Blame the Fed, Freddie and Fannie, and Financiers

Katherine Mangu-Ward | October 6, 2008

In today's Washington Post, Sebastian Mallaby—who is far from being a knee-jerk libertarian—wallops the folks who want to blame deregulation for the country's financial woes.

Instead, he points fingers at the Fed (for following a we'll-clean-up-the-mess-after-the-bubble-pops philosophy), Freddie and Fannie (where "heavy government oversight obliged them to push money" toward the marginal buyers who are now up the creek), and financiers (specifically, the already highly-regulated U.S. investment banks that bought "piles of toxic waste").

He winds up with this chilling assessment of the fading love for markets in the world today:

Blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis. Even before finance went haywire, the Doha trade negotiations had collapsed; wage stagnation for middle-class Americans had raised legitimate questions about whom the market system served; and the food-price spike had driven many emerging economies to give up on global agricultural markets as a source of food security. Coming on top of all these challenges, the financial turmoil is bound to intensify skepticism about markets. Framing the mess as the product of deregulation will make the backlash nastier.

Comments

classwarrior|10.6.08 @ 12:51PM|#

Though there's a lot of blame to go around, the most immediate cause of the current crisis is the issuance of credit default swaps which were essentially unregulated insurance contracts between financial institutions. Because there were no capital reserve requirements, these firms didn't have enough money to honour the claims, leaving taxpayers holding the bag. Sorry this doesn't fit into the free market narrative, but it happens to be why the whole finanacial world is in this mess now.

|10.6.08 @ 12:59PM|#

oh, CW, when you say "leaving taxpayers holding the bag", how is that free-market again?

idiot.

|10.6.08 @ 1:00PM|#

Kudos Classwarrier:

When the totally of CDS is a higher number than the entire world pool of money in fixed securities.....WTF!!?

adrian|10.6.08 @ 1:00PM|#

except that you are wrong. CDS' are contracts between 2 (or more) firms. People (firms) can get into any contract they want, and they take on the risk associated with it. Blaming CDS' is like blaming gambling addiction on playing card manufacturers.

|10.6.08 @ 1:01PM|#

Your point taken as well, TAO

|10.6.08 @ 1:05PM|#

The Mallaby article was good. But it's tough to make a case for unlimited leverage for broker-dealers and lenders. And the loosening of net cap requirements played a substantial role in this debacle.

Yes, deregulation of airlines, energy, trucking, and other industries has been a huge success. But if you try to apply those lessons in a crude way to the financial industry, you run into trouble. One reckless player who leverages to the hilt can cause widespread disaster. Where market value hinges so much on perception and expectation, as it does with financial products, there are potentially large externalities associated with individual firm decisions.

I think libertarians should not be too quick to dismiss the case for some regulation in this area. And loosening of some regulations (particularly net cap) did help get us here.

|10.6.08 @ 1:10PM|#

Dow is down 550...Woot!

|10.6.08 @ 1:20PM|#

he ignores the fact that the vast majority of the subprime mortgages origniated from private unregulated lenders, not fannie freddie or investment banks.

nobody knows how to value them b/c they aren't considered securities and therefore do not fall under SEC disclosure requirements.

additionally, the SEC's relaxation of minimum debt:equity ratios allowed banks to over-leverage at 30:1 to 40:1, which made the crisis exponentially worse. again, a failure to regulate.

Paul|10.6.08 @ 1:30PM|#

I for one am glad to see the global market recovery after Congress finally acted with leadership and passed the Rescue Plan(tm).

What does Soros know?|10.6.08 @ 1:31PM|#

"The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets..."

Soros further opines elsewhere;

"...regulations have been progressively relaxed until they have practically disappeared". …

One of the first targets of financial system deregulation in the Reagan administration was savings banks and commercial banks. …

In less then 7 years after the initiation of this major banking deregulation, in February of 1989, President Bush (the first of course) unveiled the S&L bailout plan. …

In 1998, the stakes are raised, as the financial industry goes for the juggular. Again from Frontline; …

"After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic."

