Financial Regulations Reformed?

On Wednesday, if all goes as planned, President Barack Obama will sign the financial-reform bill crafted by Senator Chris Dodd of Connecticut and Congressman Barney Frank of Massachusetts, sponsored by the Democratic Party in both houses, and supported by three Republican Senators – Scott Brown of Massachusetts and Susan Collins and Olympia Snowe of Maine. When the bill is signed, we will be told, as we have repeatedly been told in the last few months, that the measures included within it will prevent future financial crises of the sort that we have suffered from over the last two years.

By now, of course, most Americans have become skeptical of such claims. We were to told that the so-called “stimulus” bill would bring unemployment down, and we learned that its main function was to reward constituencies favoring the party in power. It increased dramatically the salaries of those within the federal civil service, it expanded that civil service massively, and it enabled the state governments and the localities to continue to pay those who worked within the public sector at those levels. Similar lies were told during the healthcare debate. We were told that no one would lose his coverage, that no one would be forced to acquire health insurance, that the cost curve would be bent downward. It is proper to ask whether we are being lied to now and whether Senators Brown, Collins, and Snowe have sold us down the river.

The answer depends – to a considerable degree – on what were the causes of the recent financial crisis. Was it caused by a market failure? If so, is it likely that governmental regulation will prevent such failures in the future? These are the claims advanced by Paul Krugman and the like; these are the claims put forward by President Obama, Senator Dodd, and Congressman Frank. And, on the face of it, they would appear to be true. There was, after all, a bubble in the real estate market. Goldman Sachs and the like marketed junk bonds, made up of mortgages, on a gigantic scale and managed to get for them a triple-A rating from S&P and from Moody’s, and insurance against default was purchased from outfits like AIG that had no idea of the risks involved. The Securities and Exchange Commission and the Federal Reserve could and should have intervened.

But one must be cautious about calling what happened “a case of market failure,” for the real-estate market was not a free market. One could, of course, reply that no market is a genuinely free market. The “free market” is an ideal type. It does not exist in reality. The government interferes and gives shape to virtually every market through taxation, regulation, and laws detailing how contracts are to be enforced.

These objections are all too true. But they are not pertinent to this particular case – for, in the years leading up to the crisis, the real-estate market was structured and regulated by the federal government in a particularly dangerous way.

The mortgage market is not a great mystery. It has existed for a very long time, and by a process of trial and error bankers have learned to calculate the risks. Long ago, they figured out to whom they could safely make loans and under what conditions. If one is provided with the proper information, it is not hard to judge whether a prospective borrower proposes to pay substantially more than the property he intends to buy is worth and whether he is likely to be able to pay back what he is loaned and can be relied upon to do so. One can easily enough discover how much he makes, whether he is in a profession where he may soon lose his job, and whether he has in the past consistently paid off his loans. Where there are doubts, an interview by a canny loan officer can clear up a lot. Moreover, it makes good sense to require that a borrower put down on the house or condominium he proposes to buy at least 20% of the price. A borrower who has a substantial amount of skin the game is far less likely to default.

Why, then, did the mortgage market produce so great a crisis? For one simple reason: the banks were not allowed to do their job. Starting under the Clinton administration, when Andrew Cuomo was Secretary of Housing and Urban Development, local banks were required to ignore what had been learned about the likelihood of default and to loan money to prospective borrowers who did not meet the standards previously maintained. As a consequence, prospective borrowers with insufficient income and bad credit were given loans they were most unlikely to be able to service, and they were not required to put down anything more than a nominal sum.

This practice – the issuing of what came to be called sub-prime loans – was justified on the grounds that, at one time, banks were cautious about making real-estate loans to people who lived in poorer parts of town. This was called red-lining. Its critics claim that the motives for red-lining were racist, and there may be something to the charge. But, before simply accepting the truth of this claim, we should consider whether loans made on real estate in such neighborhoods were not in ordinary circumstances exceedingly risky. The sub-prime loan scam was a species of what is euphemistically called “affirmative action.”

Why, one might ask, did the banks not cry wolf when Andrew Cuomo came knocking at their doors? Here the answer is that the Clinton administration offered them the means to offload these loans and all of the attendant risks onto others. This is where Fannie Mae and Freddie Mac came in. The former was founded in 1938 and turned into a publicly-owned, government-sponsored enterprise (GSE) in 1968. The latter was founded as a GSE in 1970. Both were designed to expand the secondary market in mortgages, which they bought from banks and re-packaged as bonds to sell to investors. All of this was aimed at increasing the supply of funds available for mortgages and at reducing thereby the interest rate charged. In the Clinton years, at the insistence of Andrew Cuomo and others in the administration, these two entities began systematically buying up the sub-prime loans that the banks were forced to issue. These they repackaged along with other loans, and the bonds created in this fashion were sold to investment banks, which sold them in turn to individuals, pension funds, and the like. What began under the Clinton administration was expanded at the insistence of George W. Bush. What a fine thing it would be, thought he, if more and more Americans owned their homes?

