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.
THE HOUSING BUBBLE
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 199298, 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 200304, 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.
MARK TO MARKET
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 198185, agrees that mark to market has been a mistake. But Treasury Secretary Henry Paulson seems utterly opposed to such a reform.
REPEAL OF GLASS-STEAGALL
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 deregulation.
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.
October 1, 2008
Alan 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.