Fresh off of this "victory", incredulously, the man who was charged with being the banking systems chief regulator, Fed Chairman Alan Greenspan continued to lead the charge towards a completely unregulated financial system as he turned his sites towards championing the growth of unregulated derivatives. …

The ensuing years saw the accelerating phenomenon where, with the last major regulatory impediment removed, and more importantly perhaps, not replaced with any form of updated regulation, the credit bubble accelerated, fueled heavily by the explosive growth in unregulated derivatives. #8230;

The result of this is that today we have what is called the $516 trillion shadow banking system, the "secret banking system built on derivatives and untouched by regulation" according to the worlds largest bond fund manager, Bill Gross.

troll trooper|10.6.08 @ 1:35PM|#

Deregulation is BAD. I want MORE regulation. I love REGULATION. We all should LOVE regulation. HOORAY for the demise of deregulation. FINALLY the government can CONTROL more. I THINK that is what we always REALLY wanted.

Alan Vanneman|10.6.08 @ 1:41PM|#

Sebastian speaks the truth, but not the whole truth. The NYT pointed out here http://www.nytimes.com/2008/10/03/business/03sec.html?_r=1&ref=todayspaper&oref=slogin that the SEC exempted banks from "too stringent" requirements for maintaining reserves, which would have allowed them to cover their losses. The banks assured the SEC that they would "self-monitor," and the SEC never got around to checking to see if they did so. McCain wasn't that far off when he attacked the SEC.

This whole boom was built on the assumption that the real value of the average U.S. home would increase 16% a year forever, which is, um, ridiculous. The people in charge at Bear Stearns, Lehman, etc. were too busy making money to worry about the facts. Now they want the fed. gov. to cover their losses with no strings attached. I guess some people just stay stupid.

adrian|10.6.08 @ 1:44PM|#

Of course deregulation caused a 50% run up in the price of houses. Of course deregulation flooded the market with easy money and no safe place to put it.

I could go on but since you have no possible way of explaining those two I'll save my breath on the others.

Naga Sadow|10.6.08 @ 1:44PM|#

Soros said that? He's more of an idiot than I thought.

joetroll|10.6.08 @ 1:46PM|#

People, it wasn't deregulated like you think it was. It was different. No, not like that, the other way. Geez, you don't get it.

You're all about as sharp as a sack of wet mice.

troll eternal|10.6.08 @ 1:56PM|#

I had a splendid evening with some ultra liberals who with the finesse of an elephant ballerina explained to me that DEREGULATION caused by BUSH/CHENEY was the ONLY cause of this problem.

I tried to be RATIONAL and argue that they didn't fully understand that there are more culpable agents than their go-to scapegoat. I was met with yelling and disaster.

The BACKLASH will be felt, and it too will pass. Is the sinking? Why don't we make some nice REGULATION to jam in the hole in the hull?

YEAH.

|10.6.08 @ 1:57PM|#

alan is right on the SEC deregulation. over-leverage turned it from downturn to crisis.

Naga Sadow|10.6.08 @ 1:57PM|#

Joetroll,

Now wrap it up with descriptions of how you have a mancrush on Obama.

robc|10.6.08 @ 2:02PM|#

These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms.

And this is exactly what has been happening. And what the bailout is supposed to stop (or at least slow down).

No one ever said the market was going to be nice when it self-corrected. The invisible hand may come in the form of a bitch slap.

Alan Vanneman|10.6.08 @ 2:03PM|#

Megan McCardle, about whom I'm not always crazy, has a nice take here:

http://meganmcardle.theatlantic.com/archives/2008/10/how_did_it_all_happen.php

|10.6.08 @ 2:05PM|#

and the SEC never got around to checking to see if they did so. McCain wasn't that far off when he attacked the SEC.

I wonder if he McCain also targetted his good friend Phil Gramm.