Why, one might then ask, did the investment bankers, the individual investors, and the managers of pension funds not recognize the risks they were taking? Here the culprit is a man named Alan Greenspan, and one might mention Ben Bernanke as well. Greenspan chaired the Federal Reserve Board for nearly twenty years – from 1987 to 2006. That institution was created in 1913, in response to the financial panic of 1907, for the purpose of manipulating interest rates and advancing loans to banks in such a fashion as to head off financial crises. Its remit has been expanded and its focus readjusted at intervals since. Its creation and the expansion of its responsibilities are based, however, on the presumption that a small number of experts, located in Washington, DC, can more efficiently manage the money supply and the market for money than an unfettered market would.

From time to time, we have been reminded that this presumption is highly questionable. The financial crisis that descended upon us in 2008 was one such occasion. To put it bluntly, Alan Greenspan in the 1990s and in the first five years of the new millennium did what he could to keep interest rates low, duplicating the blunder made by the Federal Reserve Board in the 1920s. The result was what, at a speech delivered in my presence at a dinner put on by the American Enterprise Institute, he called “irrational exuberance” in the markets.

What Greenspan had in mind when he gave that talk was the dot-com bubble. What he failed to recognize was that he and his colleagues had produced that bubble. They had kept interest rates artificially low. It was unusually cheap to borrow money because the supply seemed endless, and people borrowed for the purpose of investment, bid up the price of stocks, and others jumped on the bandwagon. When that bubble burst, Greenspan kept interest rates low, and a real-estate bubble emerged in precisely the same fashion.

But this was not all. Interest rates were so low that the sub-prime market expanded on a grand scale at the same time, and the banks had no reason not to loosen standards further. After all, cheap loans are easier for borrowers to service – and Fannie Mae and Freddie Mac were prepared to buy these loans as well, and this meant lots of work and income for the rating agencies as long as they went with the flow and refrained from acknowledging that what was going on was a scam.

Was there corruption on Wall Street? You bet. Did the rating agencies engage in fraud? I fear as much. But, given the well-known propensity of human beings for excess and greed, this is what one would expect.  In the 1920s, the easy-money policy of the Fed produced irrational exuberance in the markets, and the same thing happened under Alan Greenspan.

How could it have been avoided? If Andrew Cuomo had not interfered in the mortgage market, there would have been no subprime mortgages. If Alan Greenspan had not kept interest rates artificially low, there would not have been so much cash sloshing about in search of high returns. Of course, if the folks at Goldman Sachs, Bear Stearns, Lehmann Brothers, S&P, and Moody’s had been paragons of virtue, caution, and thrift, we might also have avoided the worst. But can one expect this sort of virtue from moneymen? Or from anyone else? The temptation to make a quick killing is hard to resist – especially if your aim is to make a bundle from the outset.

I do not mean to argue that the market, if left unfettered, would never produce a bubble. On any given day, a lot of people will pay too much for a particular stock, the bonds of a particular institution, and for real estate, and sometimes dimwits will jump on the bandwagon. But, if the market is left relatively free, what goes up too high will quickly come down as others identify and capitalize on the blunders of those who have overpaid. What the government does, when it interferes unduly in markets, is to magnify those blunders. Andrew Cuomo thought that he was being clever; so did Robert Rubin (both when he was Secretary of the Treasury and when he bankrupted Citibank); and, alas, so did George W. Bush and Alan Greenspan. They all thought that they understood what no central administrator has or can have at hand the information needed for understanding. The financial crisis of 2008 was caused by an easily predictable failure on the part of those who pretend to be expert at what Franklin Delano Roosevelt called “rational administration.”

Does the financial reform address this failure? Not at all. It pretends to be the cure when it is, in fact, an aggravation of the disease. It presupposes that the antidote for a crisis caused by attempts on the part of the government to manipulate the mortgage market is more government interference in the financial markets.

This is, of course, what one would expect from Chris Dodd and Barney Frank. After all, when Alan Greenspan and the administration of George W. Bush finally became concerned about the solvency of Fannie Mae and Freddie Mac, Dodd, Frank, and their fellow Democrats blocked the Bush administration’s attempt to rein in these GSEs.

In short, a number of the doctors most responsible for infecting us with the disease from which we now suffer have taken charge of supplying us with a cure.

And Senators Brown, Collins, and Snowe? Well, they have a lot to answer for.