Did Deregulation Cause the Financial Crisis?
Although many politicians and much of the mainstream media would like you to believe that it was rampant deregulation of the financial industry that "caused" the economic crisis we now face, don't believe it for a minute.
The fact is that deregulation is almost certainly not the culprit. For one thing, the least regulated sectors of the financial markets have been the least affected by the malaise. Hedge funds, for instance, are still functioning smoothly and efficiently. It's the more heavily regulated commercial banking sector that's freezing up. Rather than deregulation, the immediate cause of the liquidity crisis is over-regulation - or at least, the wrong type of regulation. Here's why:
A crucial post-Enron change in accounting regulations - the infamous "mark to market" requirement - was written into law with good intentions, but turns out to have had disastrous unintended consequences. It has pushed perfectly healthy commercial banks into virtual bankruptcy, for no good economic reason. I say "perfectly healthy" because most of these banks had no shortage of actual cash when they began to fail. Rather, because of the mark-to-market rule, they were required to take big paper losses on their portfolios of risky mortgages, even though the vast majority of these mortgage-backed securities were still generating healthy interest payments.
For an ordinary company this would not be a disaster. Marking down such an asset and reporting the markdown as a loss of income would certainly hurt a company's earnings statement and probably punish its stock price, but it wouldn't pose a threat to its financial solvency or its continued existence as a business. In addition, smart investors would look beyond the accounting rules to value the company based on perceived economic reality.
Unfortunately, commercial banks are constrained by many other government rules, including a requirement to maintain certain ratios of capital and liquidity to support the loans they make. For that reason, when this new accounting rule requires a bank to mark any of its mortgage-backed securities down substantially, the bank has to hurry and line up replacement capital for its balance sheet or risk being in violation of other banking regulations. If the bank isn't able to maintain its capital ratio, then other rules require the government to declare it insolvent and take it over. As more and more banks were taken over, or appeared to be under threat of being taken over, other banks became afraid to lend to them (because they might forfeit their loans if the borrowing bank were to be declared insolvent), and so you had a cascade of fear that led to the freezing up of our whole credit system.
This is perhaps an over-simplified version of events, but it is accurate enough. There is an infuriating irony in this scenario, brought to you by the same people who brought you the incredibly costly and inefficient (even if well-intended) Sarbanes-Oxley Act. The irony is that this new mark-to-market rule requires a bank to write down its mortgage-backed security and take the resulting loss even if the asset itself is still performing fairly well. That is, even if the bank is still collecting payments on time, when the "market value" of the asset is impaired the bank has to mark it down to whatever price could be collected in a fire sale.
Remember that the mortgages underlying these securities are mostly 20-year and 30-year home loans, and the overwhelming majority of these loans - even in the subprime category - are not in default at all (is your mortgage in default?), and the payments are not late. In many cases, the commercial banks and other investors who hold these securities have no plans to unload them any time soon. The mark-to-market accounting rule, however, forces a bank to revalue this kind of asset as if it had to get rid of it in 30 days at whatever price it could get. One financial columnist called this not a "mark to market" rule but a "mark to disaster" rule.
Regardless of the accounting rules, however, the fuel for this financial crisis is the large volume of bad mortgage debt that has precipitated the need for asset writedowns in the first place. And the buildup in bad mortgage debt has been under way for years. Partly it was a result of the go-go low-interest days immediately following 9/11, when the Fed's rate hovered in the 1% range, and at one point the biggest fear was that the U.S. economy could tip into a period of prolonged price deflation. These low interest rates spurred a lot of speculative home building, especially in places like Florida and California.
In addition to low interest rates, however, there was also an overt political effort by the Federal government to stimulate more lending, in order to spread the benefits of home ownership to lower-income segments of the population. Our elected politicians pushed this policy with enthusiasm over the last decade or so. Fannie Mae and Freddie Mac, the two quasi-governmental companies charged with setting standard rules for certifying mortgages as sound and making the mortgages themselves marketable to investors, were encouraged to adopt lower down-payment requirements and to relax other lending standards in order to encourage more home ownership. For their part, Fannie and Freddie deployed huge lobbying budgets to keep the lending spree going (and to keep their profits flowing). They spread their contributions and political fund-raising largesse across Congress like manure fertilizing a field of kudzu.