Harold Meyerson at the WaPo:

Gramm was always Wall Street's man in the Senate. As chairman of the Senate Banking Committee during the Clinton administration, he consistently underfunded the Securities and Exchange Commission and kept it from stopping accounting firms from auditing corporations with which they had conflicts of interest. Gramm's piece de resistance came on Dec. 15, 2000, when he slipped into an omnibus spending bill a provision called the Commodity Futures Modernization Act (CFMA), which prohibited any governmental regulation of credit default swaps, those insurance policies covering losses on securities in the event they went belly up. As the housing bubble ballooned, the face value of those swaps rose to a tidy $62 trillion. And as the housing bubble burst, those swaps became a massive pile of worthless paper, because no government agency had required the banks to set aside money to back them up.

Michael Ejercito|10.6.08 @ 2:08PM|#

Why should there be a bailout?

It is not as if the government forced banks and mortgage companies to lend money to people who could not pay it back.

Naga Sadow|10.6.08 @ 2:14PM|#

Michael Ejercito,

You should have placed a (wink) at the end, but I got it nonetheless.

JP|10.6.08 @ 2:25PM|#

The invisible hand may come in the form of a bitch slap.

LOVE IT.

Don the libertarian Democrat|10.6.08 @ 2:28PM|#

It was a good column, but he also said this:

"The financial turmoil has pushed the Obama campaign into the lead, and this is mostly justified. Barack Obama is more thoughtful on the economy than his opponent, and his bench of advisers is superior."

Hayek\'s Ghost|10.6.08 @ 3:00PM|#

Economics is an exact science, and only libertarians have mastered it.

Kolohe|10.6.08 @ 3:01PM|#

James | October 6, 2008, 1:10pm | #

Dow is down 550...Woot!

Ah, the good ol days, I remember them well.

Amakudari|10.6.08 @ 3:02PM|#

Because there were no capital reserve requirements, these firms didn't have enough money to honour the claims, leaving taxpayers holding the bag. Sorry this doesn't fit into the free market narrative, but it happens to be why the whole finanacial world is in this mess now.

Several banks would have needed huge capital reserves to cover losses. JPMorgan is writing down about $30 billion on the WaMu acquisition. So, just some rough calculations from what I can find of last quarter's 10-Q for WaMu, they had $240 billion in risk-weighted assets and $22 billion in Tier 1 risk-based capital. To write all of that down and remain well-capitalized at 8%, WaMu would have therefore needed to raise around $27 billion (240*8% + 30 - 21). Assume they raised it at a very favorable $3.50, and that's 7.7 billion shares versus an initial 1.7 billion outstanding: almost 80% shareholder dilution.

A lot of smaller, less diversified banks have serious problems, where even if they had conservative leverage they can't raise capital and they can't recognize real values for their assets. Sure, thinly capitalized i-banks failed, but so will many retail banks that met regulatory capital requirements.

Mike Laursen|10.6.08 @ 3:09PM|#

Barack Obama is more thoughtful on the economy than his opponent...

He's more thoughtful than The Maverick on everything. Which isn't saying much.

|10.6.08 @ 3:09PM|#

WaaaaaaaaaaMuuuuuuuu!

voxpo|10.6.08 @ 3:25PM|#

amouse | October 6, 2008, 1:20pm | #
he ignores the fact that the vast majority of the subprime mortgages origniated from private unregulated lenders, not fannie freddie or investment banks.

so...you want to spray herbicide on the unregulated lenders??

LarryA|10.6.08 @ 4:02PM|#

Rule of Thumb: If a Congressional Deregulation Bill has 100+ pages, it doesn't really "deregulate."

he ignores the fact that the vast majority of the subprime mortgages origniated from private unregulated lenders, not fannie freddie or investment banks.

Rule of Thumb 2: If your Private Unregulated Lender includes a 1-inch+ stack of government-mandated paperwork in your mortgage application, the lender isn't "unregulated."

alan|10.6.08 @ 4:42PM|#

Hayek's Ghost | October 6, 2008, 3:00pm | #
Economics is an exact science, and only libertarians have mastered it.

