New Financial Regulations: Trying To Fix Self-Correcting Problems

In the midst of the banking crisis, the Obama administration is considering sweeping financial regulations.  But before fixing problems with a sledgehammer, let’s assess which of these problems have fixed themselves.  It turns out that many of the private sector errors that helped trigger the financial crisis are not going to be repeated; at least not for many years.  These mistakes are only part of the problem, of course, but the new financial regulations focus on them, yet most of the private sector errors have already self-corrected.

The greatest private sector error was over-optimism in the housing market, which led first-time homebuyers to purchase larger homes than they needed or could afford.  It led people with marginal credit to strive to qualify for a home mortgage. It led individual investors to buy homes either to flip or to rent out.  It led institutional securities investors to believe that mortgage pools were as good as gold, and it led ratings agencies to put AAA labels on bundles of sub-prime mortgages.  However, we do not need new regulations to solve this problem, for now everyone knows that real estate prices can go down.  That memory will last many, many years.

The second private sector problem was a willingness by institutional investors to buy securities they did not understand.  The collateralized mortgage obligations and collateralized debt obligations became terribly complex.  A full understanding requires computer simulations that would dim the lights of a major city.  Investors simply accepted the results of the ratings agencies.  Investor appetite for these securities helped to fuel the lax mortgage lending practices, but what’s happening today?  Securitization has come to a standstill (aside from federally guaranteed issues), not because of regulation but because investors are now scared of anything they do not understand.  When the market for asset-backed securities returns, it will return only for plain vanilla transactions, deals simple enough that anybody can easily understand them.  No one will buy complex pools of sub-prime mortgages for many years to come.

The third private sector mistake was the high leverage of investment banks and hedge funds.  Companies that had historically operated with 10 to 1 debt-to-equity ballooned up to 30 to 1 or higher.  Although the large investment banks have all become bank holding companies to qualify for federal money, even unregulated companies would be more conservative now.  Everyone has seen what happened to Bear Stearns, Merrill Lynch, and Lehman Brothers.  Moreover, the leverage they attained required a willing lender.  In the current environment, no one will lend money to an investment bank or hedge fund that has too much debt already.

Private sector individuals and businesses are not immune from mistakes, but they adjust their behavior to avoid further losses.  In contrast, public sector errors tend to continue.  Fannie Mae (FNM) and Freddie Mac (FRE) continue to have government backing with a misguided mission.  The Community Reinvestment Act continues to encourage banks to make high risk loans to people with poor credit.  The tax code continues to encourage excessive leverage, including to homeowners.  Congress and the President should focus their attention to an area in which they can do some good: public policy.  They need not concede that only the private sector made mistakes.  They need only acknowledge that the private sector errors are self-correcting.

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