The Democrats were the majority party in Congress during most of this period, and they were also the most enthusiastic about encouraging broader home ownership, having the most to gain politically from the low-income beneficiaries of this more liberal lending policy. But the fact was that lots of Republicans piled on to this boondoggle as well, so there is plenty of blame to go around.
The result should be seen as a disgrace for both our political parties, and as a cautionary tale about the occasionally dysfunctional workings of a representative democracy.
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No offense taken, Dave.
What's astounding to me is the degree to which our politicians, on both sides, have stooped to such stupid, patently simplistic explanations for this very complex economic situation. And it's all complicated immensely, of course, by the fact that we're in the middle of an election campaign.
Now is the time for thoughtful leadership, and for trying to find common ground. It's not a time for blaming unnamed fat cats and trying to ignite class warfare. But it's unlikely we'll get that from either of our presidential candidates or their surrogates. That would be entirely too mature.
DOn,
Thanks for the thoughtful reply. On re-reading, my comment was a bit shrill and that was not fair. My apologies. I think once I saw the finger being pointed at Dems and the CRA, I saw red. The CRA was around for a long, long time before this current crisis. As you say, rightly, there is plenty of blame to go around.
Incidentally, the hedge funds are now in even more pain than a couple of weeks ago. I care a little as I'm involved with nonprofits that count on the largesse of the hedgie managers....
Miro, Dave: The SOX requirement to write down assets has a completely different effect for commercial banks than for other businesses. That's the reason this problem is gumming up our credit system.
Other businesses write down their assets and it can be a problem in terms of their reported balance sheets, but their shareholders get to make their own decisions in terms of valuing the company's stock and continuing to own it or not. However, when we require a commercial bank to follow the same rule, the bank itself may not be able to survive, because of other regulations - banking regulations - that require commercial banks to maintain their capital ratios, in order to continue to operate as banks.
Dave's point that hedge funds have also been damaged is a good example of the difference here. Yes, hedge funds have taken a beating (as have all investors), but so what? It doesn't really affect me (or you either, probably) if a hedge fund's investors take a bad haircut because they can't get their money out under the investment rules they agreed to. I can still borrow at my bank, I can still make my payroll, I can still buy a house - so what do I care if a bunch of rich investors take a hit?
But if commercial banks stop functioning, then it very definitely does affect me, and it affects the whole economic system.
In my view, the crisis isn't the fact that the Dow Jones has plummeted. That's an economic cycle, not a financial crisis.
The crisis is that the credit system is freezing up. It is this problem that makes the current economic downturn different from previous ones, and much more threatening to our economic well-being.
And the credit system is freezing up not because the stock market is going down, but because of a particular interaction between several different banking regulations.
I'm NOT saying we should deregulate banks. But we need to ADJUST the regulations that apply to banks in order to get out of this vicious cycle, that's all.
I have to agree with Dave, I think he covers most of the dominoes that fell
the fact that SOX requires asset write downs - hasn't caused other institutions to collapse suggests that this is at best a minor factor
we must not forget that the human factors of greed, short-termism and abject disregard for responsibility (Moral Hazard) were the fuel for this fire
the holes in the dike were there, I'm sure plenty of people tried to sound the alarm, but those with the responsibility and ability to take action did not.
This isn't a "Made in the USA" problem as we seen its global spread uncover the same underlying issues of over extended leverage, hubris in risk identification and risk management
Profit baby profit!
I hope this expensive lesson teaches everyone the value of balancing short and long-term and creates a new era that we can build from founded on partnership not expediency - which as you know Don - I have been yelling into the wind for some time now.
Miro
Well, I couldn't agree with you more, Graham. As for you, Dave, I think we disagree some, but agree a lot more than you think.
The economy is indeed a complex adaptive system, and better characterized as an evolutionary network with wealth and income distributed in a power-law fashion. By the way, for an excellent description of how "stuff happens" in such a system, in unpredictable ways, I highly recommend Mark Buchanan's book Ubiqity - Why Catastrophes Happen (2000), and also Eric Beinhocker's more recent classic work, The Origin of Wealth (2006).