So writes the ignoramus who by those choice of words shows he has no idea what Hayek actually wrote about anything.

|10.6.08 @ 4:44PM|#

Deregulation combined with government assumption of responsibility results in disaster. It's like a parent buying their teenager a new car every time she wrecks her old one.

|10.6.08 @ 6:08PM|#

re: amakaduri

I would like to salute you sir for taking up the libertarian cause against capitalization requirements. I think you are insane but I want to point out this is the intellectually honest libertarian position - and it helped create this financial disaster.

Back to the issue: no, you are wrong, lack of capitalization requirements did contribute heavily to the downturn. 4 of the 5 investment banks who won the exemption from the SEC have either gone bankrupt, been bought up for a penny on the dollar, or been socialized. That's a pretty strong track record. It could be 5 out of 5 before the year is over. I could be mistaken but I'm pretty sure that 80% of the banks out there that are properly capitalized are not going to implode on that scale.

Paul|10.6.08 @ 6:45PM|#

The invisible hand may come in the form of a bitch slap.

Yep, that market do that from time to time. According to our knowlegable overlords, that's a market failure.

|10.6.08 @ 7:39PM|#

additionally, the SEC's relaxation of minimum debt:equity ratios allowed banks to over-leverage at 30:1 to 40:1, which made the crisis exponentially worse. again, a failure to regulate.

No, that would be a failure to enforce.

Amakudari|10.6.08 @ 8:09PM|#

I would like to salute you sir for taking up the libertarian cause against capitalization requirements. I think you are insane but I want to point out this is the intellectually honest libertarian position - and it helped create this financial disaster.

I'm not against capital or any other requirements as long as the government is acting as a backstop. My take is that selective deregulation is a major cause in exacerbating current problems.

I won't speculate on how modern financials would function without government because the status quo is so different.

Back to the issue: no, you are wrong, lack of capitalization requirements did contribute heavily to the downturn. 4 of the 5 investment banks who won the exemption from the SEC have either gone bankrupt, been bought up for a penny on the dollar, or been socialized. That's a pretty strong track record. It could be 5 out of 5 before the year is over. I could be mistaken but I'm pretty sure that 80% of the banks out there that are properly capitalized are not going to implode on that scale.

I assume you're referring to Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. The first three are gone, although Merrill sold for about $50 billion (all-stock and pegged to BAC), which is hardly a fire sale. The other two are bank holding companies, effectively avoiding mark-to-market asset valuations and by sheer coincidence benefiting from recent tax code changes on acquisitions.

And I'm not saying leverage is irrelevant, I'm saying that historically safe leverage and capital adequacy ratios are very far from enough (by the way, "well-capitalized" tier 1 capital ratio is 6%, God knows why I said 8%). My math above regarding WaMu is wrong but close, and the fact is that many more banks will fail without being propped up.

|10.6.08 @ 8:43PM|#

# Michael Ejercito | October 6, 2008, 2:08pm | #
# Why should there be a bailout?

# It is not as if the government forced banks
# and mortgage companies to lend money to people
# who could not pay it back.

Indeed. I keep half-expecting some in government to make this point by way of declaring that "we broke it, we bought it." It's a marvelous piece of rhetorical jiu jitsu. When critics charge that intervention caused the problem AGREE with them, but counter that additional intervention is necessary to deal with the problem because of our obligation to fix what we broke (and thus bought). Genius, I tells ya! (And I'm being sincere! The gambit works amazingly often.)

|10.6.08 @ 8:51PM|#

The problem with the "deregulation is bad, mmm'kay" crowd's logic is at least twofold:

1. We never see true deregulation. You have to trust in the words of the politicians and their pet pundits that some change in the regulatory environment is actually any sort of deregulation.

2. Even when regulations are slashed, it never seems to be in a way that establishes (or re-establishes) market mechanisms that would enable normal market discipline to naturally regulate the market. In fact, "deregulation" so often accompanies the establishment of government-backed "insurance" schemes, which tend to insulate players in the market from the consequences of their misbehavior.