Adding to the Fire: Obama's Regulatory Plan
Yesterday Barack Obama unveiled his new financial regulatory proposals. These include greatly expanding the scope of the Federal Reserve’s regulatory duties, creating a government agency to “protect consumers” from the financial industry, and increase government control over many investment and financial outlets.
The first problem with this proposal is that it completely disregards how this bubble and bust came about. “Lack of regulation” did not cause the bubble or the pain we feel today. In fact, it was the federal government and Federal Reserve who were actually encouraging banks and lenders to lower their lending standards to riskier customers. The government was pushing lower lending standards in the name of equality and the right for lower income families to own a home.
In Obama’s plan banks would be forced to hold the mortgage-backed securities they create and sell to investors, with the belief that they will be more conservative with their loans if their own money is on the line. The problem with this is that it ignores how mortgage-backed securities, or the secondary mortgage market, came about. For those who don’t know, the secondary mortgage market is where a bank sells a loan it made with a customer to another business, relieving the bank of the responsibility to maintain that loan. The business buying those loans from banks may hold them in its portfolio or group them into mortgage-backed securities and sell them to investors.
This market started with Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) created in 1937. Fannie and Freddie have enjoyed special privileges and treatment since their creation. They created the secondary mortgage market to give banks the opportunity to give more loans (and thereby sell them to Fannie and Freddie) and therefore give more people the chance to borrow money to buy a house.
In the 1990s, the Clinton administration continually pressured Fannie and Freddie to buy riskier mortgages from banks. This would encourage banks to sell mortgages to lower income individuals regardless of the increased risk of foreclosure involved. In 1999, after pressure from the federal government, Fannie Mae lowered some of its previous standards so it could buy riskier mortgages from the banks.
We often hear today that it was greed, deception, and lack of regulation that pushed subprime mortgages onto the market, when in reality these risky loans were being openly encouraged by the federal government. The mortgage bubble would not have been possible had it not been for Fannie and Freddie and the special government treatment they have received since their creation. Any government agency involved in the housing market (in both the Clinton and Bush administrations) was pressured to lower mortgage standards, allow lower income individuals and families to get loans, and ignore the extra risks and consequences.
The very reason why many politicians didn’t want equal treatment and oversight for Fannie and Freddie was because they thought it would take away the GSEs’ ability to “commit” to riskier customers. The government was pushing “affordable housing” by lowering mortgage standards in any way possible, rejecting the market’s natural rates of risk, and ignoring the risks involved with increased loans to people who clearly couldn’t afford them.
No one in government pushing these practices believed they were adding to an unsustainable and deadly bubble, and no amount of government regulators would have had the nerve to ignore what Congress, the President, and the Federal Reserve were all pressing for. The push for decreased mortgage standards for lower-income people gradually spread into decreased standards for the mortgage industry as a whole. Subprime mortgages were not the only portion of the mortgage market that crashed, many “prime” mortgages faced high foreclosure rates because of the spillover of decreased lending standards.
Obama’s plan assumes that forcing businesses in the secondary mortgage market (mainly Fannie and Freddie) to own part of their own mortgage-backed securities will solve the problem. If the government suddenly has to jump into the secondary mortgage market to ease and control the industry, why are we not simply allowing Freddie and Fannie to compete on the free market, suffer the consequences of unreasonable practices, and go bankrupt if necessary? Instead allowing Freddie and Fannie to fail because of their poor practices, the government nationalized the two corporations last year. The secondary mortgage market would not have been possible had it not been for the government’s unending support for Fannie and Freddie. Rather than look at the root cause of the problem, Obama is taking an issue that the government essentially created and sustained and using it as an excuse to increase government regulatory power.
People rarely ask how banks suddenly got the money and ability to loan to people who obviously should not have gotten loans. In response to the bursting tech bubble and weak economy, then-Federal Reserve Chairman Alan Greenspan lowered the Fed’s interest rate to 1% for a full year starting in 2003. Greenspan kept rates artificially low for one purpose: lower rates mean banks can borrow more money, which they can loan out to more people (who otherwise couldn’t have gotten those loans) who will go out and spend those dollars. Lower interest rates encourage spending, borrowing, and discourage saving; if they are held at artificially low levels that money will drift to areas that it never would have gone before. By keeping rates at unsustainable and artificially low levels, the Fed gave banks the money and opportunity to loan cash to people who otherwise never could have gotten it (i.e. subprime mortgages).
The Federal Reserve’s easy money and cheap credit policy played a huge part in giving banks the chance to take advantage of their lowered lending standards. Lower lending standards coupled with the artificial credit from the Federal Reserve put the subprime mortgage market in full gear. Without the Fed, the banks could not have gotten that cash in the free market. It is frightening that the practices employed at the Fed, which were so instrumental in causing today’s mess, are now being looked upon as the solution. The leaders of the Fed are the very people who ignored the bubble forming from their own policies.
In 2005 Ben Bernanke said that rapidly rising housing prices “largely reflect strong economic fundamentals.” At the same time Greenspan said the housing market was merely experiencing “froth,” not a bubble, and would only correct in local markets. Why in the world would we want to give more power to the Fed and the people who manage it when they continually ignore the consequences of their easy money policies and denied for years that the housing bubble was unsustainable and irrational? Why are we listening to the people who helped create the problem, ignored the problem for as long as possible, and suddenly feel they have all the answers that will lead to massive economic damages if not put into place?
The fact that they see the same policies that brought us into this mess as the perfect solution should caution everyone about their judgment. Artificially low interest rates and cheap credit may boost the economy in the short-term - even for a few years as it did after the tech bubble burst until 2007 - but they will guarantee another bubble of this magnitude and a more disastrous bust several years down the road.
Because of the policies endlessly pursued by the Fed and the government over the past year (artificially low interest rates, bailouts, increased intervention) do not be surprised to see excessive malinvestment in the years ahead, a period of artificial wealth (just as the tech and house bubble “wealth” proved to be nonexistent after their respective bubbles popped), and a painful collapse.
Obama’s new regulatory plan is nothing more than a continuation and massive expansion of the exact policies that brought us to this point. More government and central control will not solve problems that they themselves were strongly supporting when the economy seemed to be in great shape. Obama’s plan simply hands buckets of gasoline to the arsonist watching the fire he started.