April 28, 2010

Regulating Something Other than the Problem

Justin Katz

Veronique De Rugy argues that deregulation was not the culprit in the current economic crisis:

The great villain in the deregulation myth is the Gramm-Leach-Bliley Act, signed into law by Bill Clinton in 1999, which repealed some restrictions of the Depression-era Glass-Steagall Act, namely those preventing bank holding companies from owning other kinds of financial firms. Critics charge that Gramm-Leach-Bliley broke down the walls between banks and other kinds of financial institutions, thereby allowing enormous systemic risk to percolate through the financial world. This critique is the keystone of the "blame deregulation" case, but it doesn't hold up: While Gramm-Leach-Bliley did facilitate a number of mergers and the general consolidation of the financial-services industry, it did not eliminate restrictions on traditional depository banks' securities activities. In any case, it was investment banks, such as Lehman Brothers, that were at the center of the crisis, and they would have been able to make the same bad investments if Gramm-Leach-Bliley had never been passed.

Another common claim, that credit-default swaps and other derivatives left unregulated by the Commodity Futures Modernization Act of 2000 were a cause of the financial crisis, doesn't stand up to scrutiny, either. Research by Houman Shadab of the Mercatus Center has shown that this argument is undermined by its failure to distinguish between credit-default swaps, which are simply insurance against loan defaults, and the actual bad loans and mortgage-backed securities at the root of the crisis. Stricter regulation of credit-default swaps wasn't going to make those subprime mortgages any less likely to go bad.

There is room to argue that stricter regulation might have prevented risky loans from permeating the economy so deeply. Such arguments, however, assume that regulators would have targeted the correct risks, when the evidence — indeed, the origin of the crisis — suggests that government officials would not have (and still would not) dampened the trends that needed dampening.

As conservatives have been arguing for quite some time, the implicit government backing of bad mortgage loans through Fannie Mae and Freddie Mac was the key ingredient encouraging the financial industry to treat such mortgages as too safe of an investment. De Rugy notes that Fannie and Freddie "guarantee[d] nearly $5 trillion in home loans with a mere $100 billion in net equity." She also highlights decreases in capital ratios permitted by the regulators themselves.

I suppose there's a case to be made that regulations that counteracted incentives that the government created with low interest and financial backing of bad mortgages would be to the good. But why not just stop creating those incentives by decreasing the role of government?

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Regulation is the direct cause of the housing bubble and the mortgage crisis. The Community Reinvestment Act was strengthened and perverted in the 1990s to force banks to make home loans to unqualified buyers for political purposes. It was enforced by a combination of official action by the Office of the Comptroller of the Currency(or OCC, of which I was once an employee) and indirect action in the form of lawsuits and jamming up the regulatory process by "community organizer" pressure groups such as ACORN, the Urban League, and La Raza.

This was further abetted by Congressional action that required the government loan guarantee companies, Fannie and Freddie, to guarantee or buy these poor-quality loans. And when the GSEs hit their authorized ceilings, the Democrats in Congress increased their legal capacity. Financial capacity wasn't an issue at the time, because the federal government implicitly guaranteed the debt of the GSEs. Meanwhile, prominent Democrats including Franklin Raines (who got over $100 million in bonuses during his tenure at Fannie Mae) and Rahm Emanuel made $millions personally out of the scheme.

At the same time, the Federal Reserve held interest rates down as a policy action to "stimulate the economy," which made it easier at any income level to qualify for a bigger mortgage, thus feeding the bubble.

Honest observers will remember that the Bush administration and Republicans in Congress warned about the abuses and recommended stricter regulation of the GSEs, but were rebuffed in the most insulting terms by Barney Frank, Chris Dodd and other Dems in Congress.

Dishonest commenters will say it was all due to the repeal of Glass-Steagall. This is a canard. Glass-Steagall repeal merely allowed banks to own subsidiaries that underwrote and sold securities just as the investment banks on Wall St. did. It had no negative effect on the banks' exposure to real estate or any other sector of the loan business. In fact, the repeal actually helped the soundness of the banks as it made it easier for them to securitize and sell off to willing, sophisticated, professional investors loan exposure from their balance sheets that they otherwise would have been stuck with.

Bottom-line: Democrats gamed the system for their own political purposes and the banking industry was either forced or encouraged to play along. The perceived risk was low (although the actual risk was high and growing like a bubble). After all, the government was implicitly behind the entire racket.

The present government wants us to believe that it can, through regulation prevent financial bubbles and economic cycles to give us all a smooth, rising road to prosperity. This is a shameless, cynical lie, akin to a flea claiming it can make an elephant dance.

Posted by: BobN at April 28, 2010 8:26 AM

Bob is correct. When the meltdown occurred a couple of years ago, I realized that it was probably one of the biggest, most significant events that I would experience during my lifetime and that I should probably take the time to understand it. The other thing I realized was that most commentators on the news and radio and most of the people around me had no real idea of what had happened. I started reading books and online writings about the crisis and listening to economics shows and podcasts to try and make sense of what even the so-called experts admit is an extremely complex topic.

Even though these sources have demonized various sources and choose to emphasize different parts of the problem, the underlying causes always point back to the same thing in their stories - a bubble of perverted market incentives caused by the GSEs, the Fed, the FDIC, interest rates, and Congressional mandates. When cornered on these issues by Russ Roberts of EconTalk, even the most Keynesian and liberal of economists have to admit that these were at the real root of the problem. They cannot explain it without conceding this point. Those who advocate for increased regulation can only differ as to the prescription for moving forward, they cannot credibly dispute the causes with anyone who is educated about the surrounding regulatory climate and events.

