"The Congress told the American people to go to hell."-Lou Dobbs, on the passage of the 700 billion dollar Wall Street bailout plan, 10.1.08.PART I: REPEALING ROOSEVELT
"The federal reserve is still struggling to contain what is already the most severe credit contraction since the Great Depression. Yet in all of the press coverage, commentators have scarcely acknowledged that this old-fashioned panic is a child of deregulation. During the past decade, the financial economy has repeated the excesses of the 1920s -- too much borrowing to underwrite too many speculative bets with other people's money, too far beyond the reach of regulators, setting up the entire economy for a crash.
The Roosevelt schema of financial regulation was built around two principles -- disclosure and outright prohibition of inherent conflicts of interest. All publicly listed and traded companies were required to disclose to the Securities and Exchange Commission and to the public all financial information deemed "material" to investor decisions. The New Deal also prohibited stock trading based on insider information, and it created structural barriers against the kinds of temptations that ruined the economy in the 1920s. The most notable of these was the 1933 Glass-Steagall Act, which prohibited the same financial company from being both a commercial bank and an investment bank.
The Glass-Steagall wall was devised to prevent a repeat of the 1920s' scams, in which banks made speculative investments, turned the debts into securities, and sold them off to unsuspecting investors with the blessing of the bank. With Glass-Steagall, commercial banks were tightly supervised and given access to federal deposit insurance, to keep savings secure and prevent runs on banks. Investment banks, meanwhile, were not government-guaranteed and were free to do more speculative transactions for consenting adult customers. But Roosevelt's newly created SEC subjected securities markets to much tighter structures against self-dealing and insider conflicts of interest.
The New Deal also acted on the home mortgage front. Millions of people were losing their homes and farms to foreclosures, both creating human tragedies and deepening the Depression. In response, the Roosevelt administration literally invented the modern system of home finance. Pre–New Deal mortgages had typically been short-term notes, where most of the principal was due and payable at the end of a brief term, often just three to five years. The New Deal devised the modern long-term, fixed-rate, self-amortizing mortgage. Congress created the Federal Housing Administration to insure these mortgages and win their acceptance among lenders. It also created the Federal National Mortgage Association to sell bonds and buy mortgages, and thus replenish the funds of local lenders. And the New Deal devised a system of federal home loan banks to supervise and advance capital to savings and loan institutions. Deposit insurance was extended to government-supervised mortgage lenders.
The system worked like a watch, combining sound lending standards with expanded opportunity. The rate of home ownership rose from 44 percent in the late 1930s to 64 percent by the mid-1960s. Savings and loan associations almost always ran in the black, there were no serious scandals, and the government deposit-insurance funds regularly returned a profit.
If you fast forward to 2000, much of this protective apparatus has been repealed. Regulators who didn't believe in regulation and a compliant Congress have allowed financial engineers to evade what remains. In the 1980s, regulators began allowing exceptions to Glass-Steagall. In 1999, Congress finally repealed it outright, permitting financial supermarkets like Citigroup to operate ANY KIND OF FINANCIAL BUSINESS THEY DESIRED, and profit from multiple conflicts of interest. The scandals that pumped up the dot-com bubble of the late 1990s, as well as the most flagrant cases like Enron, and the crash that followed, were the result of the SEC and the bank regulators CEASING TO POLICE CONFLICTS OF INTEREST. In the scandals of the 1990s, corporate CEOs, their accountants, and stock analysts working for their bankers, all conspired to puff up corporate balance sheets and pump up stock prices on which executive bonuses depended. This is a little harder today, thanks to the honest accounting requirements of the 2002 Sarbanes-Oxley Act (which the Bush administration hopes to water down). But the same kinds of conflicts and potentials for abuse exist when a mega-bank underwrites a leveraged buyout by an affiliated hedge fund, and then hypes the sale of securities when the fund is ready to sell the company back to the public.
Meanwhile, the once staid and socially directed system of providing home mortgages was seized by financial wise guys and turned into another casino. In the early 1980s, exploiting the Reaganite theme of government-bashing, the savings and loan industry persuaded Congress to substantially deregulate S&Ls -- which then speculated with government-insured money and lost many hundreds of billions, costing taxpayers upward of $350 billion in less than a decade.
