So no responsibility for not recognizing the problem and not doing anythng about it for almost eight years? I'm not an expert but blaming the current meltdown entirely on ... Clinton seems a stretch to me.
But I don't blame it on Clinton. I think that the regulatory steps taken under the Clinton administration were entirely appropriate. To put it more boldly, I don't think that this represents a failure of prospective regulation.
I hope that this will result in deep changes to our regulatory system, starting with unifying the diverse bank regulatory body, and giving them a stronger mandate to watch systemic risk like a hawk. I hope the GSEs will be broken up, stripped of their government guarantee, and regulated like other companies that do the same thing. I hope the central bank will pay more attention to inflation, and less to unemployment.
But that is retrospective. What can I say that Bush, or Clinton, or anyone else, should have done, knowing what they did at the time? I can demand that they be omniscient, but since I'm not willing to hold myself to that standard (nor, I expect, is Andrew), that hardly seems fair.
There are a couple of problems that I don't have answers to yet:
- Should the Fed watch asset price bubbles? It's obviously tempting to give a glib yes, but there are deep problems with this. The Fed already has a lot on its plate; adding asset prices would vastly multiply the complexity. And it's not clear we'd be happy with the results. If the Fed is too conservative, it will tamp down growth prophylactically. I'm not confident that regulators can correctly identify the moment that we enter an asset price bubble. And asset price bubbles are really, really hard to pop. I refer you to John Kenneth Galbraith's description of the government's attempts to shut down the 1929 boom.
- How should the Federal Reserve have dealt with the river of money flowing into American markets from central banks and savers abroad? This was the primary culprit in the credit expansion, not the Fed--indeed, that's why the yield curve got so funny looking at the end.
- What standards should we use for evaluating derivatives? Derivatives don't just create risk; they can also lower it, by allowing firms to hedge. When Robert Shiller tells me that overall they're a good thing for the financial system, I'm inclined to listen.
- Is mark-to-market accounting a good idea? A lot of the problem can be traced to the practice of marking all assets to market value at the end of the day. This has advantages, in that it gives investors a better idea of the breakup value of the firm. But it can also touch off downward spirals--they open up balance sheet holes that create ratings downgrades and force asset sales, which further depresses the value of those assets and opens up similar holes at other firms.
Then there are things that I think would have helped, but cannot see where the political will would have come from:
- Keep Fannie Mae and Freddie Mac out of risky mortgages, and give OFHEO some teeth. Bush and several Republicans tried, and failed, to do this. My preferred solution, an explicit strip of the government guarantee and a supervised breakup, wouldn't even have gotten on the radar. Fannie and Freddie were politically powerful, as were voters who wanted to buy houses.
- Regulate mortgage brokers at the federal level. Given the way mortgage funds now flow across state lines, this made sense. But the state governors would have screamed bloody murder. Moreover, no one knew about the fraud when it would have helped--i.e., before most of it happened.
- Mandate 20% down payments. Political suicide. Affluent people would continue to borrow downpayments in private family loans, while the poor were shut out of the housing market. Poor neighborhoods would have been devastated by the credit cutoff. House prices would have dropped sharply everywhere.
- Change regulatory standards to take more account of small-probability, devastating systemic risk. Nassim Taleb has been talking about this for the last few years. But I didn't hear more than academic interest in this until mid-2007. Most people on the Street really believed that they had gotten better at assessing credit risk.
- Unify the bank regulators, including the SEC, into one agency. At least some of this crisis might be traced to the fact that the regional banks who originated many of the bad loans were often regulated by a different body from the investment banks who bought them. It might have been done, I suppose. But each of those agencies has powerful constituencies among their employees, and the firms they regulate. Moreover, the transition process would have involved some ugly internicene warfare that probably would have eroded regulatory effectiveness in the short run.
- Mandate contingency plans for the dissolution of large firms, and other unlikely but devastating scenarios. If people had some certainty about the likely outcome of an insolvency, the panic selling wouldn't be so rampant, and people would be more willing to loan money, albeit at a discount. But again, I didn't hear anyone talking about this in, say, 2006. I certainly didn't think of it. Is it reasonable to say that this should have been utmost on the mind of Bush or his advisors, while other big priorities, like trade deals, loomed large?
