There is a lot of noise and confusion about what caused the recent financial panic. The Obama Administration believes that the basic problem is that markets do not work right, people are too dumb to choose for themselves, and that regulatory agencies were not able or were unwilling to keep up with bank shenanigans. Their solution: more of the same, that is, create a variety of new government agencies and bureaus that have the authority to dictate and control any part of or player in the financial system, including control of financial customers large and small (look in the mirror for the definition of financial customer). This neglects the fact that government agencies were the most blameworthy in the recent financial panic. In fact, it is impossible to have a long, sustained economic recession or depression without government policies causing it. (I will save for another day how the policies of the Federal Reserve and the Franklin Roosevelt administration made sure that an economic downturn became a depression lasting for a decade.)
Let me address the first of these points in the Obama administration’s justification for taking over the financial system. First of all let us consider the markets. It is true that the markets did not perform right. That was because government rules, structures, and programs did not allow the markets to perform right. The government guarantees bank deposits, so depositors do not care very much how safe or sound a bank is. Government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac, bundle up mortgages into securities that investors assume have little or no risk. The Securities and Exchange Commission (SEC) approves and controls the small number of credit rating agencies, and investors believe that these agencies are right when they give to a particular company or investment their highest credit rating (such as AAA), a rating that is thought to present little or no risk. The SEC has protected these agencies from competition and from market discipline for their errors while providing little in the way of regulatory discipline.
With those and other government protections in place the appearance of risk just about disappeared from the mortgage markets. Different investors have different appetites for risk. It was not the people hungry for high risk returns that fueled the housing bubble. Many of those with the weakest appetite for risk, seeking the safest investments, were drawn to the mortgage markets. In this government-manufactured atmosphere of little or no risk, many mortgage firms, increasingly non-bank mortgage firms, made it more and more possible for people to buy houses that they could not afford. Once the mortgage firm made the mortgage, regardless of the ability of the borrower to repay, the firm sold the mortgage to the GSEs, who sold it on to investors who poured trillions of dollars into what they thought was a safe haven. Then the mortgage firm went on to make more mortgages. Investors were shielded from asking whether the mortgages were any good, that is, whether the person buying the house could actually afford it.
That mispricing of the risk pulled more and more money into mortgages and real estate, driving prices up and up, pulling in more and more investors as the prices rose, until it was impossible to put one more Jack on the house of cards without it tumbling down. People panicked when “safe” investments turned out to be risky. Then the government started panicking, bailing out some firms and not others, changing the rules almost weekly, demanding hundreds of billions of dollars from taxpayers in order to pick financial winners and losers. Investors, not knowing where the government would turn next, panicked some more.
It was government interference in the market that failed, not the markets. Without all of the government camouflage, investors would have insisted on knowing that the mortgage borrowers could afford their houses before funding loans to buy them. Ask yourself this: would we have had the whole housing blow up if people who could not afford to buy houses were not given mortgages? Yet the Obama Administration, even today, is tripping over itself to find new ways to guarantee new mortgages, in many cases especially for people who cannot afford their houses. Where have all the subprime mortgages gone? They have gone to the Federal Housing Administration (FHA), where they have a government guaranty. (Watch what happens to the FHA house of cards in the coming months.) When will they every learn? Oh, when will they ever learn?
Giving more power to the kind of government agencies that helped create these problems hardly seems like the sensible answer. That is what the Obama Administration proposes, though. Instead of controlling the markets with more government interference and masking of risk, more bailouts for firms that should be allowed to fail, more power for some new government bureau to pick winners and losers and to tell people which financial products they can and cannot have, we should be exposing financial players more to market discipline. We should make it harder to hide risk and easier for investors to recognize the risks and allow the markets to charge higher prices for higher risks and lower prices for lower risks.
Market discipline has always been the quickest and surest regulator. It rewards the efficient provider of what the buyers in the market want, and it punishes the incompetent. Very importantly today, the market is stingy about bailouts.
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