Regulatory Arbitrage
On regulation and trade.
AIG was a key player in the 2008 financial crisis. Specifically, AIG’s Financial Products division was a central actor. This London-based unit sold hundreds of billions of dollars of notional principal of risky credit default swaps, many tied to subprime loans.
“As it became clear that Financial Products had bet more than twice the market value of AIG in those credit default swaps, and failed to hedge or otherwise protect itself against collateral calls, the situation turned dire.”
How did this work?
Banks loaned money to people to buy homes (residential mortgages) and to companies to purchase commercial properties (commercial mortgages).
Market actors, including government-sponsored enterprises like Fannie Mae and Freddie Mac, purchased these whole loans from the issuing banks and pooled them together to create securitized structures that financed themselves by issuing residential mortgage-backed securities and commercial mortgage-backed securities, depending on the nature of the whole loan collateral in the relevant pool.
On one side of the mortgage-backed securities balance sheet, there were the pooled whole loans of a particular stripe, e.g., residential subprime mortgages. On the other side, there were different claims (called tranches) with varying levels of risk. As individual subprime loans in the pool defaulted, this loss would reduce the amount available for the equity, the lowest piece of the capital structure. As more subprime loans defaulted, once the equity was wiped out, then the second-loss tranche would bear the loss of subsequent defaults. This continued until there was nothing left to pay the most senior tranche. The equity was the riskiest piece so it had the highest potential reward; the most senior tranche would have the lowest return. Cash flows from the servicing of the whole loans would cascade through the capital structure, paying the senior RMBS tranches first, eventually letting the RMBS equity capture whatever remained.
Private issuers structured collateralized debt obligations similarly. Instead of a pool of whole loans on the asset side, they would have a pool of RMBS securities. As these RMBS securities paid out income, the interest and principal on the senior tranche would be paid first, followed by the next most senior tranche, and so on in a cash flow waterfall with the equity receiving the residual after every layer above it had been paid. The equity would be the first loss piece, as above, similarly. The tranches above the equity constituted financial leverage for the CDO equity, amplifying the potential returns the equity could receive if defaults were sufficiently low.
In the period before the financial crisis, CDOs invested in riskier tranches of RMBS with the belief that diversifying across RMBS portfolios helped lower the overall risk of the portfolio.
For years, there had been a well-defined, quantifiable, stable subprime lending profile, tied to the economic cycle, but things started to change in the early 2000s.
“Subprime mortgages grew from 5% of total originations ($35 billion) in 1994, to 20% ($600 billion) in 2006.”
This was tied to the steep increase in housing prices.
“Between 1997 and 2006 (the peak of the housing bubble), the price of the typical American house increased by 124%. Many research articles confirmed the timeline of the U.S. housing bubble (emerged in 2002 and collapsed in 2006–2007) before the collapse of the subprime mortgage industry.”
Housing was a sure thing and banks were only too happy to provide the money. Naturally, others emerged to help the banks keep the money flowing.
FP wrote insurance against defaults on tranches of collateralized debt obligations tied to subprime loans. These took the form of credit default swaps. FP collected premia in exchange for a promise to make the other side whole if they suffered any losses due to defaults in the underlying RMBS collateral. So, for example, the owner of a senior CDO tranche could collect. cashflows from the CDO waterfall and use some of those proceeds to purchase insurance against those cashflows drying up because of the default experience realized in the RMBS securities on the CDO’s asset side of the balance sheet.
In a practice referred to explictly as “regulatory arbitrage,” the financial engineers at AIG FP exploited weaknesses in the system.
First, AIG put itself in a position where it was regulated by a relatively unsophisticated entity, exploiting the diversity of regulators in US financial markets.
“By purchasing a savings and loan in 1999, AIG was able to select as its primary regulator the federal Office of Thrift Supervision (OTS), the federal agency that is charged with overseeing savings and loan banks and thrift associations.”
Second, FP was run out of London. The British decided not to oversee it because FP’s holding company, i.e., AIG, was regulated by an American agency (OTS), deemed to be sophisticated.
‘AIG Financial Products is not a licensed insurance company and is not regulated by the states. Financial Products is an investment unit based chiefly in London. It was able to evade regulation under the British Financial Services Authority because the AIG holding company was registered with an “equivalent regulator,” the OTS.’
Third, before the financial crisis, credit default swaps managed to escape regulation.
“Although OTS has acknowledged its role as the holding company supervisor, it is worth noting that credit default swaps were exempted from regulation under the Commodities Futures Modernization Act of 2000, which prevented both the C.F.T.C. and the states from regulating these instruments.”
“AIG engaged in regulatory arbitrage by setting up a major business in this unregulated product, locating much of the business in London, and selecting a weak federal regulator, the Office of Thrift Supervision (OTS).”
Having set up an entity with regulatory treatment that was engineered to be artificially favorable, FP then sought to monetize this contrived Golden Goose.
‘To quote Chairman Bernanke again, Financial Products “took all these large bets where they were effectively, quote, ‘insuring’ the credit positions of many, many banks and other financial institutions.”’
The banks were regulated and they managed to avoid these regulations by getting FP to take it off their hands, exploiting FP’s special status.
FP rented out its unique status as an entity that the regulators ignored or didn’t understand to banks who didn’t have this luxury.
