Perfect Storm of Regulatory Ignorance

You may be familiar with the Community Reinvestment Act of 1977 that mandated loans to “sub prime” (poor credit risks) borrowers and the roll that the Federal National Mortgage Association (Fannie Mae) and Freddie Mac subsequently played by encouraging loans to sub prime borrowers with little or no down payment.  Perhaps you suspect that government may have caused the housing bubble that precipitated the financial crisis of 2008 and the depression that followed.  But there is more to the story!

Commercial banks are familiar to anyone with a checking or saving account; they accept our deposits and use the money to make loans and mortgages. In 1933, Federal regulators created the FDIC to insure bank depositors who worried that if banks made risky loans, their accounts might be in jeopardy.

Once deposit insurance took effect, regulators feared that since the government would guarantee bank deposits; bankers would be more likely to make risky loans and investments.  The regulators solution to this (real or imagined) problem was to institute bank-capital regulations which required banks to hold a minimum capital cushion against bad loans and investments.

In 1988, world financial regulators agreed that commercial banks did not have to devote capital reserve to its holding of government bonds, cash or gold, but had to reserve 4% of each mortgage issued, and 8% of commercial loans and corporate bonds. The United States in 1991 implemented a 10% requirement for “well-capitalized” commercial banks.

Ten years later, however, came what proved to be the pivotal event. Regulators issued an amendment that extended reserve requirements to asset-backed securities (ABS): bonds backed by credit card debt, car loans or mortgages. This new amendment required a mere 2% reserve, as long as these bonds were rated AA, AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie Mae or Freddie Mac.

Obviously the banks loaded up on Mortgage Backed Securities (MBS)’s because of the extremely favorable treatment they received. Where a well-capitalized bank previously needed to reserve $10 of capital to support $100 worth loans or corporate bonds, and $5 to support $100 worth of mortgages, it now needed only $2 of capital to hold mortgage-backed security (MBS) worth $100. Banks were anxious to trade their loan portfolios for MBS.

These regulations helped turn an American housing bubble into the world’s worst recession in 70 years.

When sub prime mortgages began to default in the summer of 2007, those high ratings on MBAs were in doubt.  A year later the doubts turned into panic.  Federal regulators mandated Banks use mark-to-market accounting – requiring that assets they were holding be valued at the price for which they could be sold right now. This action translated temporarily low market prices into actual numbers that looked very bad on a bank’s balance sheet.  The market for MBS dried up and banks, worried about their solvency, stopped making new loans; the result a lending freeze that led to recession.

Given the large number of contributory factors, it has been said that the financial crisis was a “Perfect Storm of Regulatory Ignorance”.  Here are a few more factors.

• Bank panics were almost uniquely American events; there were none in Canada during the Great Depression.  Many believe that bank panics were caused by 19th century regulations that impeded branch banking and bank “clearinghouses”.  Thus, deposit insurance instituted in 1933 might have been a mistake based on the New Deal legislator’s ignorance of the fact that the bank panic in America was the unintended effect of previous regulations.

• The tax code discourages partnerships in banking.  Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. 

• Tax and securities laws encourage publicly held banks-as opposed to partnerships or privately held banks and these entities tend to encourage their employees to generate short-term profits.  One way to generate short-term profits was to buy into the housing bubble.

• No-recourse laws in many states, allowed borrowers to default on a house then simply walked away with no financial liability. This encouraged people to take on a potentially unaffordable mortgage with virtually no risk.

• Regulators treat monies set aside for loan losses as part of a banks’ Tier 2 capital, which is capped in relation to Tier 1 capital-equity raised by selling shares of stock.  The tax code makes equity capital unnecessarily expensive; thus banks are discouraged from maintaining a large capital cushion.

Bankers appear to have been ignorant of yet another obscure regulation.  A 1975 amendment to the SEC’s Net Capital Rule turned the three prominent rating agencies S&P, Moody’s and Fitch into a legally protected monopoly.  As we would expect of corporations shielded from market competition, these three rating agencies became sloppy.  Moody’s had not update its residential mortgage model sense 2002, when the housing boom was barely underway. Moody’s model, like those of its’ competitors, determined what could go into mortgage-backed securities

This litany is meant to point out the myriad of regulations that have grown up in such immense profusion that nobody can possibly predict how they will interact with each other.  We are all ignorant of the vast bulk of what the government is doing for us, and what those actions might be doing to us.  That is the best explanation for how this perfect regulatory storm happened, and for why it might well happen again.

 Social Democracy appears to demand that government solve every social problem as it arises and rests on the premise that when something goes wrong, somebody whether the voter, the legislator or the regulator will know what to do about it.  Thus a great mass of laws have grow up over time- seemingly in inverse proportion to our ability to comprehend the causes of the underlying problems. Future regulators will tend to assume that the problem with which they are grappling is a new “excess of capitalism,” not an unintended consequence of an old mistake in the regulation of capitalism.

 Pat McCourt

 Based on an article written by Jeffrey Friedman and published by The Cato Institute.