There’s a recent exchange between two writers at the Economist’s Democracy in America blog that comes after a previous exchange about the role of inequality and the role of the government in the recent financial crisis. The first by M.S. argues that “If the CRA was largely irrelevant, and Fannie and Freddie were also-rans, it seems hard to understand how one could put government at the heart of the crisis”, and W.W. argues that “The market failed. And the market was what it was because government made it that way.”
You should read both since I’m going to refer to the W.W. essay in detail but I don’t want to blockquote chunks of it. Looking at W.W.’s argument, he relies on a scholar from Cato, a scholar from the American Enterprise Institute, and…..another scholar from the American Enterprise Institute. The author is capable of, Matrix-style, getting a full argument saturated in pre-conceived talking-points downloaded straight into the consciousness by only engaging a handful of right-wing think tanks. Is this what they mean by “epistemic closure” on the right?
And they are talking points: looking at the time series of financial regulatory recommendations in the Cato Handbook for Policymakers repealing the CRA and privatizing the GSEs shows up in every single year they cover financial regulation going back to the first one that is online, 1995. Back in 2000 the argument was Should CRA Stand for “Community Redundancy Act?” which argued that the innovation of subprime loans made the CRA useless and incapable of doing anything and should be repealed. (“In fact, lending in low-income neighborhoods grew faster than other types of lending at institutions not covered by CRA…The subprime mortgage market, which makes funds available to borrowers with impaired credit or little or no credit history, offers a good example of competition at work.”) The CRA was incapable of doing anything because the unregulated subprime market was replacing it – unregulated because Greenspan refused to enforce the 1994 The Home Ownership and Equity Protection Act and other consumer laws, which he could do when Citigroup and HSBC started buying out subprime lenders. Now the CRA is the boogeyman. Go figure.
M.S. is the doofus who engages with reports from the San Francisco Federal Reserve excellent research department as well as the Joint Center for Housing Studies from Harvard University. Those reports are doing cutting edge research to answer specific questions related to the the role of the CRA and the GSEs against these arguments. But these arguments are getting a little dated. Most of them have been well-discredited; my favorite one-stop to get a lot of these weaker arguments cleared is Arpit Gupta’s excellent discussion of the book Fault Lines. The Federal Reserve’s role is a debate that is still ongoing. It’s worth remembering that the CRA was reconfigured by the OTS and Bush in 2005, in a move that OTS noted was criticized by community organizers and applauded by financial institutions and industry trade associations. Also this fantastic review by Karl Smith on the Conservator’s Report on Fannie and Freddie clears up a lot of the GSE debate.
Smith’s argument about capital gains taxes is important but when he invokes “both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded” argument it would be really helpful to figure out what the mechanism was. Gupta points to the latest research that is showing that the increasing use of securitization drove the expansion of mortgage credit among high-risk borrowers.
Was the government’s role in the private securitization market a response to inequality or over-regulation? History should show it to be the result of intense lobbying efforts from investment banks to clear out any of the legal hurdles to private securitization of home mortgages, the most notable one being the Secondary Mortgage Market Enhancement Act of 1984 (SMMEA) where Congress preempted a variety of state laws that inhibited private home mortgage securitization. This was part of the deregulation culture of the past 30 years, and we should identify it as such.
Recourse Rule as Deregulation Culture
There’s a game of three-card monte going on here where the government deregulates the financial markets and that is called regulation. Kevin Drum sees this blurring and notes “There’s a sense in which it doesn’t matter: government policy is government policy, and if federal regulations were too lax, that means the government was at fault.”
But we can get more specific. Let’s look at this recourse rule, which is W.W. biggest piece of evidence that government policy is at the heart of the financial crisis. (Also note: not housing bubble, but financial crisis. Two different things.) There’s little evidence that this was a driver, but let’s look at the ideology behind this rule.
Here’s the Federal Register from November 29, 2001 introducing the Recourse Rule (my bold):
The [regulatory] agencies expect that banking organizations will identify, measure, monitor and control the risks of their securitization activities (including synthetic securitizations using credit derivatives)...Banking organizations should be able to measure and manage their risk exposure from risk positions in the securitizations, either retained or acquired, and should be able to assess the credit quality of any retained residual portfolio…Banking organizations with significant securitization activities, no matter what the size of their on-balance sheet assets, are expected to have more advanced and formal approaches to manage the risks.
So what does it do? It takes an older, blunter government rule (all mortgages at 50% risk), and makes it more market friendly (mortgages at the level where the market prices risk). It outsources risk-management to private companies, the ratings-agencies, assuming that companies willing to pay to get ratings on their mortgage bonds would lead to more efficient information than government regulators. It takes as granted that financial innovation has “worked” and that government regulation should act to help move the latest financial innovations more coherently into the regulatory regime.
It is telling banks to handle this themselves, because the “science” of risk management is well provided within private financial services, and it is better for it to be handled this way rather than with the crude tools public regulators used. Both the incentives of private agents are well-aligned to increase shareholder value as well as maintain their own reputational capital. With this in mind, it’s hard not to plug this amendment into the familiar narrative of “deregulation.” The idea that we are trusting financial markets to handle this themselves, because markets will know as well if not better than regulators what risks people are taking on, is written into the very fabric of this financial deregulation.
And sure enough, it’s now become the centerpiece of the argument that regulation caused the financial crisis. Go figure.