Barack Obama and the Democratic majority in Congress need an economics lesson. Greed is not the deadly sin at the root of the current financial crisis. If anything, sloth is. And that means that loading a ton of new regulation on the already highly regulated financial sector will not prevent future crises.
Populist Washington holds that the man behind the trading strategies at Wall Street houses is some latter day Gordon Gekko, a “greed is good” I’ve-got-mine swashbuckler. The truth is anything but. Try instead a guy with Coke bottle glasses tapping exotic programs into his laptop. He is a studious math whiz whom the boyhood Gekko would undoubtedly have taunted had they shared a grade school playground. If you want a portrait of the financial community’s decision makers, don’t rent the late-80s movie “Wall Street”. Grab “Revenge of the Nerds” instead.
The current financial crisis is rooted in innovations that were good in themselves, but later abused, mainly by politicians. In the early 80s, a series of regulatory reforms came out of Washington that opened the way to banks bundling mortgages and selling the packages (called derivatives) on the global capital markets.
In developing these reforms Treasury and the other departments of government had to account for Wall Street’s desire to control the risks inherent in mortgage loans. But at that time the risks were not so much of nonpayment as of early repayment. What the bond markets termed “call protection” was not possible with mortgages. So, working with Wall Street, the regulators opened the door on instruments that allowed selling investors different levels of risk, the so-called traunching feature in mortgage-backed securities and similar financial instruments.
The reforms worked splendidly. New money flowed into the mortgage markets – and soon into markets for consumer debt, commercial paper and a number of other uses. Home ownership for the middle class expanded. Other now fundable economic sectors grew. Investors received competitive returns.
The financial instruments involved were, however, highly complex. Each was tailored to market conditions at the time of its initial sale. More and more elements were added as the years went on, including the default insurance that has now sunk underwriting giant AIG.
With the success of this new (as some called it) “financial technology”, the major Wall Street players came to believe that they could quarantine risk and fund previously untouchable levels of uncertainty. In turn, the markets for the instruments involved became bewilderingly complex numbers games. Specialists understood the slivers of activity that they developed or traded. But, as has become clear in the past few weeks, few if any players fully understood the entire picture.
As everyone now knows, in the 90s,Washington began to understand that Wall Street had revolutionized risk management and decided to get in on the act. Cheaper mortgages for the middle class were not enough, particularly to the Democrats in Congress, who formed the Congressional majority in the period this game flew out of control. What is the financial sector doing for the lower middle class and even the poor, they asked as they pushed for increasingly more risky mortgage lending. After all Fannie Mae and Freddie Mac would take care of defaults.
Political pressure supplemented monetary ease. About five years ago, the Federal Reserve began a long-term campaign to keep interest rates at historic lows. Between the low rates and excessive confidence in their risk calibrating computer models, the financial community met Washington’s demands and then exceeded them.
Wall Street was working earnestly and hard, but in a key way it wasn’t working hard enough. Neither were other global financial players, who participated in a global run up in housing prices. This is where sloth came in. No one was asking, what is the context? What are the assumptions underlying the so-called derivatives markets, particularly in housing? What are the weak points? Where are the vulnerabilities?
The “No one” in this case was comprehensive. It included global financial trading and investment houses, global regulators and finance ministries, global insurers, the global financial media. No one. And why should we expect otherwise? All were looking at the same data. All used the same analytical tools? All were educated at the same schools.
The failure was not unlike that of the tech bubble. In the late 90s the Fed loosened monetary policy, in part in anticipation of a Y2K meltdown. With Silicon Valley in overdrive, the venture capital community funded vast numbers of on-line ventures, not realizing that regulatory barriers absolutely prevented a build-out in Internet speeds and capacity at a pace that would allow most ventures to achieve viability in an acceptable timeframe if the financial environment changed. No one at any level appears to have asked about the interplay of political and monetary policy factors that might crash the dance and end it.
But even if some players had understood the context and the factors that could stop the music, it might not have mattered. Plenty of people – from the Wall Street Journal editorial board to former Reagan White House counsel and American Enterprise Institute scholar Peter Wallison – have long warned of the coming insolvency of Fannie Mae and Freddie Mac. Congress brushed them aside. The media largely ignored them. To his credit, John McCain picked up on these warnings early — but not Barack Obama or any player in the now-so-vocal Democratic leadership. Why should we believe warnings in other areas of the current crisis would have brought different results?
So this is the lesson to keep in mind. Whatever we do in adding regulations, the next crisis will come as a surprise to everyone, just as this one did, just as the burst of the tech bubble did. The fault here is not in twisted passions but limited vision. It is a human fault. Whether one works in financial houses or government agencies or the media, we are all subject to it. We all have been in the past. We all will continue to be in the future.
Clark S. Judge is managing director of the White House Writers Group, a Washington-based policy and communications firm. He was a speechwriter to President Reagan