This recession

July 6, 2009

Blame Not the Deregulator It was market distortions that created the bubble STEPHEN SPRUIELL Last month, Paul Krugman launched a campaign to pin the financial crisis on “Reagan and his circle of advisers.” It was “Reagan-era deregulation,” Krugman wrote, that led us to the “mess we’re in.” The substance of Krugman’s screed was so tissue-thin that even ultra-liberal columnist Robert Scheer responded to it with bafflement: “How could Paul Krugman, winner of the Nobel Prize in economics and author of generally excellent columns in the New York Times, get it so wrong?” So let’s not credit Krugman with making a serious argument, rather than throwing a partisan grenade. The broader narrative into which Krugman’s column fits, however, must be addressed. Left-wingers and Democratic partisans are united in a vigorous effort to blame deregulation for the financial crisis. Scheer, for example, agreed that deregulation set the meltdown in motion; he disagreed with Krugman only on who, specifically, was to blame. In Scheer’s less partisan version of the narrative, Bill Clinton and his advisers are the “obvious villains” for having backed various deregulatory acts during the 1990s. (Of course, Republicans are hardly absent from this version of the story: Former senator Phil Gramm is portrayed as the architect of the late-Nineties deregulation that allegedly brought down the banking system.) 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. Krugman argued that the 1982 Garn–St. Germain Depository Institutions Act sowed the seeds for the 2008 financial crisis — and that, because President Reagan signed it, the blame for 2008 lies on his doorstep. Never mind that Garn–St. Germain passed by veto-proof margins in both chambers; that it was co-sponsored by prominent Democrats, including Steny Hoyer and Charles Schumer; and that it was the second of two bills that deregulated the savings-and-loan industry, its predecessor — the Depository Institutions Deregulation and Monetary Control Act of 1980 — having been signed by President Carter. The line supposedly connecting Garn–St. Germain to the mortgage meltdown is itself more crooked than Lombard Street; it exists, finally, only in Krugman’s imagination. For while Garn–St. Germain did pave the way for the kinds of adjustable-rate and interest-only mortgages that Wall Street gorged on during the housing boom, this result was not inevitable: Scheer points out that “as long as the banks that made those loans expected to have to carry them for 30 years, they did the due diligence needed to qualify creditworthy applicants.” What happened, according to Scheer and other subscribers to the less partisan version of the blame-deregulation narrative, is that a series of deregulatory moves in the late 1990s and early 2000s enabled the market for mortgage-backed securities and other derivatives to grow huge while disregarding risk. The 1999 Gramm-Leach-Bliley Act allowed depository institutions to acquire investment-banking and insurance arms. The 2000 Commodity Futures Modernization Act (CFMA) allowed derivatives (such as credit-default swaps) to be traded over the counter, with little regulatory oversight. And a 2004 rule change at the Securities and Exchange Commission allowed investment banks to operate with debt-to-equity ratios of over 30 to 1. Paul Krugman: mythmakerPaul J. Richards/AFP These policy changes certainly contributed to the size of the crisis, which is why the blame-deregulation narrative seems plausible at first. 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, 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. Add to these factors Wall Street’s ability to skirt rules and influence regulators, and it is far from clear whether any amount of regulation could have quelled investors’ appetite for seemingly safe mortgage debt. By now, the case against the GSEs is well rehearsed, but it’s worth restating in this context because it provides such a vivid illustration of why regulation is needed when market discipline is absent. Fannie and Freddie’s role as government-chartered companies with public missions gave investors the (correct) impression that Uncle Sam would never let them fail. Thus the GSEs enjoyed borrowing costs only slightly higher than those of the federal government, and they used this subsidy to expand rapidly, doubling the amount of mortgage debt on their books every five years since 1970. (When they finally collapsed last year, they owned or guaranteed over $5 trillion in debt.) For years, it was conservatives who argued that Fannie and Freddie had grown dangerously large and needed stronger oversight. The GSEs’ old regulator, the Office of Federal Housing Enterprise Oversight, had neither the experience nor the authority to rein them in. Democrats and Republicans alike ignored these warnings, though President Bush and the Republicans made a failed effort to reform the GSEs after a series of accounting scandals at the companies in 2003–04. (The bill died when Democratic senator Chris Dodd threatened to filibuster it.) But both parties were complicit in giving the GSEs “affordable housing” goals to meet. In 1995, the Clinton administration lifted restrictions on the kinds of mortgages the GSEs could purchase to meet these targets; Bush increased the affordable-housing goals during his presidency. As Peter J. Wallison and Charles W. Calomiris pointed out in a study for the American Enterprise Institute last fall, this enabled Fannie and Freddie to purchase or secure more than $1 trillion in subprime and Alt-A loans between 2005 and 2007 alone. Unlike the deregulatory acts that Scheer and others are blaming, this contributed directly to the inflation of the housing bubble. Wallison and Calomiris wrote: “Without [the GSEs’] commitment to purchase the AAA tranches” of the bulk of the subprime mortgage-backed securities issued between 2005 and 2007, “it is unlikely that the pools could have been formed and marketed around the world.” 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.