasury/White House managers have signed off on the "stress tests" of 19 major shareholder-owned financial institutions.  (Notice that the Social Security System and major public employee pension funds - e.g. the State of California's mega fund Calpers - have not had to undergo similar scrutiny.)

What do we know now that we didn't know yesterday?  Not a great deal more.  The regulators took these institutions' current balance sheets, posited a set of assumptions about future economic conditions and loan losses, and let the Excel spreadsheets generate a set of numbers and ratios. These purport to estimate the "capital buffers" each institution has to have to weather a more severe economic downturn. A fairly simple exercise for any reasonably competent MBA.

The Reality.  What has been the true purpose of this exercise?  The answer can be found in John Maynard Keynes' "The General Theory of Employment, Interest, and Money."  But it has all to do with "confidence" and nothing to do with spending and fiscal stimulus. 

The answer is in Chapter 12, "The State of Long-Term Expectation."  Long term expectations, Keynes pointed out, do not depend solely on forecasts, but also depend upon "the confidence with which we make this forecast."  The state of confidence, in turn, is critical to determining the appetite for investment and enterprise. I suspect that more than a handful of Federal Reserve governors and staffers, and a few Treasury Department types, have been re-reading this classic essay in recent weeks.

In other words, since the rating agencies have been shown to be close to useless in such matters, and the credit default swap market had been so bad-mouthed by politicians and journalists, and the regulators themselves were shown to have been clueless, a hopefully credible alternative had to be immediately established.  

Washington's "stress tests" have been one in a series of actions designed to restore confidence in the financial system and among bankers.  This is to ensure that depositors and other lenders are comfortable in entrusting their funds to such institutions, who in turn will be able to extend credit.   

The Politics. The results of the stress tests rest on fairly credible assumptions: the "more adverse" stress simulation assumed a two-year loss rate of 9.1% of total loans (the highest rate in at least 90 years) and the highest unemployment rate since the 1930s. Ten of the 19 financial institutions evaluated were seen as needing to augment their "Tier I" capital to cope with such a  downturn, but the initial reaction in the market is that this should be feasible without a major problem.

As I have suggested in this corner before, "modern money is magic." Destroy my confidence in my bank - any bank - and you destroy money, as represented by that bank's deposits, as I withdraw my deposit and turn it into currency, gold, or some other borrower's liability (Treasury bills?). The stress tests, originally announced in February, were designed and orchestrated primarily to restore confidence in major financial institutions.

In short, the entertaining saga of the "stress tests"  has more elements of a long-running, elaborate Japanese noh drama than technocratic public policy - but that doesn't mean we can't congratulate the dramatists for a useful script. 

"FINANCIAL CRISIS MANAGEMENT 101" FOR POLITICIANS - AND THE PUBLIC

A short course in current financial market realities is badly needed for most members of Congress and a fair number of the chattering class, many of whom are threatening to exacerbate the current situation.

1. Please don't forget that the primary objective of nearly all of the money that has been pumped into commercial and investment banks and AIG, as well as the expansion of government deposit/money market fund insurance by the FDIC and the Treasury was intended to stop a massive and highly dangerous run on the nation's banking system in the last six months of 2008.

2. That effort has been successful. Give the Treasury and the Federal Reserve some credit for what they did, even if their public explanations were unsatisfactory - as they still are.

3. Stop asking the banks "Where did the TARP money go?" The complexity and daily volume of multimillion dollar transactions on any large bank's balance sheet makes this essentially a rhetorical question. Stopping the run on bank and money fund deposits was the first and most important step in avoiding an excessive contraction of the banking system.

4. Stop trying to get the banks (and the government mortgage agencies) to lend or guarantee more loans. In a recession, such as we are now experiencing, lenders quite properly become more cautious, as do potential borrowers. Wasn't it the combination of loose lending standards and over-leveraged lenders and borrowers/buyers that made this downturn so serious?  The need to generate income will provide sufficient incentive for lenders to extend new credits. (No bank can cover its overhead investing in Treasury bills at 1%.)

5.  Understand business cycles. All recessions are characterized by sharp slowdowns in credit extensions. In fact, in March loans outstanding at large commercial banks to both business and consumers were still at higher levels than a year ago.  At some point in the near future, we should expect them to be below year earlier levels, as they normally are at later stages of the business cycle.   

6. Stop bad-mouthing bankers and threatening to impose regulatory burdens on hedge funds. You need them (1) to sort out the mess of bad assets still on banks' balance sheets and (2) to restart the markets for securitized mortgages and loans if you want the credit markets to open up fully.

7.  Study what recently happened in Iceland where a politician was appointed to head up the Central Bank and was instrumental in creating a real financial disaster.

CHINA, CONVERGENCE, AND MARKET CAPITALISM

Most of the noise coming out of this week’s meeting of the  G-20  heads of state in London will be about regulation,  “stimulation” and new barriers to international trade.   But there Is very likely to be one truly significant long-run political outcome: the functional acceptance of China by “the West” as a major financial and economic power.

This acceptance will take the form of communiqué  language that makes it clearer than ever that China’s share of voting power in the International Monetary Fund (and, perhaps, in the World Bank) will be increased substantially within the next two years.  This shift in voting power will be facilitated by a large increase in IMF resources contributed by member governments, most prominently the Chinese.  

