Beyond Stage One Politics

During most of this past decade, the housing market rose at an unprecedented rate (12.5% in one year alone), only to come crashing down in 2008 to such a degree that $4.5 trillion in US wealth was lost. What were the circumstances that converged to cause the rate of mortgage securitization to increase over seven-fold from 2001 to 2006, allowing the underwriting of high-risk loans without fear of having to hold those loans? The answer, surely, is a complicated one, but simply chalking it up to the greed of Wall Street while refusing to look below the surface is a bit too simplistic for me.

The banking crisis which stemmed from the bursting of the housing bubble was concentrated in commercial banks, but contrary to popular belief and the myth of “lack of regulation,” the commercial banks were more heavily regulated than were the investment banks. While the investment banks were caught holding large inventories of MBS’s they hadn’t yet sold off and mortgage loans that hadn’t yet been securitized, commercial banks held large numbers of mortgage-backed securities that became essentially worthless and put many at substantial risk of failure, all while being heavily regulated.

In 2001, the Federal Reserve, along with the FDIC, Comptroller of the Currency, and the Office of Thrift Supervision instituted what is known as the recourse rule. This rule was meant to steer the funds of banks into “safe” assets and make it attractive to buy MBS’s as opposed to actually lending out their own money. (In 2006, a similar rule was instituted for non-US banks, exposing them to the same types of risk just before the housing meltdown in 2008.)

[U]nder the recourse rule, “well-capitalized” American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans.

As the demand for MBS’s increased, so did the supply from Wall Street and the GSE’s. This timing coincided nicely with the fact that major pressure had been put on banks during the 1990s to make loans to individuals who wouldn’t qualify under traditional guidelines. The banks, of course, weren’t willing to hold on to those loans – they simply sold them off to Wall Street and bought back highly rated bonds that offered them a huge tax advantage.

As I’ve written in a previous post,

According to economist Milton Friedman, the use of political channels, as opposed to the market, for the provision of resources leads to the straining of social cohesion. The reason for this is that markets allow diversity, while government policies require conformity. In Capitalism and Freedom, he states that the more extensive the range of issues we attempt to solve through political means, the greater the strain on the “delicate threads that hold society together.”

The problems found in the issue of lack of diversity v. conformity apply when dealing with economic issues, as with other public policy issues. Regulations have the express purpose of homogenizing behavior, and in a capitalist system where competition reigns supreme, the natural state is one of diverse behavior, ideas, and experimentation.

If capitalists stop acting heterogeneously–if they compete through imitation, rather than innovation–the risk of systemic failure increases . . . Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk.

The more we expect the government to regulate, the more we can expect risk to increase throughout society and have a greater and greater negative impact on ever-larger numbers of people. Is there another way?

So, 36% of the American public thinks Obama is doing a good job on the deficit. In fact, 23% didn’t think the stimulus package added to the deficit at all. That level of miseducation is astounding to anyone even the slightest bit economically informed. The federal deficit for the 2010 budget is projected to be 10.6% of GDP, with an expected increase even higher next year. This, even though according to our President, we’re in the middle of recovery.

Federal discretionary spending increased over 80% from 2008 to 2010, thus resetting the baseline at an extraordinarily high level. Every new budget going forward starts at that point and goes upward from there; any reductions are considered cuts – something that almost never happens in Washington. What does tend to happen is that spending will increase each year, thus ensuring greater and greater deficits, and an exploding national debt as far as the eye can see.

Deficits under George W. Bush were in the 1-3.5% range until 2009, for which President Bush and President Obama were both responsible. Most of us believed spending was out of control under Bush, only exacerbated by the $800 billion (ten year) price tag on Medicare Part D.

President Clinton was elected to his first term in office with a minority of the popular vote, which had been split by Ross Perot with 19%. What was the issue that so divided fiscal conservatives and was the basis of Perot’s campaign? Concern over a deficit of approximately 4% of GDP.

A quick review of articles written during the Bush administration attests to the fact that liberals have been consistently concerned with out-of-control deficits during periods of time when they’ve been a fraction of what they currently are. I certainly hope this concern is genuine rather than political and we’ll soon see wide-ranging support for massive spending cuts in order to meet the historically consistent level of spending at 18-20% of GDP.

Politicians from both parties have been selling out the future of our country in order to buy votes in the here and now, and the rest of us just can’t afford this party any more.

In The Battle, Arthur C. Brooks outlines a consistent 70/30 split among the American population. That is pretty much what we see in this support for current policies dealing with budget and spending issues.

Nearly 70% of Americans agree that they’re better off in a free market economy than not, “despite its severe ups and downs.” Fifty-six percent of Americans believe their income taxes are too high, while 33% believe they’re just right. Astoundingly, while many Americans believe that the rich should pay more taxes, 69% believe that the top tax rate should be 20% or lower! Seventy-six percent believe the strength of America is based on the success of American business and 66% believe that when “big business” earns a profit it helps the economy; alternately, 18% believe it hurts (where did they go to school?) When asked if they would prefer larger government with more services and higher taxes or smaller government with fewer services and lower taxes, only 21% of Americans chose larger, more expensive government while 69% preferred smaller.*

There is a minority of the population, the 30%, who will, due to lack of understanding or pure ideological drive, charge ahead in attempts to completely redefine and transform this nation of freedom and wealth which was unimaginable in the world just a few centuries ago. It is the rest of us, the 70%, the mainstream of America, who stand in their way. It’s time for the politicians to represent us.

(Polling data excerpted from The Battle by Arthur C. Brooks, Basic Books, 2010, pp. 3-12)

Fascinating discussion Friday on CNBC about the falsification of Lehman Bros. balance sheets prior to their collapse. The fraud was completely missed by regulatory agencies despite extensive government oversight by the SEC and the NY Federal Reserve, who had regulators inside Lehman after the Bear Stearns meltdown. Sarbanes-Oxley, put into place after the Enron scandal to ensure that such a thing never happened again, failed to keep Lehman honest, and numerous other rules and regulations had no effect either. Even Ernst and Young, Lehman’s accounting firm, still stands by Lehman’s practices which apparently amount to outright fraud.

Who investigated and discovered the problems? Short sellers. Could it be that those with an economic interest are in many ways more effective regulators than the government? (Not to say we don’t need some government regulation, to be sure, so don’t even go there.)

Watch the video, and tell me what you think.