In 1989 when Congress reregulated S&Ls, the financial engineers just did another end run. Mortgage companies that were exempt from federal regulation came to dominate the mortgage lending business. This loop of the story begins in 1968 with the privatization of Roosevelt's Federal National Mortgage Association. In the wake of that move, investment bankers invented a daisy chain known as "securitization" of mortgage credit. Through securitization, a mortgage broker could originate a loan, sell it to a mortgage banker, who would then sell it to an investment bank like Salomon Brothers, who in turn would package the mortgages into securities. These were then evaluated and coded (for a fee) by private bond-rating agencies according to their supposed risk, and sold off to hedge funds or pension funds. Each of these worthies took their little cut, raising the cost of credit to the borrower. Rather than diffusing risks, securitization concentrated them, because everyone was making the same bet on real-estate inflation.
In the sub-prime sector, you could get a loan without a full credit check, or even without income verification. The initial "teaser" rate would be low, but after a few years the monthly payment would rise to unaffordable levels. Both borrower and lender were betting on rising real-estate prices to bail them out, by allowing an early refinancing. But when a soft housing market dashed those hopes, the whole sub-prime sector crashed, and the damage spilled over into other financial sectors.
How aggressively the Fed should move has been the subject of extensive commentary. If the Fed moves too slowly or doesn't cut enough, it ends up playing catch-up behind an advancing panic. If it moves too quickly or too generously, it just invites the next round of speculation with cheap money, and in passing might erode confidence in the none-too-robust dollar. But all of this commentary misses the larger point: If monetary policy is the only tool the government has at its disposal, the Fed can't possibly solve the larger crisis (or prevent the next one) by using interest rates alone.
Indeed, until Congress dismantled financial regulation, the Fed was not called upon to mount these heroic rescues, which have become so common in recent years. Until the 1960s, the central bank could keep interest rates low, confident that they would underwrite the growth of the real economy rather than risky financial speculation, for the simple reason that entire categories of speculation did not exist.
But during the past quarter-century, as deregulation has turned the economy into a casino, the Federal Reserve has had to mount major rescues at least six times. In the early 1980s, it bailed out the big New York banks, some of which lost more than the total amount of their capital in failed speculative third world loans; the money-center banks would have been adjudged insolvent if the Fed hadn't bent its usual capital-adequacy rules. Next, the Fed poured huge quantities of liquidity into financial markets after the stock market crash of 1987, in which the market lost more than 20 percent of its value in a single day. The Fed intervened again on several occasions after speculators destabilized several third world currencies and economies from Mexico to Malaysia. The Fed cleaned up after the aforementioned Long Term Capital Management collapse. It flooded markets with money after the dot-com crash and the attacks of September 11, and most recently in the credit crunch of summer 2007.
Indeed, markets have become so reliant on the Fed's bailouts that they even have a term for it -- "the Greenspan put." A put is a financial term meaning a right to sell a financial security at a predetermined price. The knowledge that the Fed would cheapen money in a crisis reassured speculators that they could always unload their paper. That awareness also influenced financial insiders to behave more recklessly."
PART II: WHOSE TO BLAME?
"There's plenty of blame to go around, and it doesn't fasten only on one party or even mainly on what Washington did or didn't do. As The Economist magazine noted recently, the problem is one of "layered irresponsibility ... with hard-working homeowners and billionaire villains each playing a role." Here's a partial list of those alleged to be at fault:
- The Federal Reserve, which slashed interest rates after the dot-com bubble burst, making credit cheap.
- Home buyers, who took advantage of easy credit to bid up the prices of homes excessively.
- Congress, which continues to support a mortgage tax deduction that gives consumers a tax incentive to buy more expensive houses.
- Real estate agents, most of whom work for the sellers rather than the buyers and who earned higher commissions from selling more expensive homes.
- The Clinton administration, which pushed for less stringent credit and downpayment requirements for working- and middle-class families.
- Mortgage brokers, who offered less-credit-worthy home buyers subprime, adjustable rate loans with low initial payments, but exploding interest rates.
- Former Federal Reserve chairman Alan Greenspan, who in 2004, near the peak of the housing bubble, encouraged Americans to take out adjustable rate mortgages.
- Wall Street firms, who paid too little attention to the quality of the risky loans that they bundled into Mortgage Backed Securities (MBS), and issued bonds using those securities as collateral.
- The Bush administration, which failed to provide needed government oversight of the increasingly dicey mortgage-backed securities market.
- An obscure accounting rule called mark-to-market, which can have the paradoxical result of making assets be worth less on paper than they are in reality during times of panic.
- Collective delusion, or a belief on the part of all parties that home prices would keep rising forever, no matter how high or how fast they had already gone up.
-Robert Kuttner, PART I: "The Bubble Economy," The American Prospect, 9.24.07 , Part II: –Joe Miller & Brooks Jackson "Who Caused the Economic Crisis?" Factcheck.org, 10.1.08. Image: -John Wardell, "Roulette Wheel," Flickr 1.1.06).
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