When the subprime market boomed, FP couldn’t sell these products fast enough. After all, this was free money. Given the prevailing wisdom that nothing would happen to disrupt this happy setup, hedging seemed like a waste of money. Ironically, the actions of FP (and others like it) killed the trade. With the help of FP and other institutions, banks could accelerate their origination of subprime loans, confident that they could lay off the credit risk and the regulatory capital requirements to FP and others like it, so they put out subprime loans indiscriminately, lending to people who had no capacity to pay back the money unless housing prices kept increasing monotonically. Once the market ran out of marginal buyers, once the Ponzi was up and Wile E. Coyote was hanging in mid-air having run off the cliff, housing prices started to fall, bringing defaults with them.
Credit analysis? That’s the other guy’s problem.
Regulatory arbitrage created the conditions for its own demise.
Today, we are faced with tremendous turmoil related to international trade. The US Administration is concerned about persistent trade deficits with the rest of the world, but principally with China. The arithmetic tells us that the flip side of a trade deficit is a capital account surplus. Countries like China purchase assets like Treasury bonds with the dollars they earn from trade.
Similarly, we have seen the increased financialization of economic life in the West, the so-called “financialization of everything.” One strange example was the announcement just before the so-called “Liberation Day” of the introduction of buy-now-pay-later loans from Klarna for customers of DoorDash, the food delivery service.
“Social-media platforms like X were flooded with memes about “burrito bonds” and “lunch-backed securities” in late March after Klarna Group Plc., the Swedish provider of buy-now-pay-later (BNPL) loans, filed paperwork to prepare for a U.S. public offering and also announced a partnership with DoorDash Inc. to offer interest-free financing on its platform for purchases of at least $35.”
Maybe it’s a coincidence.
One aspect of our trade imbalance that might explain its appeal is regulatory arbitrage.
Here’s Matt Taibbi, albeit tendentiously as always:
“It seemed obvious that NAFTA, the WTO, and the extension of cushy trade arrangements with China and other unfree labor zones were a gigantic end-run around American labor, safety, and environmental laws. It was an asset-stripping scheme, designed to help CEOs boost their share prices by cutting costs of American parts, labor, and regulatory compliance from their bottom lines. There seemed nothing complicated about this, except the marketing challenge. How could corporate management convince Americans, who fought for so long to scrape their way into the middle class, that it was in their interest to compete against countries that didn’t have to follow any of the same rules we did?”
Not only were costs lower, but regulation was, too. There doesn’t seem to be much in the way of environmental controls or concerns about slave labor when the iPhone arrives at a reasonable price (or at least a lower price than it would have cost to make in North America). In the US, companies have to comply with myriad regulations while paying union wages with union work rules without the benefit of subsidized financial capital thanks to the financial repression of the local savers.
It's not like China was trading in a fair manner, either.
“It never happened. China never opened its markets, and the trade imbalance kept ballooning, alongside persistent complaints about violative practices that reminded me of Wall Street fraud cases I covered. Whether after rulings by the Department of Commerce or the DOJ or the WTO, China would admit to currency manipulation or “relabelling” or some other offense, promise to stop, and just keep going. The fact that they were there to buy whenever the U.S. issued debt was clearly a huge factor in us always turning a blind eye.
“In the early 2000s, we began to be sold on the idea that globalization was really working, it was just hard for ordinary Americans to see because they were so wrapped up in bitterness and nostalgia. Papers like the New York Times gave top billing to boosters like David Brooks and Thomas Friedman to castigate the lost-in-the-past crowd and extol the exciting new world of borderless innovation.”
Perhaps we, as a nation, were taking one for the team.
“Trump’s tariffs returned him to the subject, but with a different take. Friedman this month explained that yes, free trade hasn’t been great for the U.S., but so long as we can accept being taken advantage of a little, it’s all good:
“The world has been the way the world has been these past 80 years because America was… a superpower ready to let other countries take some advantage of it in trade, because previous presidents understood that if the world grew steadily richer and more peaceful, and if the United States just continued to get the same slice of global G.D.P. — about 25 percent — it would still prosper handsomely because the total pie would grow steadily. Which is exactly what happened.”
If we accept that a big driver of international trade is regulatory arbitrage (in addition to lower wages – offset by lower productivity, at least initially), then the re-imposition of tariffs means a net increase in effective regulation. This increases the urgency of the de-regulatory effort. Put another way, deregulation is necessary for the restoration of American competitiveness, in part, if a significant portion of Chinese comparative advantage stems from the regulatory disparities between our two countries.
If the US move to increase outsourcing to China and to drive trade volumes higher was about avoiding American regulation, the EU is weaponizing regulation to restrict trade.
The EU’s inability to compete in digital services on a global scale with the likes of Apple, Google, Facebook, and other American titans has led them to regulate these winners with onerous conditions around privacy. Their regulation is actually a tariff, especially given that the penalties they would charge are upwards of 10% of global revenue.
“Under the law, EU regulators can impose massive fines of up to 10% of a company’s global revenue for a first offense and 20% for repeated violations. That amounts to tens of billions of dollars for companies like Sundar Pichai-led Alphabet and Mark Zuckerberg’s Meta.”
Here’s the EU essentially trying to force Meta to offer Facebook services for free without any advertising.
“The expected decision relates to whether Meta should be forced to give Facebook and Instagram users the option of accessing those services free without seeing personalized ads, something that would undercut the main way Meta makes money.”
The EU didn’t like Meta’s offer to allow people to opt in to using the service while being exposed to advertising, apparently.
If Meta loses, they’ll likely stop providing the service (or curtail it, at least) in Europe, assuming Europe doesn’t try to apply their regulation globally.
Regulation is at the heart of everything.