Monday, September 22, 2008

You Got Us Into This Mess, Now You're Going To Get Us Out?

Excellent editorial in today's WSJ that should serve as a primer in the months and years ahead when we hear that the current financial mess is a result of not enough government regulation and intervention. A Mortgage Fable lays outs five ways that government directly contributed to the problems:

- The Federal Reserve: The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.

- Fannie Mae and Freddie Mac: Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.

- A credit-rating oligopoly: Thanks to federal and state regulation, a small handful of credit rating agencies pass judgment on the risk for all debt securities in our markets. Many of these judgments turned out to be wrong, and this goes to the root of the credit crisis: Assets officially deemed rock-solid by the government's favored risk experts have lately been recognized as nothing of the kind.

- Banking regulators: In the Beltway fable, bank supervision all but vanished in recent years. But the great irony is that the banks that made some of the worst mortgage investments are the most highly regulated. The Fed's regulators blessed, or overlooked, Citigroup's off-balance-sheet SIVs, while the SEC tolerated leverage of 30 or 40 to 1 by Lehman and Bear Stearns.

- The Community Reinvestment Act: This 1977 law compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

Obviously the companies who took on unreasonable risks and the individuals who took out loans they couldn't afford bear a large share of the blame as well. But when you hear that this crisis is a "failure of the free market" you should remember the significant role that government played in creating it. And you shouldn't believe that more government is automatically the solution.

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