By Donald Devine
Published: 10-08-08
Et tu Brute? Before the first Congressional vote on Treasury Secretary Henry Paulson’s mindboggling $700 billion bailout/socialization of investment-banking risk no less than the editors of The Wall Street Journal deserted free market solutions and declared “this government intervention is justified” and “we support it.”
Friends of the market were perhaps not as shocked as Caesar that the editors of what was considered the first newspaper of capitalism capitulated but state capitalism seemed a dramatic reversal nonetheless.
Indeed after the House rejected the first bill the editors even lashed out at their former allies as “safe in their think tank” ideologues who think economic reality is an “academic seminar” and criticized the courageous Congressional opponents for their “run for cover” from the majority of their constituents who clearly opposed the bailout.
The abandonment of principle did not even work judging from the negative world market and night-after economic expert reactions once the then even more humongous $850 billion ($17000 per taxpaying household) bailout became law.
Still even the Journal editors were clear about what was the source of the financial crisis - that it was the government that caused the panic in the first place.
• “The original sin of this crisis was easy money” which the Federal Reserve had promoted right up to the present crisis but especially from 2003 to 2005 as it was brewing creating a “vast subsidy for debt that both households and firms exploited.”
• Fannie Mae and Freddie Mac were created by government with the explicit purpose of borrowing at below market rates and with the implied support of the taxpayers which was in fact made explicit during the crisis. It was they who bought the “increasingly questionable” Countryside mortgages that began the rout. Spurred on by Congress to issue more and more “affordable mortgages” to those who could not afford them it is not surprising Freddie and Fannie collapsed and dragged the rest after them.
• This was abetted by Federal and state regulations creating an oligopoly of ratings agencies—S&P Moody’s and Fitch—who promised to rate the risk on securities accurately and therefore provided an implied government safety protection that proved unreliable and misleading but which increased risk-taking before that became apparent. The 2007 action by Congress to end the oligopoly unfortunately came too late.
• The more regulated finance firms like Lehman and Bear Stearns were allowed increased leverage rates from the previous 10 to one ratio up to 30 or 40 to one by the SEC overseers under rules adopted in 2004 by everyone’s favorite aggressive regulator SEC Chairman William Donaldson. When the bull market cooled not surprisingly they failed. By contrast minimally regulated hedge funds and private equity companies have so far survived without government rescue.
• The Community Reinvestment Act of 1977 “compels banks to make loans to poor borrowers who often cannot repay them.” In 1993 the Clinton Administration rewrote the regulations to force more loans and in 1994 announced a National Homeownership Strategy to push even more poorly financed minority borrowers into mortgages. Fannie and Freddie were allowed to hold just 2.5 percent of capital compared to 10 percent for banks. Wonder why these loans might fail in a crisis?
It is not as if no one foresaw what would happen in face of these governmental actions. In 2005 even the normally opaque Fed chairman Alan Greenspan told Congress in the bluntest possible terms: If Fannie and Freddie “continue to grow continue to have the low capital that they have continue to engage in the dynamic hedging of their portfolios which they need to do for interest rate risk aversion they potentially create ever-growing potential systemic risk down the road. We are placing the total financial system of the future at a substantial risk.”
The Journal editors could have added that it was the initial New Deal regulations that were the seeds of the current crisis. The Glass-Steagall Act of 1933 separated investment firms from bank depositories and forbade such combinations in the future in the mistaken belief that intermingling the two had caused the Great Depression. After years of academic study proving otherwise Glass-Steagall was finally overturned in 1999 by overwhelming votes of 362-57 in the House and 90-8 in the Senate.
Still the bottom line for the Journal editors was that only the Government could solve the problem although they would prefer the Federal Deposit Insurance Corp to the Treasury. Only the American people and a few courageous free market Congressmen economists and commentators favored letting the market hit bottom and allowing those who had taken the risks to pay the costs of their decisions. Investment bankers made billions in profit and were expected to bear the burden of the downturn. Individual mortgagees received the benefits of initial 1.9 percent interest rates and living in houses they could not afford were expected to bear the balloon burden of their decisions. There was no reason to expect the Paulson plan to work over the long run so there would probably be a rough adjustment in any event so why not save the trillion dollars and allow an otherwise sound economy to recover?
As President George Bush was on television rallying the nation to support the bailout deal a Rasmussen poll showed that only 30 percent of voters approved his rescue of the financial markets. Indeed 63 percent were concerned that the Federal Government would over-react to the crisis up from 49 percent the week before. While 77 percent of Republicans believed the government might over-react even 47 percent of Democrats believed so too. Half of the voters said it would be better if the government let the financial firms that made the investments go bankrupt Republicans by a 15 point margin and Democrats narrowly.
In spite of this the call from unreconstructed New Dealers was not “let the market work” but for “more regulation” the constant mantra of the Barack Obama campaign - as if John McCain as head of the Commerce Committee had not favored plenty of regulation and in spite of the fact regulations mandating cheap loans were the source of the problem. To his credit Sen. McCain was one of three Senate cosponsors of S-190 which at least attempted to rein in Fannie and Freddy in 2005. As economist Alan Reynolds emphasized even after Glass- Steagall ended the Federal Reserve the Securities and Exchange Commission the Comptroller of the Currency and the FDIC were still in charge of regulating all of the giant conglomerates that emerged and they issued and enforced plenty of regulations.
Innocents who seek security in regulation need to recall however that not one of those august agencies exhibited timely foresight or concern about the default risk among even prime mortgages in some locations or about any lack of transparency with respect to bundling mortgages into securities. People do not become wiser more selfless or more omniscient simply because they work for government agencies.
Indeed how could the current crisis have been mitigated at all if J.P. MorganChase bank could not have bought Bear Stearns investment banking Reynolds asks? The Bank of America could not have bought Merrill Lynch Barclay’s Bank could not purchase most of Lehman and Goldman Sachs and Morgan Stanley could not become bank holding companies. Moreover
A powerful motive for converting investment banks into commercial banks is to get around those onerous balance-sheet rules that required fire-sale pricing of securities that were virtually unmarketable during a panicky scramble for liquidity. Strict adherence to those mark-to-market Sarbanes-Oxley rules made patience a vice and a buy and hold approach impossible. This confirms what many of us have long been saying about the foolishness of letting arbitrary bookkeeping rules dominate economic reality.
Reinstating hard money the privatization of Freddie and Fannie elimination of the unrealistic mark-to-market accounting rules higher liquidity standards the combination of deposit and investment banking and the elimination of the Community Reinvestment Act and its Clinton enhancements would be sound long term solutions. Were there market solutions for the short term other than just eliminating these dysfunctional regulations? Economist Brian Westbury proposed to allow financial firms to erect accounting firewalls around at-risk assets created between December 2003 and August 2007 to isolate them on their balance sheets from the rest of their assets and then holding them to maturity. The government’s only role would be to insure rather than purchase the sequestered funds keeping the assets as private property away from government socialized control a suggestion essentially incorporated into a Republican Study Committee proposal.
In any event some adjustment to the fact of massive over-leveraging must take place or the U.S. economy will go into a long-term decline like the decade-long Japanese stagnation or even the similarly long Great Depression. It is not just the banks and the government agencies that are over-leveraged.
Martin Wolf in the Financial Times reports that U.S. household indebtedness jumped from 50 percent of gross domestic product in 1980 to 100 percent in 2007 while financial sector debt increased from 21 percent of GDP to 116 percent over the same period. This gross deviation from historical degrees of indebtedness must and will be corrected leading to lower – but one hopes more sustainable – levels of growth in the future. The only question is how long government actions will delay and deepen the inevitable.
