Deregulation and the Financial Crisis

It would be nice to write off the current crisis on Wall Street and global financial markets as something that only matters to the investor class.

Unfortunately, the effects are already being felt in lower-income communities around the United States. Worst-case scenarios for what spins out from the U.S. mortgage meltdown are truly frightening -- a severe world recession is a distinct possibility.

Whether such worst-case scenarios can be averted, or softened -- and preventing the recurrence of similar crises in the future -- depends on abandoning the laissez-faire financial regulatory regime entrenched over the last decade.

The current crisis is the predictable (and predicted) result of a massive U.S. housing bubble, which itself can be traced in part to global economic imbalances that could have been prevented.

At least five distinct regulatory failures led to the current crisis.

Regulatory Failure Number One: Failure to Manage the U.S. Trade Deficit. The housing bubble (as well as the surge in leveraged buyouts of publicly traded companies ("private equity")) was fueled by cheap credit -- low interest rates. One reason for the cheap credit was an influx of capital into the United States from China. China's capital surplus was the mirror image of the U.S. trade deficit -- U.S. corporations were sending lots of dollars to China in exchange for the cheap stuff sold to U.S. consumers.

Regulatory Failure Number Two: Failure to Intervene to Pop the Housing Bubble. Along with an influx of capital, Federal Reserve policy kept interest rates very low. There were good reasons for the Fed Policy, but that did not mean the Fed was helpless to prevent the housing bubble. As economists Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research insisted at the time, Federal Reserve Chair Alan Greenspan simply by identifying the bubble -- and adjusting public perception of the future of the housing market -- could have prevented or at least contained the bubble. He declined, and even denied the existence of a bubble.

Regulatory Failure Number Three: Financial Deregulation and Unchecked Financial "Innovation." A key reason that mortgages were made available so widely and with such little review of recipients' qualifications was a shift in which institutions hold the mortgages. Traditionally, banks made mortgages and held them. In the new era, banks and non-bank mortgage lenders made loans, but then sold the loans to others. Investment banks packaged lots of mortgage loans into "Collateralized Debt Obligations" (CDOs) and then sold them on Wall Street, with a promise of a steady stream of revenue from interest payments. These operations were pretty much unregulated. Despite the supposed sophistication of the investors involved, no one took account of how shoddy the loans were or -- more fundamentally -- the certainty that huge numbers would go bad if and when the housing bubble popped.

Regulatory Failure Number Four: Private Regulatory Failure. It was the job of ratings agencies (like Standard and Poor's, and Moody's) to assess the CDOs and give investors guidance on how risky they were. They failed totally, likely in part because they wanted to maintain good relations with the investment banks issuing the CDOs.

Regulatory Failure Number Five: No Controls Over Predatory Lenders. The toxic stew of financial deregulation and the housing bubble created the circumstances in which aggressive lenders were nearly certain to abuse vulnerable borrowers. The terms of your loan don't matter, they effectively purred to borrowers, so long as the value of your house is going up. Lenders duped borrowers into conditions they could not possibly satisfy, making the current rash of foreclosures on subprime loans inevitable. Effective regulation of lending practices could have prevented the abusive loans, but none was to be found.

Unfortunately, the consequences of the mortgage meltdown go far beyond the foreclosure epidemic, as horrible a toll as that is taking. The entanglement of the financial sector with mortgage instruments, and the ripple effects of the housing bubble, has made lenders uncertain of who even among large corporations and financial institutions is credit worthy. The resulting credit crunch endangers the functioning of the global economy. Financial markets are guessing wildly about the prospects of banks, insurers and other financial corporations, and the plunging value of stocks poses immediate dangers to the real global economy.

Less acute, but probably more profoundly, the popping of the housing bubble is driving down home prices. U.S. consumer demand over the last five years has been driven by consumers borrowing against the increased value of their homes; with housing values falling, that process is working in reverse. The depressed housing market is also ravaging the construction sector, a nontrivial portion of the U.S. economy. A serious recession looms as a real possibility.

Mitigating these harms and preventing the worst now depends on active and interventionist government -- a government stimulus plan, and aggressive efforts to force lenders to adjust mortgage terms and let people stay in their homes. Preventing financial panics of the kind now underway require new standards of transparency and regulation for high finance. The coming days and months will tell whether any lessons have been learned.

Comments

[Henry]

Back in the 20s there was deregulation, or is that better to say no regulation. This resulted in the crash, record bank failures, and people putting money under their mattress' instead of in the bank or alternatively in an investment. Coupled with the dust bowl it was a period of relative failure for the government.
So what do the Republicans do, they deregulate in several steps. (starting with J Carter to be technically correct) The big failure, in my opinion, was permitting banking accross state lines. This resulted in financial consolidation of some of the mega banks for the country. A local bank is usually concerned about local issues(the ownership lives there). A bank in NY City does not care the least (and to top that they are so terrible at faking sincerity) about a local community. They are interested in profit. Then trail wizkids from mba schools with schemes to funnel profits to the consolidated bank. And you have a distinct difference of the Normal Rockwell America of yesterday to the Andy Warhol America of the big investment bank consortiums. All banking should be local.

