Sunday, December 19, 2010

Beware the Deregulators

Alabama Rep. Spencer Bachus, a darling of free market conservatives and the incoming chairman of the House Financial Services Committee, was honest enough last week to summarize the fundamental contrast between the outgoing and incoming Congressional philosophies when it comes to federal oversight of the financial services industry: "In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks."

Rep. Bachus' comments stirred up a lot of controversy, but they weren't terribly shocking to those of us who have followed the debate over financial reform legislation in general and sought sweeping changes to government regulation of the banking industry in particular. Rep. Bachus opposed virtually every step in the legislative process, bizarrely characterized the Dodd-Frank bill as a permanent bailout law, and even opposed the creation of a consumer financial protection agency designed to prevent the disastrous 2008 meltdown in the financial sector that dealt serious blows to individual investors and pensioners.

But his candor is refreshing because it at least puts his cards on the table and sends a very clear signal to the U.S. electorate regarding one of the consequences of the 2010 mid-term elections. The House leadership has shifted away from a team of elected officials who -- in spite of their obvious failings -- viewed government regulation of the financial services industry as a tool for protecting consumers from excessive risk-taking in the pursuit of maximum profits. The leadership is now held by elected officials who view government as a tool of the private sector that exists to clear the markets for the fittest to survive.

(Of course, the irony is that we surely have learned an immutable fact of American politics by now: massive institutions will not be allowed to fail by the U.S. government as the impact on the American electorate would be too politically costly for our elected officials.)

There is a fundamental myth that underlies the philosophy of Rep. Bachus and other House Republicans who are staunchly opposed to reform of financial industry regulation. It centers around a belief that the 2007-2008 financial collapse was triggered by the bursting of the housing bubble, a bubble that existed because of government-chartered lending organizations Fannie Mae and Freddie Mac, who in turn were pressured by overzealous liberals in Washington to crank up their lending to low-income Americans who couldn't afford their mortgages.

Nice narrative, but one problem: it's nonsense.

First of all, while Fannie and Freddie did indeed dive into sub-prime lending, the truth is that they were very late to get into the game. Ironically, the housing inflation was actually powered by the private lending institutions, leading some to begin opining on whether Fannie and Freddie would be able to compete in this new reality. They finally turned to sub-prime lending in order to get off the sidelines and into the game with the private lenders.

Second, proponents of the Fannie/Freddie myth neglect the fact that both institutions were rocked by accounting scandals in 2004-2006. These significant business problems placed pressure on Freddie and Fannie to reduce the inventory of higher risk loans on their balance sheets, so they were actually withdrawing from the market at the height of the housing bubble. Check the data from 2008 and you'll find that the vast majority of the loans going bad at that time were coming from the private sector lenders.

Third, with the benefit of hindsight, we know that the U.S. residential mortgage debacle was tied to an international real estate meltdown and a commercial real estate bubble that was growing at the same time. It doesn't take a forensic accountant to tell you that neither Fannie nor Freddie were guaranteeing a nickel of mortgage loans outside of the U.S., let alone any commercial real estate mortgages. Tough to connect those dots.

So if Fannie and Freddie weren't the cause of the meltdown, what was? I'm not a believer in finding a single cause for any macroeconomic problem, just as I tend to scoff at the idea that there would be a single solution to the same problem. But in my view, if you're looking for a more logical culprit, it would be deregulation.

Starting in the late years of the Clinton Administration and accelerating in the Bush Administration, the Republican-controlled Congress advocated a series of free market principles as related to the regulation of the financial services industry. They either dismantled or declined to enforce a wide range of banking rules -- mortgage origination fees limits, disclosure laws pertaining to the risks of adjustable rate resets, laddering up of the leverage ratio that investment banks were allowed to use in the creation of those toxic mortgage pools, and other "laissez faire" policies that left investment banks free to create arcane investment products (credit default swaps, CDOs, etc.) marketed to investors without any government regulation.

There is no way for us to know with any precision whether a more consistent and pro-active regulatory regime would have prevented the situation from spiraling out of control in 2007 and 2008. But what is clear is that -- in the words of David Abromowitz, senior fellow at the Center for American Progress Action Fund --"the referees who were supposed to be on the field calling fouls and keeping the mortgage game fair were told to go sit on the sidelines" by the Republican-controlled Congress.

It would appear that was old is new again. In the aftermath of the meltdown, Congress created a bipartisan Financial Crisis Inquiry Commission, allocated a $6 million taxpayer-funded budget, and tasked it with examining the causes of the financial crisis, then reporting its findings back to the Congress, the President and the American public. After 18 months of hearings, including the testimony of more than 800 witnesses and the review of millions of pages of documents, the commission has now completed its work and is preparing to deliver its final report next month.

Apparently, the Republicans on the bipartisan commission are doing their best to align themselves with the incoming philosophy represented by Rep. Bachus. They voted to ban the use of words such as "deregulation" and "Wall Street" from the commission's final report for fear that it would embarrass their pals in the private sector; when their colleagues on the panel didn't go along, the Republicans did the only sensible thing in a democratic republic. They took their toys, went home, and quickly cranked out their own nine-page report that is free of those offensive terms -- as well as many annoying facts or distracting numbers. Instead, it tells a story about how the evil government-chartered lending institutions of Fannie Mae and Freddie Mac triggered the crisis that swept up the heroic private sector bankers.

Sound like a familiar narrative?

Given the recent historical lesson of what happens when we allow the foxes to guard the banking henhouse, one would think that we'd be safe from revisiting the deregulation train again any time soon. But the comments of Rep. Bachus last week make it clear that the train is pulling back into the station when the new Congress takes its seats in January.

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