[corp-focus] Deregulation and the Financial Crisis

[robert weissman]

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Deregulation and the Financial Crisis
By Robert Weissman
January 22, 2008

It would be nice to write off the current crisis on Wall Street and 
global financial markets as something that only matters to the investor 
class.

Unfortunately, the effects are already being felt in lower-income 
communities around the United States. Worst-case scenarios for what 
spins out from the U.S. mortgage meltdown are truly frightening -- a 
severe world recession is a distinct possibility.

Whether such worst-case scenarios can be averted, or softened -- and 
preventing the recurrence of similar crises in the future -- depends on 
abandoning the laissez-faire financial regulatory regime entrenched over 
the last decade.

The current crisis is the predictable (and predicted) result of a 
massive U.S. housing bubble, which itself can be traced in part to 
global economic imbalances that could have been prevented.

At least five distinct regulatory failures led to the current crisis.

Regulatory Failure Number One: Failure to Manage the U.S. Trade Deficit. 
The housing bubble (as well as the surge in leveraged buyouts of 
publicly traded companies ("private equity")) was fueled by cheap credit 
-- low interest rates. One reason for the cheap credit was an influx of 
capital into the United States from China. China's capital surplus was 
the mirror image of the U.S. trade deficit -- U.S. corporations were 
sending lots of dollars to China in exchange for the cheap stuff sold to 
U.S. consumers.

Regulatory Failure Number Two: Failure to Intervene to Pop the Housing 
Bubble. Along with an influx of capital, Federal Reserve policy kept 
interest rates very low. There were good reasons for the Fed Policy, but 
that did not mean the Fed was helpless to prevent the housing bubble. As 
economists Dean Baker and Mark Weisbrot of the Center for Economic and 
Policy Research insisted at the time, Federal Reserve Chair Alan 
Greenspan simply by identifying the bubble -- and adjusting public 
perception of the future of the housing market -- could have prevented 
or at least contained the bubble. He declined, and even denied the 
existence of a bubble.

Regulatory Failure Number Three: Financial Deregulation and Unchecked 
Financial "Innovation." A key reason that mortgages were made available 
so widely and with such little review of recipients' qualifications was 
a shift in which institutions hold the mortgages. Traditionally, banks 
made mortgages and held them. In the new era, banks and non-bank 
mortgage lenders made loans, but then sold the loans to others. 
Investment banks packaged lots of mortgage loans into "Collateralized 
Debt Obligations" (CDOs) and then sold them on Wall Street, with a 
promise of a steady stream of revenue from interest payments. These 
operations were pretty much unregulated. Despite the supposed 
sophistication of the investors involved, no one took account of how 
shoddy the loans were or -- more fundamentally -- the certainty that 
huge numbers would go bad if and when the housing bubble popped.

Regulatory Failure Number Four: Private Regulatory Failure. It was the 
job of ratings agencies (like Standard and Poor's, and Moody's) to 
assess the CDOs and give investors guidance on how risky they were. They 
failed totally, likely in part because they wanted to maintain good 
relations with the investment banks issuing the CDOs.

Regulatory Failure Number Five: No Controls Over Predatory Lenders. The 
toxic stew of financial deregulation and the housing bubble created the 
circumstances in which aggressive lenders were nearly certain to abuse 
vulnerable borrowers. The terms of your loan don't matter, they 
effectively purred to borrowers, so long as the value of your house is 
going up. Lenders duped borrowers into conditions they could not 
possibly satisfy, making the current rash of foreclosures on subprime 
loans inevitable. Effective regulation of lending practices could have 
prevented the abusive loans, but none was to be found.

Unfortunately, the consequences of the mortgage meltdown go far beyond 
the foreclosure epidemic, as horrible a toll as that is taking. The 
entanglement of the financial sector with mortgage instruments, and the 
ripple effects of the housing bubble, has made lenders uncertain of who 
even among large corporations and financial institutions is credit 
worthy. The resulting credit crunch endangers the functioning of the 
global economy. Financial markets are guessing wildly about the 
prospects of banks, insurers and other financial corporations, and the 
plunging value of stocks poses immediate dangers to the real global 
economy.

Less acute, but probably more profoundly, the popping of the housing 
bubble is driving down home prices. U.S. consumer demand over the last 
five years has been driven by consumers borrowing against the increased 
value of their homes; with housing values falling, that process is 
working in reverse. The depressed housing market is also ravaging the 
construction sector, a nontrivial portion of the U.S. economy. A serious 
recession looms as a real possibility.

Mitigating these harms and preventing the worst now depends on active 
and interventionist government -- a government stimulus plan, and 
aggressive efforts to force lenders to adjust mortgage terms and let 
people stay in their homes. Preventing financial panics of the kind now 
underway require new standards of transparency and regulation for high 
finance. The coming days and months will tell whether any lessons have 
been learned.

Robert Weissman is editor of the Washington, D.C.-based Multinational 
Monitor, <http://www.multinationalmonitor.org> and director of Essential 
Action <http://www.essentialaction.org>.

(c) Robert Weissman

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