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Chris A.

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Author unknown.


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EDITORIALS



DID DEREGULATION CAUSE 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.

By Don Peppers on October 10 2008 09:31 AM | P
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