Dealing with the Threat of Global Recession
At the global economic summit to be held at the White House later this
month - likely the last significant meeting of foreign leaders in which
the Bush administration will participate - the U.S.
should seek a goal that has so far eluded all self-anointed saviors of
the financial markets. That "something" would be a good dose of
As the meltdown has unfolded, the private "masters of the universe" on Wall Street
have been supplanted by the political "masters of the universe" in
Washington and European capitals. That transition followed the rude
awakenings of "smartest guys" in business that their financial
engineering had many flaws.
But now, the new bureaucratic "gods of finance" are assumed to have
this infallible ability to pick winners and losers through their
awarding of bailout money. Yet ironically, in many instances, the same
"masters" from Wall Street are the ones running the bailouts in
Washington. Treasury Secretary Henry M. Paulson Jr., a former chief
executive officer at Goldman Sachs, has hired former Goldman employees
to decide how to dole out the $700 billion.
But the bailouts and partial nationalizations are still premised on
what Friedrich A. Hayek, Nobel laureate in economics, called the "fatal
conceit." Once again, it is assumed that government bureaucrats can
plan the direction of the economy better than millions of consumers and
investors can. Bailout proponents also rest on a misread of recent
history in viewing the current mess as the result of "unfettered"
markets. In truth, numerous government interventions from housing
subsidies to directed lending have been big factors in this crisis.
Government-sponsored enterprises Fannie Mae and Freddie Mac
were able to purchase trillions of dollars of mortgages at low cost due
to their implicit (and now explicit) backing by the government. By the
end of 2007, according to the New York Times, Fannie and Freddie had
guaranteed or invested in $717 billion of subprime loans, and they
bought many more that were just slightly above the subprime category.
Their tremendous market power allowed Fannie and Freddie to buy many
lower-quality mortgages that likely would not have been issued by
lenders in the absence of such guarantees.
The Community Reinvestment Act, enacted in 1977 and expanded in the
mid- '90s, mandated that banks issue a certain number of loans to the
local communities they serve, including lower-income borrowers. To meet
these goals or quotas, banks were encouraged to lower lending
In the early '90s, the Federal Reserve Bank of Boston wrote a manual
for mortgage lenders stating that "discrimination may be observed when
a lender's underwriting policies contain arbitrary or outdated criteria
that effectively disqualify many urban or lower-income minority
applicants." As Stan Liebowitz, a professor of economics at the
University of Texas at Dallas Business School, noted recently in the
New York Post, "some of these 'outdated' criteria included the size of
the mortgage payment relative to income, credit history, savings
history and income verification." In other words, the Boston Fed and
other agencies were discouraging the very criteria that would have
protected lower-income families from overextending their indebtedness
and could have prevented the subprime meltdown.
Private credit-rating agencies clearly dropped the ball in
rubber-stamping these mortgage-backed securities as "AAA." The deeper
problem is, though, that the ratings of Standard & Poor's and
Moody's are enshrined in government regulations dictating the capital
requirements of banks, broker-dealers and pension funds. These
institutions frequently can only buy securities of a certain rating to
comply with capital rules. And until very recently, the Securities and
Exchange Commission had only designated S&P and Moody's as
"nationally recognized statistical rating organizations," giving them
essentially a government-protected duopoly
Despite the existence of foolish lending practices and perverse
policy incentive, by itself the sheer number of mortgage delinquencies
and foreclosures doesn't justify a crisis of this magnitude. In the
Mortgage Bankers Association's latest National Delinquency Survey, the
mortgage delinquency rate is just 6.4 percent - historically high, but
not anywhere close to the mortgage default rate of more than 40 percent
in the depths of the Great Depression.
Among the crucial factors that helped make this crisis a global
financial "contagion" were new accounting rules going into effect in
the U.S. and Europe just as foreclosures were spiking and real estate
was losing value. So-called mark-to-market accounting forces financial
institutions to take losses in their regulatory capital - which
determines how much they can lend - if another bank sells similar loans
at a fire-sale price, even if the loans at the bank in question are
still performing and are being held to maturity.
And now the bailouts are having their own perverse effects by giving
what is seen as a government seal of approval to banks that receive the
money and a black mark to those that don't. The new fear is that
depositors may make a rush to safety and pull out of banks not
receiving the bailout dough.
So the best concrete achievement coming out of this meeting would be
for governments to agree to a timetable to end the bailouts and
denationalize their banks.