[Sundialsvc4]

Let's add to this a few more noxious offenses...

(1) When your bank processes postings and payments to your bank accounts, it always does so "in the manner most favorable to itself," and they want you to believe that you "agreed to" such treatment. So a few days' worth of payments might accumulate (they have eleven days or so) so that, by processing them first and then posting your paycheck last, half-a-dozen "overdraft fees" might be charged.

(I call it "an unlawful breach of fiduciary duty.")

(2) The ordinary interest-rate on an ordinary unsecured loan, such as a credit card, can rise precipitously at any time and for any reason -- or no reason at all. You have no warning and no recourse.

(3) The "funny timing" bit from (1) above is itself an effective interest-rate ... which might be several hundred percent APR or worse.

In short: usury.

[Guitarsandmore]

Regulatory failure number six: The elimination of the capital gains tax on home sales. Previously a homeowner had to actually live in the house for one year and after the sale had to reinvest all of the money into another house or pay capital gains tax (25%) on the profit. This law kept most people from using homes as an investment and forced the average consumer to use a house as a home.

[mmckinl]

The Ugly Truth ... The US goes broke with debt based fractional banking ...

That debt based fractional banking is taking us to bankruptcy. In this system the more debt , the more money, the less debt, the less money there is to borrow and spend. With consumers tapped out or repairing savings, business cutting back, a tsunami of bad loans and a broken risk model the game is up, we will have less money, deflation and increasing bankruptcies.

The only out is Government Money not Federal Reserve Notes. It is called the 'greenback system ' whereby the government can create money without increasing overall debt levels.

Thee video they don't want you to see :

http://www.youtube.com/watch?v=cy-fD78zyvI

[Rule Of Law]

Robert, love your column! Spot on analysis. But I have the feeling I'll be writing this, often--Your Hind sight is truly awesome; where was this trenchant analysis a year ago, when many posters on these same financial blogs were already speculating about these issues?

Why is it only now, and I predict we will see a true lemming like rush to say "we told you so" by all the so called professional money guys, that these points are being made in such an easy to understand and pointed fashion? And, I guess--being one of them--why is it that the working people who stand the most to lose and have the least to give, always get this information from the experts when it is probably too late?

And lastly, now that the cat's out, and you've outlined the flaws, why isn't anyone giving the 99% of America who will pay for all of this any instruction on how to minimize the impact of the coming Depression on US?

And don't get me wrong, your column needs to be written, but even now I don't see anyone reaching down to the people who make this Country the biggest piggy bank in the world for the Rich, and offering the same simple wisdoms that might help us not just to survive, but to mobilize us for change...

[Henry]

Our current sec of Treas, Hank Paulson, came from Goldman Sachs (do we actually work for them?). Goldman of course was smart enough to sell their exposure to subprime securitizations several years ago. Hmmm...what does that tell you about the price of tea in China? (frankly it tells you everything you need to know)

[StephenSmoliar]

Weissman's analysis should be required reading in Davos at this week's World Economic Forum:

http://therehearsalstudio.blogspot.com/2008/01/innovation-and-regulation.html

[NicoleAnonymous]

Thank you - this is excellent.

[lwaxanatroi]

Finally! Thank you. One of our many problems as a political entity is that we focus, when we bother to focus at all, on the immediate issues instead of seeking to understand the big picture. This allows those who do understand the big picture to manipulate the system for their short-term gain with impunity, since the average citizen doesn't realize that their short-term gain is our long-term loss. So those citizens who "bought" twice as much house as they could comfortably afford got to live like Republicans for a couple of years and are now facing foreclosure, while those who did the original lending are long-gone with their profits (and don't think we can tax it back; that money is in the Caymans by now). The Repubs did a superb job of selling the snake oil that all government regulation was a drag on the economy and a thorn in the side of freedom, so even now, we have a collapsed bridge in Minnesota but nobody wants to pay to fix it. We have monster fires her in Southern California, and nobody want to pay for increased fire protection. We have been, are, and will be paying the price for this folly for years to come. What we need, what we always needed, is a countervailing power against the big corporations. Without a strong government on the other side, it's Bend Over, Here It Comes Again.

[Sciguy]

Let's see... local banks no longer hold local mortgages. Local stores sell cheap foreign crap instead of locally produced items. People buy (mostly) foreign oil for their (mostly) foreign cars (defined as any car made by someone who takes the profits out of the US) so that they can get to work at foreign-owned companies - if they're lucky enough to have a job that hasn't been outsourced (yet) to foreign countries with cheaper labor.

And we wonder what's wrong with the economy? Unfettered capitalism is a disaster. It needs regulation in order to work. One doesn't need to be Greenspan to see that - so why didn't Greenspan see it - or care about it?