Market Failure? Try Yet Another Government Failure Are we headed for another 'Great Depression'?

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Amid the financial
crisis that has many people talking about a new Great Depression,
or 10 years of the kind of stagnation that Japan endured during
the 1990s, the most predominant talk you hear is that this is a
failure of the capitalist system. If only the Bush administration
had not been so devoted to deregulation, many have said, we wouldn’t
be in this mess. What we need now is more regulation, more government
oversight of financial institutions, more rules to prevent greedy
investors and sellers of risky investment vehicles from fleecing
the public.

On the contrary,
I suggest, this crisis is about as far from a repudiation of laissez-faire
capitalism as it could possibly be. While many private actors played
big roles in bringing on this crisis, in most cases they were responding
to strong incentives put in place by government policies and regulations
– regulations whose intentions may have been laudable but whose
effects have been disastrous. From creating moral hazard to having
the government become a big player in financial markets, this disaster
has a distinct made-in-Washington flavor to it. The Bush administration,
although it talked about deregulation, didn’t do it; in fact, spending
on regulation enforcement steadily increased during the Bush years.

This is not
to deny that heads of financial institutions made bad calls, that
thousands of people in the financial industry failed to consider
the likelihood that housing prices would not rise forever, that
private credit rating bureaus failed abysmally, or that some loan
officers were less than explicit (or hid the details) with customers
about the possible perils of subprime or adjustable-rate mortgages.

It is important
to remember, however, that we do not live in a laissez-faire market
environment, but in a business environment created and heavily influenced
by a patchwork of regulations and mandates that have been increasing
steadily since the New Deal, 75 years ago. People, especially in
business, respond to incentives, and the government created all
too many incentives, sometimes pliably in cooperation with business.


Although events
accelerated in the past few years, this is a crisis long in the
making. It starts with the Community Reinvestment Act, a Carter-era
law designed to require banks to serve their entire communities.
The perception was that many banks engaged in "redlining,"
declining to provide mortgages and small-business loans to poor
and minority neighborhoods. The CRA provided that a bank’s record
of serving such communities would be taken into account.

As revised
and strengthened during the Clinton administration, this law virtually
created the subprime mortgage market – home loans to people
whose credit would be considered shaky under ordinary free-market
considerations – by allowing subprime mortgages to be "securitized,"
or bundled into those infamous Mortgage Backed Securities, or MBSs.
The first securitization of MBSs consisting of loans mandated or
incentivized by the CRA happened in 1997, by Bear Stearns. The number
of CRA mortgage loans increased by 39 percent from 1992–98,
compared with an increase of 17 percent for other loans.

In 1999, credit
requirements were loosened further. As reported in the New York
Times at the time, "In a move that could help increase homeownership
rates among minorities and low-income consumers, the Fannie Mae
Corp. is easing the credit requirements on loans that it will purchase
from banks and other lenders." The intention was perhaps laudable
– to increase homeownership rates among the "underserved"
– but it had unintended but perhaps predictable consequences.

The housing
bubble was further inflated by a loose-money policy at the Federal
Reserve, in the wake of 9/11, that lasted from 2002 to 2005, according
to William Niskanen, now chairman of the Cato Institute and a Reagan-era
member of the Council of Economic Advisers. The bubble really expanded
in 2005 when the government-sponsored enterprises, Fannie Mae and
Freddie Mac, which have come to dominate the secondary mortgage
market because they don’t pay taxes, had access to cheaper credit
and had lower capital requirements than fully private institutions,
and began securitizing subprime and Alt-A (the next-riskiest class
of mortgages).

This came in
the wake of a $10.6 billion accounting scandal at the two institutions
that blossomed in 2003–04, as it became obvious Fannie and
Freddie were artificially inflating their profits in order to qualify
top officers for monstrous bonuses. The price Congress exacted for
not looking into the scandal any more closely was to urge Fannie
and Freddie to become even more active in providing mortgages to
low-income people who might not otherwise qualify for them. The
Bush administration (supported by John McCain) pushed legislation
to rein in the two government-sponsored enterprises – not thoroughgoing
reform but increasing government oversight and putting an upper
limit on their growth – but Democrats in Congress wouldn’t
let it come to a vote because they were comfortable with Fannie
and Freddie, which lobby and donate aggressively, as they were.

So, the government
virtually created the subprime mortgage and cheered it on. In April
2005, former Federal Reserve Chairman Alan Greenspan exulted that
various "improvements have led to rapid growth in subprime
mortgage lending." Huzzah!

The problem
was that while packaging mortgages into securities made more money
available for lending and offered big profits to highly leveraged
institutions like investment banks and Fannie and Freddie, the risk
on the downside was huge if the housing market began to go south,
which it did.


