Did Over-Regulation Cause the Market Meltdown?

Dave Mason / October 29, 2008

This week “60 Minutes” highlighted an obscure statute that some say is at the root of the recent market meltdown: the Commodity Futures Modernization Act of 2000. The CFMA exempted certain derivatives from existing state and federal regulation. But “60 Minutes” failed to ask the most interesting question: Why was the exemption needed?

The short answer is that both federal and state law banned many useful financial transactions. The problem wasn’t regulation, it was prohibition. The only way to avoid the bans was to get out from under the statutes. So financial firms sought, and got, an exemption, creating an unregulated market.

Derivatives are financial instruments whose value is based on the price of a specified transaction (such as the price of oil in June). Credit Default Swaps (CDS) are derivatives whose value is based on whether specified bonds or other debt will be paid off (think Lehman Brothers). Over-use and under-pricing of CDS contributed to the financial problems at AIG, Bear Stearns, Lehman, and elsewhere.

Even in the wake of the global financial crisis, almost no one is calling for a ban on CDS: the instruments can act as a useful insurance policy for bond buyers. There are now various proposals for disclosure, regulation, and limits on the use of CDS. But regulation was not the option in 2000. (more…)