Finance V

Blogger bobn insists that increases in allowable investment bank leverage was the principal cause of the mortgage crisis, as opposed to regulation of the GSEs (Fannie Mae and Freddie Mac):

[T]he 2004 tripling of leverage allowances at the 5 big I-Banks certainly did. My mortgage disaster post, which Carl seems to have read very poorly, shows how these events were related temporally (1st part of my post) and causally (2nd part of my post). . .

Congress made no law requiring OFHEO to keep it's hands off of FNM and FRE. Short of a law, all the ranting in the world makes no difference to the fact that a regulator is supposed to regulate.

As part of a continuing series, my reaction:

1. bobn's post quotes a liberal housing pressure group-affiliated website saying "Because investment banks provide subprime lenders with necessary funding, they wield a great deal of power in determining what sorts of loans are offered to subprime borrowers." Well, sort of--investment banks provided funding. But they didn't hold a gun to borrowers' heads. As I have said, much of this crisis was demand driven (though for some reason that notion outrages bobn). Which is why today even prime mortgages are increasingly under water.



2. Even assuming investment bank funding was the driver--the link claims only "a great deal of power"--of subprime lending, why do I care about investment bank regulation? Investment banks are not government insured--investors assume the risk. The fact that their decisions didn't pan out should be irrelevant (so long as the government doesn't bail out investment banks as the Fed did for Bear Stearns). So, I still can't get too excited about liberalizing investment bank leverage limits--the regulatory issue still centers around the oversight of commercial banks, including commercial bank affiliation with non-bank mortgage lenders.



3. bobn's claim that Congress didn't pass laws encouraging Fannie and Freddie to up mortgage lending to less credit-worthy borrowers (via subprime, Alt-A, etc.) is naive and misleading. He overlooks a decade of "regulation by raised eyebrow" where Congress pressured the GSEs to boost and broaden mortgage lending. And he omits the fact that HUD was the Hill's handmaiden:

   For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

4. Along with economist Arnold Kling, bobn and I agree that repealing Glass-Steagall wasn't the problem but that the treatment of credit default swaps and off-balance sheet assets bear some of the blame. Yet that doesn't bolster the case for the sort of over-regulation President Obama proposes,¹ as Stephen Spruiell says in the July 6th National Review on dead tree (subscription-only for now):

   The argument that a lack of regulation caused the crisis is seductive in its simplicity; it completely ignores the other side of the government equation. Regulation is seldom necessary unless the discipline of a truly free market is absent -- such as when the government indemnifies companies or industries against failure, or when it juices markets with generous subsidies. In the case of the housing bubble, both of these distortions were present. Wall Street titans, led by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, juiced like Jose Canseco until they grew "too big to fail." In retrospect, it looks like a failure to regulate; in fact, regulations wouldn’t have been necessary if the government hadn’t provided the steroids. . .
   
   It is true that without Gramm-Leach-Bliley, Citigroup could not have grown as large as it did. But there is no evidence that Citi’s size or diversity of business lines had anything to do with its overinvestment in mortgage-backed assets. Financial institutions that did not diversify made the same mistake, and they arguably fared worse during the crisis. Bear Stearns, the first investment bank to collapse under the weight of its bad assets, did not have a commercial-banking arm. Furthermore, without Gramm-Leach-Bliley, commercial bank J. P. Morgan could not have mitigated the consequences of Bear’s collapse by acquiring it. (On the other hand, the Federal Reserve’s facilitation of the sale of Bear created the hazardous expectation that every failed firm would get a bailout.)
   
   As for the CFMA, Kevin D. Williamson and I have written in these pages that institutions buying credit-default insurance should be required to have a real insurable interest at stake. As it stands, an institution can buy insurance on a bond it doesn’t even own. That said, losses on credit-default swaps have been smaller than expected, because so many transactions are "netted" -- institutions buy credit protection and then sell it at a higher price, so their exposure is hedged. When Lehman Brothers declared bankruptcy, institutions that sold credit protection on Lehman bonds were projected to lose as much as $400 billion. After all the transactions cleared, though, sellers had lost only $6 billion on their Lehman trades. AIG’s portfolio of credit-default swaps presented a bigger problem, as the mortgage-backed assets they insured started to sour.
   
   But, contra Scheer [and bobn], deregulation was not the primary or even secondary reason that mortgage lending spun out of control. Government promotion of homeownership set the table for a massive run-up in real-estate borrowing, and the Federal Reserve’s loose monetary policy in the early 2000s rang the dinner bell. . .
   
   To be sure, the investment banks were more than happy to buy up the rest of the toxic debt, but one reason these banks took on too much leverage was their confidence that, in the event of a downturn, the Fed would cut interest rates -- and keep them low -- to stimulate the economy. They called this "the Greenspan put" after former Fed chairman Alan Greenspan (a "put" is a financial option purchased as protection against asset-price declines). The Fed had cut interest rates to stimulate growth after the tech bubble burst, and it had cut them to historically low levels after the 9/11 attacks. From late 2001 to late 2004, the Fed held interest rates under 2 percent, making investors desperate for a decent rate of return. Mortgage-backed securities met that need. Harvard professor Niall Ferguson recently contended in the New York Times Magazine that "negative real interest rates at this time were arguably the single most important cause of the property bubble." . . .
   
   The Left continues to propagate the myth that a zeal for deregulation did us in, because it prefers government interference in the marketplace. That’s why it’s important to remember that, for the current economic disaster, government interference bears much of the blame.

Conclusion: Increased transparency--including tax policy--makes sense. But if Federal interjection was the flaw, increasing avenues for Federal regulators to intervene isn't necessarily the fix.

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¹ I'm particularly troubled by the President's plan to "reverse-preempt" and give states "the ability to adopt and enforce stricter laws for institutions of all types, regardless of charter, and to enforce federal law concurrently with respect to institutions of all types, also regardless of charter" (White Paper at 60). The result would give state-charted banks an enormous comparative advantage over nationally charted banks--the former would fall under the oversight of a single regulator, rather than 51 potentially inconsistent regulators. This would steamroll national banks to abandon their current charter for a state charter, effectively ending national banking.