Another government
mandate that accelerated the crisis was an otherwise obscure new
accounting rule, implemented last November, called "mark to
market." Again the intentions were good – to make financial
transactions more transparent and to prevent overstating of profits
of the sort that eventually brought down companies like Enron.

As explained
by John Berlau, director of the Center for Entrepreneurship at the
free-market-oriented Competitive Enterprise Institute: "[I]f
a troubled bank sells a mortgage-backed security at a fire sale,
many solvent banks have to take a paper loss on similar assets.
This is the case even if the loans are still performing and even
if the banks are holding the loans to maturity and simply collecting
the payments instead of selling. In a small market such as those
for unique securities, one fire sale can set the ‘market price.’

"If all
this required was showing a loss to shareholders in annual reports,
this would still be bad accounting, but not that much of a contagion
problem. But because mark-to-market has been adopted as part of
solvency rules, these ‘losses’ contract banks’ ‘regulatory capital’
on paper and mean they can’t make as many loans without being declared
technically ‘insolvent.’ So these financial assets become ‘hot potatoes,’
as banks scramble to get them off their books, driving the asset
prices down even further. This explains much of the ‘cascading effect’
that has caused the credit crunch."

Good intentions
– to encourage more transparency – and something similar,
if a bit less ironclad, might not be a bad idea. But it set up a
downward spiral in the paper solvency of all kinds of financial
institutions. Berlau thinks simply suspending the mark-to-market
rule might be enough to arrest the downward spiral without a government
bailout. William Isaac, chairman of the Federal Deposit Insurance
Corp. from 1981–85, agrees that mark to market has been a mistake.
But Treasury Secretary Henry Paulson seems utterly opposed to such
a reform.


A number of
commentators, led by Ralph Nader, have suggested that one of the
most egregious examples of deregulation that contributed to this
crisis was the repeal of the Depression-era Glass-Steagall law.
It barred commercial banks, which take deposits, from engaging in
marketing securities and other investment activities that investment
banks can do. It was repealed in 1999, with the chief instigator
being, conveniently enough, Sen. Phil Gramm, who committed the "nation
of whiners" gaffe. Bill Clinton signed it, which Nader says
illustrates his contention that both parties are guilty of irresponsible

However, the
evidence, if anything, is that the Gramm-Leach-Bliley bill, which
replaced Glass-Steagall, mitigated rather than exacerbated the crisis.

The institutions
that have failed, Bear Stearns and Lehman Brothers, were investment
banks that declined to take advantage of the Gramm-Leach-Bliley
loosening of regulations and get into depository activities. They
were bought by banks, JPMorganChase and Bank of America, that had.
A few smaller banks are likely to fail after having invested too
heavily in Fannie and Freddie securities. Washington Mutual had
to be bought by JPMorganChase after expanding too quickly and suffering
a bank run. But, by and large, the banks that took advantage of
the ability to combine depository and securities activities are
in reasonably decent shape. Most have money to lend, but given the
crisis they are being more demanding than ever of creditworthiness,
which is likely to be the way this financial crisis wreaks real
damage on the "real economy."


Going forward,
besides repealing the mark-to-market accounting rules, what kinds
of reforms might help to stanch the sense of panic without putting
taxpayers (or our grandchildren) on the hook and tying the hands
of the next administration (which might not be such a bad idea)?
Some people, notably Jeremy Siegel, who teaches at the Wharton School,
have suggested extending federal deposit insurance to money-market
funds and/or increasing the amount the feds will cover from $100,000
to $500,000 or even $1 million. That might halt in the short run
the urge to draw money out of institutions already facing liquidity
problems, but in the long run it would reduce the incentive for
depositors to pay closer attention to the soundness of the institutions
where they put their money, which could encourage risky behavior
again. Maybe a short-term expansion of deposit insurance?

Of course,
Fannie Mae and Freddie Mac should be broken up and reconstituted
as much smaller, purely private enterprises with no access to the
federal treasury.

Right after
the Bear Stearns collapse, Paulson put forward a fairly comprehensive
financial regulatory-reform proposal that had been in the works
at Treasury for several years. Given that the financial markets
are governed by a patchwork of regulations and agencies that have
been added to since the 1930s without much concern about whether
they fit together coherently, that could be the basis of regulatory
reform once the current crisis has passed – if it does.

Given the decisive
contribution of government rules and mandates to the current crisis,
however, I fear what we will see will be the equivalent of giving
an alcoholic free drinks for the rest of his life.

1, 2008

Bock [send him mail] is Senior Essayist at the Orange County
Register. He is the author of Ambush
at Ruby Ridge
and Waiting
to Inhale: The Politics of Medical Marijuana

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