Perfect Storm of Regulatory Ignorance
If you do not know your history; You are destine to repeat it!
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) 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 accept deposits then use the money to make loans and mortgages. In 1933 Federal regulators created the FDIC to insure bank depositors who worried that their local bank might make risky loans and place their account in jeopardy.
Bank panics were almost uniquely American events; there were none in Canada during the Great Depression. Many believe that bank panics were caused by an earlier 19th century regulations that restricted branch banking and bank “clearinghouses” making it very difficult for small local banks to compete with the large population center banks. 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.
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 had to reserve 4% of each mortgage issued, and 8% of commercial loans. In 1991 the United States implemented a 10% requirement for “well-capitalized” banks but exempted from this rule holdings of government bonds.
Ten years later, however, came what proved to be the pivotal event. Regulators issued an amendment that extended reserve requirements to asset-backed securities: 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 such as Fannie Mae or Freddie Mac.
Obviously the banks loaded up on Mortgage Backed Securities (MBS) because of the extremely favorable treatment they received. Where a well-capitalized bank previously needed to reserve $10 of capital to support $100 worth of loans 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 MBS were in doubt. A year later the doubts turned into panic. Federal regulators mandated Banks use mark-to-market accounting – this required the assets they were holding be valued at the price for which they could actually 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.
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 and regulators 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 updated 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 the highly rated 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. This 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 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.
And now folks for their next act!
Senator Chris Dodd's 1,408 page financial reform bill! Lobbyists from big labor and big finance joined forces to make sure the legislation is a Wall Street Bailout Bill. And that's exactly what it is.
1. The new Financial Stability Oversight Council will determine which firms are "too big to fail." Qualifying firms will be encouraged to take on undue risk because they'll know with certainty that the government will bail them out.
2. The Treasury Secretary will have the power to order seizure, without meaningful judicial review, of any firm he deems "in danger of default."
3. The Federal Deposit Insurance Corporation will have the ability to set aside funds for the liquidation of covered financial institutions. This is similar to the AIG bailout where Creditors, not shareholders, would be eligible for a cash bailout.
4. The "Orderly Resolution Fund" is a clear indication of future bailouts. This $50 Billion Bailout Fund is funded by taxes on financial firms, a cost that will ultimately fall on the firm's customers.
5. Bailout authority can also apply to firms the FDIC determines are "solvent depository institutions." The additional costs will be funded by the Treasury's newly established "line of credit" to the FDIC, which will come from taxpayers.
6. The Senate bill would require virtually all derivative contracts, which help markets manage risk, to be settled through a clearinghouse rather than directly between the parties. This would make financial derivatives more costly, more difficult to customize and consequently, less widely used—which would increase overall risk in the economy.
Lawmakers who support the bill should consider they are doing nothing to reduce the systemic risk offered by "too big to fail" firms. These firms will continue to take risks because the federal government has promised to clean up the mess.
“Too big to Fail” undermines the very foundation of the Free Enterprise System; a system that has brought free Americans the highest standard of living the world has ever known. The freedom to fail is the basic self cleaning mechanism of the free enterprise system; to eliminate the possibility of failure, will eventually cause the whole system to collapse. Unfortunately that appears to be the ultimate plan.
Congress should instead establish accountability by creating a modernized bankruptcy procedure for these large institutions. This would ensure that regulators cannot revert to politically motivated bailouts and other forms of government intervention.
The consequences of allowing the government to direct the economy are always disastrous. Warding off a future economic crisis should not be in the hands of the government. Instead, the government's approach should be hands-off.