- Make subprime loans illegal. As long as most subprime borrowers are still making their payments, I can't endorse cutting them off to protect the fools. Moreover, this would simply not have been possible, no matter who controlled congress or the presidency. Cutting off subprime loans would have prevented more people from buying homes. The politics of it are terrible.
- Make option ARMs or negative amortization loans illegal. Option ARMs are debateable-they're actually useful for people who have uneven income flows, like, er, a lot of journalists. But clearly they were abused, and negative amortization loans are nuts. However, these exotic instruments are only a fraction of the toxic subprime loans. They appeared mostly late in the process, when lenders were scraping the bottom of the barrel to keep the boom going.
- Change the way that these securities were accounted for. Most risk models for ABS and MBS were focused on prepayment risk, not default risk, which was assumed to be fairly well known. This assumes a rather stunning level of prescience on the part of regulators or legislators.
- Force banks to keep some amount, say 10% of the loans they originated. Spain does this, and its housing market is even more bubbleicious than ours was, believe it or not. It might have made the banks more secure. But there are good reasons to want banks, especially small banks, to have the flexibility to match the durations of their asset portfolios to those of their liabilities. When interest rates skyrocketed in the early eighties, banks were stuck with long-term mortgages at low rates, but forced to offer high interest rates on savings accounts in order to keep business. The result was, ultimately, the S&L crisis. And again, while there may have been someone proposing this somewhere, I didn't see a lot of people talking about it in 2003, when it really might have helped.
Then there are the things that people think would have helped, but which wouldn't have done anything I can see:
- Repealing Gramm-Leach-Bliley, or at least the provisions that repealed Glass-Steagall's ban on commercial banks entering other lines of financial business. If this were part of the problem, it would be the commercial banks, not the investment banks, that were in trouble.
- Lowering CEO pay. Whaaaaaa? If Dick Fuld had been paid a dollar a year, we'd be in exactly the same mess. Probably worse, because what kind of CEO do you get for a dollar a year?
- Raising the Fed Funds rate The MBS money was long money, not overnight funds. And when a bubble is truly going, raising rates may just attract more long money, without deterring speculators who are expecting double-digit annual returns.
- Requiring better disclosure of loan terms Disclosure of loan terms is already quite exhaustive, including a term sheet right on top that provides a congressionally mandated summary. You can't make people read things, and the extra disclosure you mandate goes into the "fine print" that people claim they can't read. Moreover, the fundamental problem for most borrowers are things that aren't hard for buyers to understand, like "I have an adjustable rate mortgage"; "Interest rates can go up"; and "My housing payment should not be two-thirds of my gross income".
- Changed the neo-liberal "culture" The president and congress are not the parents of Wall Street, and believe me, bankers do not look towards Washington for moral guidance. The "Miasma Theory" of political influence is the last refuge of partisans who know they are full of it.
There are more, but considering all this nonsense is frankly exhausting.
The point is, given what they could reasonably have known then, did regulators act unreasonably? Did legislators ignore politically feasible policy options? I don't see it.
But if you are looking to place regulatory blame, whatever changes you'd care to point to happened on Clinton's watch, not Bush's. You cannot have it both ways--hailing the Clinton genius at economic management (and implying that Obama will bring back those halcyon days), and then claiming that Bush should have trailed around undoing all his work. You most certainly cannot explicitly claim, as Obama did in his speech, that this crisis is the result of the Bush administration's deregulation of the financial markets:
The challenges facing our financial system today are more evidence that too many folks in Washington and on Wall Street weren't minding the store. Eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans have brought us to the most serious financial crisis since the Great Depression.
This is flat out untrue. And I know that Barack Obama is smart, and well-informed, enough to know it.
Update: I should note another thing regulators could have done, which is required more reserves. It's hard to do this when banks are in trouble, since if they had a lot of cash, they wouldn't be in trouble. But while it's now clear that we should do so going forward, I'm hard pressed to say that I could have predicted it then. One reason debt-to-equity ratios are so high now is that toxic securities have caused balance sheets to collapse. Moreover, while this would have let the Fed off the hook, somewhat, it's hard to see how lower debt-to-equity ratios could actually have prevented most of this. As far as I can tell, the scale of the collapse is so epic that unless regulators were willing to really make the banks radically delever (remembering that the resulting credit contraction would have had negative economic effects--the ones we're seeing now), it still would have taken down a lot of firms.
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