When somebody tells you that the banks "caused" the meltdown, tell them that they caused it like a fork causes obesity. When somebody tells you that the problem was "the free market", "deregulation", or "greed," simply say nothing and walk away from them - you are listening to a willfully ignorant person who has gleaned out of this what they want to believe rather than using it as an opportunity to actually educate themselves. Needless to say that RIFuture has been full of armchair economists and philosophers making exactly those kinds of sweeping claims on a daily basis with no real understanding of what transpired.

Posted by: Dan at April 28, 2010 9:12 AM

Republicans seem to enjoy simplifying things they cannot understand, and then telling 1/2 the story.

First of all, notice how Justins post says "signed by President Clinton"? It does not say "Put forward by Phil Graham of Texas and the Republican Congress and buried in a budget bill", which is closer to the truth of the matter.

But that being said, these are complex issues.

The whole idea of the government standing behind most mortgages seems to be a BAD one from the start! But it was not based on some "socialist" idea of irresponsibility, but as a way to allow the providers of mortgages (banks, lending institutions) to provide MORE mortgages, since they could free up capital by passing mortgages off into a pool.

This is something LOVED by banks, builders, realtors, construction materials companies and even the homeowners! No down side - at first glance!

But then, as with all human endeavors, folks find loopholes and stretch the rules in order to put MORE money into their own pockets - in this case ALL the named industries and more drank the kool-aid until they puked (all over us).

While it is fine and dandy to sit here now and monday morning QB, the fact is that our entire country would come to a grinding halt if the government had stopped buying mortgages at ANY time in the last number of decades. However, as long as the as the parties involved were being honest about sales, appraisals, quality, etc......the house of cards would stand up. Heck, if the basic rules were followed, I'd invest in mortgage securities any day of the week...and I am a very conservative investor.

However, as we have seen Capitalism without regulations and Corporations without ethics will eat all of us and spit us out.

The government was not responsible for this crisis, although some seem to just love pointing the finger. A bunch of PIGS, who worked everywhere from Wall Street to Main Street, were responsible, and the relaxing of the rules just made it so that these pigs could gorge more.

I notice that I don't hear a lot of complaining about another big government real estate giveaway - allowing you and I to deduct our mortgage interest! Why should someone with a million dollar residence be able to get a free ride on the money he is paying for his mansion?

But no one complains.

Think, folks. I'm sure many of you or your families have sat down at the settlement table and had loans which were FHA backed. Based on all the critiques above, I have to wonder why you didn't refuse to take that horrible tainted money.

Posted by: Stuart at April 28, 2010 6:43 PM

>>Honest observers will remember that the Bush administration and Republicans

Honest observers will watch the speech and words spoken by GW Bush which are now history, in which he extolled giving vast amounts of new loans to those who could not afford it.

Honest observers MUST KNOW that any and all major legislation which was put forward and passed under the Bush Admin...which had majorities in Congress also......have little or nothing to do with Democrats.

Honest observers MUST know that Wall Street, Builder, Realtors and thousands of corporations and tens of millions of people were fattening themselves on the pork of misleading people and the FHA (wink wink) about the qualifications of loan applicants and the pumped up values of properties.

Honest people MUST KNOW about the prelude to this crisis, called the S&L Crisis, a 100% Republican doing, in which everyone from McCain to Bushes family were personally involved and which cost the country 100 Billion and flattened the real estate market for 10 years.

But, no.....it must be Barney Franks fault...a guy who is one of 455 Congress members and who was in the minority at the time.

Honest people should know a lot. The problem is, we don't have many of them here.

Posted by: Stuart at April 28, 2010 6:50 PM

Without getting into the sophistry of the techniques employed, what we have is human nature at work.

The businessmen involved were not hired to provide for the common weal, they were hired to produce profits and advance themselves.

The politicians involved want to see "the good time roll", this facilitates their re-election. If easing a regulation advances that cause, and aids in their re-election, they will go for it. By now, they are secure in the knowledge that if it all fails there will be plenty of people to point fingers at.

The sheeple cannot escape some blame. I knew plenty of people habitually refinancing because "it was the thing to do" and "everyone was doing it". It seemed like free money, I suppose it is part of a "stimulated economy"

An aside, has anyone else noted that the case against the Hutaree Militia seems to be falling apart? At a bail hearing the FBI was hard pressed even to explain why they were arrested.

Posted by: Warrington Faust at April 29, 2010 12:12 AM

You are right, Faust, on the human nature part of the equation. When you provide each business and person along the way with a carrot...to be selfish...you get what you ask for.

As to the militia, I'm glad you are not a member of media. Perhaps you are referring to the bail bond hearing, not the actual case.

It is always a difficult thing to determine when talk is just talk, and when it means more. Heck, they are talking planes out of the sky for a sentence or two with absolutely no proof....but then it seems as if you support the rights of a bunch of folks to run around with guns, training and written plans to kill cops and government officials? I hope not........wouldn't want to think traitors live among us here in RI.

Posted by: Stuart at April 29, 2010 2:43 PM

Stuart writes:

"As to the militia, I'm glad you are not a member of media. Perhaps you are referring to the bail bond hearing, not the actual case."

Yes, I was referring to the bail hearing. The judge seems to be having some difficulty in understanding why they were arrested, and the FBI seems unable to clearly explain that.

The FBI is having a hard time showing "discussions", not to mention "written plans".

"but then it seems as if you support the rights of a bunch of folks to run around with guns," In a way I do, it is called a constitutional right. I am not about to join a militia, but, there are those Black Helicopters.

Posted by: Warrington Faust at April 29, 2010 3:40 PM
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