The Death of Market Capitalism?  At the same time, noisemakers at the G-20 meetings will add decibels to the continuing funereal chorus from the chattering classes about “the death of market capitalism.” This, despite the fact that China owes its rise to global power thanks to its embrace of the key elements of market capitalism:  market prices to provide incentives to producers and letting individuals own the means of production and grow rich.

Market capitalism is not going to wither away just because financial regulators around the world decide to insist on less risk-taking by (government-supported) financial institutions, such as FDIC-insured banks, “too big to fail” investment banks, and government real estate lending agencies (FNMA and Freddie Mac). 

It was a form of market capitalism that lifted 400 million Chinese out of dire poverty in the fifteen years between 1990 and 2005, and which now makes some pundits muse about turning global leadership over to the “G-2” – the United States and China. 

Why Losing Market Share May Be Progress.  If market capitalism is not dying, then perhaps the U.S. is threatened by China because of a shrinking share of global economic output?  This notion surfaces in numerous discussions about China’s extraordinary economic achievements as well as international comparisons  of spending on research and development,  patents issued, educational achievements and a myriad of other measures.

But the emphasis on “market share” is simple-minded and incorrect, if the absolute level of economic well-being continues to improve.  In this situation, which certainly describes the past 15 years or so, a smaller market share for #1 simply reflects more rapid growth by lower-ranked countries. 

Furthermore, as Nobel prize winning economist Edward Prescott and Stephen Parente have suggested, if all countries would dismantle “barriers to experimentation”  (ranging from civil strife to monopolies to trade protectionism), “there is no reason why the whole world should not be as rich as the leading industrial country.”  In short, China’s progress over the past two decades is a strong argument in favor of what is known as the “convergence” hypothesis among economic growth theorists – as well as market capitalism.

Cut the Bad-Mouthing.  So, when China sits down in a much bigger chair at IMF board meetings in 2011, there is no reason to bad-mouth either the U.S. or market capitalism.  Instead, congratulate the Chinese and remind yourself that it was a form of market capitalism that got them there.

THE SIREN CALL OF FINANCIAL MARKET REGULATION

At the recent meeting of G-20 finance ministers in London it seems "more regulation" was on everyone's lips as the way to avoid a repeat of the current financial mess.  The only difference between the U.S. and most of the other countries was "how much?" 

The Europeans are hung up on bringing hedge funds under much tighter regulation.  Why is this so?  At first glance, it is hard to understand: no huge "too big to fail" fund had to be bailed out by any government - although a lot have simply folded up and returned a few cents on the dollar to their original investors.  It is true that hedge fund managers became very nervous when their "prime brokers" such as Bear Stearns and Lehman Brothers started looking sickly.  These funds started pulling out their money and securities - or buying credit default swaps to protect themselves if their broker went bust. Were they wrong to behave in this manner?

The standard European politician's complaint is that hedge funds are secretive and disruptive, especially for the managements of old-line, sleepy corporations. That would help explain the push for regulation - along with the fact that they pose a long-run competitive threat to already over-regulated traditional financial institutions. 

Who's the Biggest  Problem?  The fact is that it was the most regulated institutions in the U.S. that have caused us the most problems: investment banks and money market funds overseen by the SEC plus commercial banks and bank-holding companies overseen by the FDIC, the Comptroller of the Currency and the Federal Reserve. 

With respect to the rating agencies (who made a major contribution to the 'perfect storm' of the current financial mess), the SEC has plenty to answer for. They required money market funds to structure their portfolios around S&P and Moody's credit ratings as a substitute for the funds' own due diligence. And anyone who studied the models used by  credit agency analysts to rate complex mortgage securities had to take a dim view of their robustness (i.e. using less than 10 years loss experience). All this, plus the well-known weakness in the agencies' current business model, where issuers, not investors, pay for the rating.

While the new SEC Chairwoman has talked obliquely about moving the agencies towards an "investor pays" model, the major government initiative at the moment seems to be to impose regulation and its attendant costs on the only honest canary in the credit rating coal mine - the unregulated credit default swap market.

And then there's the shadowy links between Bernie Madoff and the SEC staff, and the failures to follow up on credible suspicions of a long-standing Ponzi scheme.

AIG's Regulator: Asleep at the Switch.  Only just coming to light - and lost in the uproar over AIG bonuses -  is the failure of Federal government oversight of AIG's disastrous bets on derivatives.  In an extraordinary "mea culpa" in recent Congressional testimony, the Acting Director of the Office of Thrift Supervision has conceded that his agency (which had authority to examine all parts of AIG due to its ownership of a federal savings bank) fell down on the job despite "continuous, consolidated supervision of the AIG group."

You would think that thoughtful politicians and public officials would understand that it wasn't too little regulation that contributed to the financial mess, but a combination of clueless regulation, perverse incentives (e.g. for rating agencies and financial firms' compensation arrangements) and an inability by the federal government to effectively address the "too big to fail" issue that are the central regulatory issues.  Addressing these subjects effectively is where real leadership in Congress and at the agencies is needed - and sorely lacking.