The Journal had an interesting opinion piece yesterday. The article notes how Congress (specifically the current leadership) was resistant to imposing prudential restraints on Fannie Mae and Freddie Mac (the GSEs). It is noteworthy in all the calls for new regulatory oversight, that the first two companies to fail were the most heavily and directly regulated. Those GSEs are also the only large financial institutions beside for AIG who have yet to pay the Treasury back for the TARP loans. It is clear that regulators had a direct hand in causing the GSEs to implode by mandating activities that were net risk enhancing. The article is worth a read.
It reminded me of another piece the Journal ran some time ago. That article also enumerates some of the ways that the federal regulatory apparatus directly caused the financial system to take risk it otherwise would not have.
Why does Senator Dodd think that regulators, including himself, who not only dropped the ball in the past but actively mucked things up, will do any better this time?
For a more detailed story on financial regulatory failings see: Andrew Cuomo and Fannie and Freddie
The GSE’s are indeed an embarrassment. They were the purest form of privatized profits and socialized losses. But they, along with affordable housing mandates, were not the cause of the crisis, even though they contributed. Saying they were the cause is a Republican talking point, not a useful analysis. I agree, though, that it doesn’t bode well for the efficacy of future financial reform. And I realize you weren’t saying they were the cause of the crisis – I just wanted to make it explicit.
R.E.L. I did not claim they were the exclusive cause rather that they were a cause, or as you say a contributing factor. Either way the regulators and legislators pushed in the wrong direction wanting them to be more influential. So the point stands regulators came down on the wrong side.
Incidentally, there are more examples of regulators “contributing to the bubble economy.” these include the 20 or so year policy of cheap money after every recession; the Community Reinvestment Act; the silly incentives in the tax code, most importantly the “REMIC” election which allows the elimination of the corporate tax if you separate origination of a loan from ownership (a giant tax incentive to securitize). These examples indicate that regulators will almost always do the politically expedient at the cost of economic stability.
As far as the claim that these are Republican talking points, I am not sure what that adds to the discussion. Republicans are saying this therefore it must be false. Sounds like the fallacy ad hominem. I am interested in more of your thoughts on the matter.
I don’t disagree on the tendency of regulators to bow to political expediency. I don’t have high hopes for the current legislation – I don’t think it’s the result of a well-thought-out process. But putting that aside, my point was this: Fannie and Freddie were colossal failures, as was pointed out by free-market types for years, but their failures were not necessarily instrumental in the crisis. They were huge in the mortgage markets, responsible for securitizing and insuring about $5 Trillion in mortgages, but they were only insuring high-quality mortgages, and so weren’t directly responsible for the sub-prime securitization. The heart of the crisis was not the housing bubble, it was the effect of the bursting of that bubble on the institutions of financial intermediation. There have been bubbles before, and there will be more bubbles in the future. Had the losses been limited to institutional investors greedy for yield but forced to invest only in AAA-rated securities, there would not have been a financial crisis and the subsequent recession would not have been as severe. The issue was that the financial intermediaries of our economy (whether traditional bank holding companies, like Citi, or the non-traditional SIVs it created, or institutions funded by the money market, like Lehman) were way too exposed to the housing market through sub-prime securitizations, and when those went sour people stopped trusting anything securitized. This happened for a variety of reasons – part of it was bad modeling assumptions, but a larger part of it was bad incentives at the banks. At Citi, for example, if a trader invested in anything AAA rated that was insured by a AAA entity, it was considered riskless and he could book all the profit immediately. So the CDO desk at Citi gobbled up as much AAA CDO tranches as it could get its hands on. Meanwhile, the rating agencies were rating this stuff AAA without even looking at it, since they had every incentive to do so. It was a massive outsourcing of risk and due diligence to all the wrong people. The result was huge losses at the banks, which resulted in a crisis of confidence and an old-fasioned bank-run, but this time on the “shadow-banking” system. No depositors took out their money, but short term funding for CDOs, and any companies with significant CDO exposure (like Lehman) dried up completely. That was at the heart of the financial crisis. That’s why Greenspan says that, at the end of the day, the solution to the crisis is higher capital ratios. He’s not saying higher capital ratios would have prevented the bubble. Perhaps we need regulation to do that, perhaps not – bubbles are notoriously hard to see and prevent. But what we need more than that is a financial system stable enough to withstand the bubble popping. That’s why Fannie and Freddie are a sideshow. We can debate how much they contributed to the housing bubble, and how much of a bad idea their existence was, but ultimately they were not the “cause” of the financial panic.
This is a really interesting post, I think. The points are interesting ones, and underly an important point that neither comments, nor post, nor wsj article mentions – that of regulatory capture. The failure of Fannie and Freddie’s collapse centers more on regulatory capture than on a failure of the regulations themselves. As the recent wsj opinion piece mentions, Fannie and Freddie were unreasonably powerful – i.e., the regulators were unreasonably influenced by the regulated. This crisis is replete with regulator capture, most notably the OTS and the failure of Washington Mutual. The other largest failures in the financial system relate to unregulated behavior, including derivates trading, CDO^2, and similarly complex transactions. Asher makes an excelent point re: improper incentives built into tax codes and other regulations. But this should encourage us to “deregulate” everything, we can see what happens when we do that – in this crisis and with various other crisises. Rather, as a nation we should intelligently and appropriate incentivize good behavior and disincentivize bad behavior. Essential to any reasonably regulatory schema is both regulatory and legislative independence – who knows if we will ever get that…but we can do better. I have no idea if the current proposed regulation will address the problems which caused the most recent economic crisis, anyone who has experience with regs knows that the “exceptions” are often the key, but regulation must address the true problems with our financial system, specifically the incentive structure identified by “R.E.L.”
I agree in part. It is true that capture is a problem. It is not the only story that can be told about why regulators make mistakes. In the instance of the two big GSEs regulators also dropped the ball because they wanted to incentivize home ownership almost at any cost. I do not advocate wholesale deregulation, but I do believe we need rules governing financial markets rather than standards that give regulators any discretion. For a whole slew of reasons, including capture, I think regulators will always get it wrong. We need solid inflexible rules at the outset governing the financial industry.
Asher,
I absolutely agree, creating regulation isn’t necessarily the answer, and regulators are inherently subject to capture. But I think that there are examples of regulators that do their jobs well, the SEC and Nuclear Regulatory Commission are a few that come to mind. It is really difficult for regulators to be perfect…better to have legislators legislate, and have regulators enforce rather than make rules. At least there is some responsibility then rather than regulators who are completely non-responsible to voters….