I resisted going in to all that, which is why I said that the "mark to market" explanation is an over-simplification, which it is. But my point is that you can't really blame DEregulation. There are a LOT of factors contributing to this crisis, and they all kind of add up to the "perfect storm" as you suggest. But rather than DEregulation, per se, the contributing factor in the regulatory sphere was simply having the wrong kind of regulation (as evidenced by mark-to-market).
Sorry, Dave, I really didn't mean to malign the Democrats unfairly. My feeling is that there's enough blame to spread across the whole congressional body, and nearly every politician's hands are dirty here, on both sides of the aisle. I hope I made that point clear.
Nevertheless, whether the Democrats really were in charge or not, no one can deny that their interest in getting Fannie and Freddie to relax lending standards does mesh neatly with their political strength among the lower-income people who were being assisted by this policy. Maybe that's just a coincidence, too. But the evidence does clearly show that the Democratic Party was far more supportive of relaxed lending standards.
If it makes you feel better, I'll grant you that the Democrats supported relaxed standards out of moral principle, while those Republicans who did so were more likely to do it because of Fannie's and Freddie's intense lobbying efforts and fund-raising largesse.
As for Barry Ritholz's comment, I'm sorry I don't see any conflict with what I tried to say here and most of what he said.
Barry's main additional point, and it's a good one, involves the unregulated credit default swaps (CDS) - derivatives that were made possible by the Commodities Futures Modernization Act, enacted by a Republican Congress, and signed into law by President Clinton. No question that uncovered CDS derivatives were another "contributing factor," but I don't think they could have gummed up our credit system by themselves, although AIG and other big writers of these CDS instruments were put at risk.
I repeat my primary argument: It's complex, it happened largely because of the unintended consequences of well-meaning regulations and policies, and there's more than enough blame to go around on both sides of the political divide.
Hi Don
Financial markets are complex adaptive systems consisting of a very large number of interacting parts, many of them not easily identified from the outside.
It is meaningless to suggest any one part of financial markets caused the current problems. Which part of the markets would you pin the blame on? Meddling politicians who insisted banks take on risky mortgages as part of their social policy? Financially illiterate mortgage takers who took on debts they could never realistically repay. Overzealous mortgage brokers who sold them to them? Banks who securitized and resecuritized risky debts such that they didn't understand the risks any more? Rating agencies who somewhat over-rated these risky instruments? Lax oversight by the financial regulators? The slow response of blind-sided politicians? Or all of them and more besides?
In reality, changes in many parts of the market came together in the perfect financial storm we see today.
Just as in the meterological variety of storm, it will take a while for the storm to abate so that we can start picking the finnacial wreckage out of the water.
Graham Hill
Independent CRM Consultant
Interim CRM Manager
What you've written seems counter to facts in a major way.
You tip your hand when you say of the "go-go low interest days ppost 9/11" -- "the Democrats were the majority party in Congress during most of this period."
The Democrats won a slim majority two years ago. The GOP had been in the majority since 1995 -- that's 10 of the past 13 years. So, what else are you wrong about?
Pretty much every major economist agrees with Barry Ritholtz, the CEO and Director for Equity Research for Fusion IQ: "The proximate cause of the Housing crisis were (1) Ultra-low rates; and (2) Abdication of traditional lending standards, thanks to (3) originators ability to resell mortgages for securitization purposes, and hence, (4) not have to worry about loan defaults."
You can't rest it on the shoulders of wanting to extend home ownership -- the CRA was signed in 1977 for crying out loud.
Ritholtz continues: "The credit crisis was caused by (1) the above securitized mortgage paper, that was (2) rated triple AAA by Moody’s and Standard & Poors, which then (3) was “insured” by credit default swaps (CDS)—the unreserved for, shadow insurance products (4) whose exemption was made possible by the Commodities Futures Modernization Act. That legislation exempted these derivatives from any supervision or regulation. The lack of reserve requirements is why there is now $62 trillion in CDS, many of which will never pay their counter parties the promised insurance."
So, yes, deregulation was a big part of this cock-up. I might also add that hedge funds are screwed, too, with the most prominent seeing double-digit losses. And you often can't get tyour money out anyway (if only the banks could do that!). See http://www.forbes.com/books/2008/10/10/hedge-fund-investing-oped-cx_aa_1010ang.html