More rules wont save financial system
MY VIEW • Earlier lending mandate put economy in mess it's in
The crisis in the housing and financial markets has generated a cry for more regulation. The cry comes from Congress, presidential candidates, political commentators and even some pop economists. But a good case can be made for the opposite view: Regulations are, to a large degree, the cause of the crisis.
U.S. mortgage lenders have been under tremendous regulatory pressure to make loans to households with poor credit since 1977. That's the year the Community Reinvestment Act was passed by the Carter administration.
The CRA's expressed purpose was '… to encourage banks and thrifts to help meet the credit needs of all segments of their communities, including low- and moderate-income neighborhoods' and to adopt '… more flexible credit underwriting standards.'
Powerful regulatory sanctions were imposed on lenders that did not deepen their exposure to risky credits. I personally observed this for 13 years while overseeing part of this process for a Federal Reserve bank. Mergers and transactions that needed regulatory approval would be blocked if lenders did not meet CRA criteria.
Lenders for the most part did not want to keep weak mortgages in their own portfolios. If possible, they were sold to the likes of Fannie Mae, where the implicit government guarantee transferred credit risk to the public.
But the risky loans could not always be sold this way. So, in 1995, issuance of private label bonds - backed by nothing but CRA loans - was permitted.
In a transaction that was an ominous preview of what was to come, First Union (now Wachovia) and Bear Stearns sold the first CRA-backed mortgage bonds.
Mortgage debt and the homeownership rate skyrocketed, fueled by the pressure to 'democratize' credit access and an accommodating monetary policy. The accompanying boom in home prices created the illusion of a game where all bets paid off.
Issuers of subprime-backed bonds slept at night confident that they had diversified by pooling and parsing the risks of the underlying mortgages.
Although Federal Reserve Chairman Alan Greenspan expressed alarm as early as 1997 about the risks of subprime lending, he also inadvertently fueled its growth.
His efforts to bootstrap the post-2000 economy with four years of a low Fed funds rate resulted in the opportunity of a lifetime for mortgage lenders. They could very profitably borrow short and lend long and expand mortgage access with adjustable loans.
But the mortgage and housing boom became a bust when the Fed's low-cost money policy was reversed abruptly in 2004-05.
Suddenly, low-cost adjustable rate mortgages were high-cost, low credit scores came to roost, and home appreciation reversed. The diversification virtue of mortgage pooling evaporated as loan values all moved in the same direction.
The rest of the story is what is in the media today. The complex spaghetti of mortgage pools, derivatives, hedge funds, rating agencies and others is interesting. But it is not the core of the story. It is just the legacy of regulatory and monetary interventions gone awry. So why are we calling for more?
Randall J. Pozdena is an economics and finance consultant. He is a former professor, former research officer in the Federal Reserve and former chairman of the Oregon Investment Council living in Northwest Portland.