Despite its ostensible focus on stability, the Obama administration’s financial reform proposal offers no plan to prevent asset bubbles like the one in subprime loan securities that triggered the current crisis. Although expected, this outcome is disappointing because it appears to be based on an exaggerated fear that a policy against bubbles would fail.

The truth is a regulator directed by Congress to identify and deflate bubbles should succeed if the following conditions are met:

1. Systemically-significant financial institutions are required to continuously disclose their risk exposures to the regulator;

2. The regulator is given on-demand access to all repositories of non-public business and personal economic data; and

3. The regulator is not the Federal Reserve or a council of regulators in which the Fed has primary sway.

The first condition is straightforward. The regulator will not be able to assess the danger of potential bubbles to the financial system unless it has a clear understanding of systemically-significant firms’ exposures to them.

The second condition derives from the fact that financial asset prices are based primarily on participants’ evaluations of publicly available information because securities laws generally prohibit trading based on non-public information. SEC enforcement of such prohibitions is imperfect but credible.

A bubble inflates as public information about an asset class diverges from private information possessed by the public information’s sources. Accordingly, the key to deflating a bubble is to gather relevant private information, compare it to the corresponding public data, and then publish the comparison for all market participants to see.

Consider, for example, the twin bubbles in home prices and securities backed by subprime home loans. High volumes of subprime loans made at low rates benefitted originators (who collected fees without bearing default risk because their loans were packaged and sold) and to a lesser extent their subprime borrowers (who in essence got cheap rent on homes they could not afford to buy).

In response to these incentives, subprime originators and borrowers misrepresented borrower income and other information to make the loans and rates appear reasonable. For a time, rising home prices fed by subprime borrower demand masked the inability of borrowers’ actual incomes to support repayment of the loans. The absence of immediate consequences for fudging led to greater fudging, expanding over time the gap between public information on subprime loans and originators’ private information.

Could the government have gathered private information to identify and deflate these bubbles? Yes – in fact, it did. The IRS collected annual income data for virtually every subprime borrower. Comparing this data with public data on borrower incomes would have revealed much of the information gap responsible for the twin bubbles. This analysis was not done because no other regulator had access to the data and spotting asset bubbles was far outside the tax agency’s mission.

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