History repeats . . . sort of

Just in case you thought I was kidding about grooving on long wonky posts about important topics in financial regulation, I now pick on Ezra Klein. This is just not right:

It's got to be a scary moment if you're a conservative. The economy is in a meltdown that can be directly traced to insufficient regulation. In other words, it's in meltdown because you suck at running it, and refused to listen to warnings that subprime loans required more oversight, Glass-Steagall made sense, and somebody should really be keeping an eye on these increasingly odd financial instruments and the obvious housing bubble that was feeding them. There's only one thing to do: Blame liberals.

I in fact sort of agree with the point that Ezra goes on to make, which is that it's a severe stretch to lay the housing bubble at the feet of the Community Reinvestment Act. It is reasonable to blame the notion that homeownership is a priceless boon which should be extended to as many people as possible. That idea infected regulators, politicians, and potential homeowners at ever greater rates over the last ten or fifteen years, and it led to subtle changes at all levels which encouraged overlending/overborrowing. But the CRA was largely a sideshow to this.

However, this paragraph is just wrong in both implication and particulars. In some sense, this obviously could have been prevented by regulation; we could have outlawed all mortgages below Alt-A, for example, and jacked up capital requirements to fifty percent. This is a trivial observation, like noting that if we'd only kept all the hijackers off those planes, 9/11 never would have happened; you need to actually posit a regulatory framework that could a) prevent disaster b) do so without gigantic other costs and c) actually get passed before everyone knew that the disaster was going to happen.

The deeper implied argument, that there were regulations that we could have and should have implemented sooner, is somewhat true. Higher capital requirements, for example, are pretty much universally agreed to be long overdue. But financial regulation is usually better at preventing the last crisis than the next one. Consider some of the financial crises that rocked us in recent decades: currency speculation, banks recycling petrodollars to developing nations that defaulted, interbank lending, program trading, credit risk misvaluation. They all have one thing in common--leverage--which is why higher capital requirements do make sense, and it might be time to start looking at hedge funds. But while that would hedge the government's downside risk (only right, if it is going to be providing bailouts), it's not clear that this would have actually prevented the meltdown. Basel II is pretty much the state of the art in financial regulation, but as Seeking Alpha has noted:

With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.

Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk.

The fairly uncontroversial argument that some regulations might have mitigated our current problems has been transformed, in the minds of many commentators, into a belief that the meltdown must therefore have been the result of deregulation, or of rapacious financiers deliberately crippling the regulatory apparatus. Hence the frequent invocation of that magic name, Glass-Steagall, which of course can summon the spirit of FDR to fix the economy if only the president is brave enough to speak it three times aloud.

Contrary to popular belief, Glass-Steagall isn't magic, and also, hasn't been repealed. (Actually, there were two Glass-Steagalls, but for convenience, we shall treat them as a unified system). The sensible thing that Glass-Steagall did are pretty much all still in place--most notably the creation of the FDIC, which is thankfully still doing a pretty fabulous job of insuring bank accounts and winding up the affairs of insolvent banks. Glass-Steagall did other less sensible things which have slowly been eliminated. Regulation Q, which allowed the government to set interest rates on accounts, was gotten rid of in 1980, which is why you get a good interest rate from your bank instead of a free toaster when you sign up. It has not been much missed.

In the 1980s, commercial banks were allowed to affiliate with companies that floated securities, provided that this wasn't their primary business, and to offer a wider range of brokerage services. Citibank's in-house mutual funds are a rip-off, but they did not create the recent problems in the financial markets.

In 1999, we got rid of the rules barring commercial banks from owning investment banking arms (or vice versa, though this really hasn't happened much). This was supposed to keep speculation from taking out peoples' bank accounts, but two years after its passage, Glass, who had pushed for the provision, called it an overreaction and tried to get it repealed. At any rate, the commercial banks, which is what this regulation was designed to protect, have not been the problem during this meltdown. The act did nothing about hedge funds, and the most affected banks--Bear, Lehman and Merrill (which were threatened by the contagion) are pretty much pure play investment houses; Bear needed the balance sheet of a big commercial operation, JP Morgan, to bail it out.

That leaves that other talismanic incantation: "Regulate subprime markets". But what does this mean? Should we have capped interest rates? Set minimum credit rating or down-payment standards? Made securitization illegal? Securitization is still on net almost certainly a good thing, and I must point out, was itself invented by the government to boost homeownership. More to the point, how would you have generated the political will to do any of these things in, say, 2004?

Regulators are best at providing transparency and punishing fraud. But the opacity and fraud in the subprime market seem to have come out of the mortgage broker system, which is regulated at the state level. And the problem wasn't a lack of regulation, per se; it was bad regulation. In some states, the mortgage brokers had captured the process; these are the states that have the biggest problems. But it's hard to trace California's housing disasters to the fact that its legislature has been swept by deregulatory fervor.

I suppose one could make an argument that the subprime market was created by the end of usury laws. But there's a pretty decent literature showing that the alternatives the poor fall back on when interest rates are capped are even worse: pawnshops, loan sharks, or whatever desperate disaster they're borrowing money to avoid. And the usury laws were effectively repealed in 1980, which doesn't track any better with the timeline of the housing crisis than does the 1977 CRA.

The nature of the crisis is such that it fits some convenient narratives: the libertarian belief in overwhelming moral hazard, the Austrian fixation on the money supply, the liberal belief that a lack of regulation necessarily invites disaster. Now, each of these narratives has something worthwhile to offer to the discussion, but all of them are entirely too neat to provide anything like a comprehensive explanation, much less a solution.